**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-K**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**For the fiscal year ended December 31, 2006**

**OR**

**o**                                  TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**For the transition period from                      to                      **

**Commission file number: 000-51846**

**CLAYTON HOLDINGS, INC.**

(Exactname of registrant as specified in its charter)

| **Delaware**                                                     |   | **20-2660764**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
| **2  Corporate Drive  Shelton, Connecticut**                     |   | **06484**                             |
| (Address of principal  executive offices)                        |   | (Zip Code)                            |

 

**(203)926-5600**

**(Registrant’stelephone number, including area code)**

**[None]**

**(Formername, former address and former fiscal year, if changed since last report)**

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| Title of each class                     | ** ** | **Name of each exchange on which registered** |
|-----------------------------------------|------------|-----------------------------------------------|
| Common Stock, $0.01 Par Value Per Share |       | The Nasdaq Global Market                      |

 

**Securitiesregistered pursuant to Section 12(g) of the Act:**None

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act. Yes o No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|---------------------------|---------------------|-------------------------|

 

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

As of June 30, 2006, the last business day of theregistrant’s most recently completed second fiscal quarter, the aggregatemarket value of the registrant’s common stock held by non-affiliates of theregistrant was $137,268,122 (based on the closing price for the registrant’scommon stock on the Nasdaq Global Market of $13.05 per share). At February 28,2007, 20,996,735 shares of the registrant’s common stock were outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

The registrant intends to file a proxy statementpursuant to Regulation 14A within 120 days of the end of the fiscal year endedDecember 31, 2006. Portions of such proxy statement are incorporated byreference into Part III of this Annual Report on Form 10-K.

 

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**TABLEOF CONTENTS**
|                   | ** ** | ** **                                                                                                                      | ** ** | ** ** | **Page** | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| **PART I**   |       |                                                                                                                            |       |       |     |
| Item 1.           |       | Business                                                                                                                        |       | 2          |     |
| Item 1A.          |       | Risk Factors                                                                                                                    |       | 13         |     |
| Item 1B.     |       | Unresolved Staff Comments                                                                                                       |       | 22         |     |
| Item 2.           |       | Properties                                                                                                                      |       | 22         |     |
| Item 3.           |       | Legal Proceedings                                                                                                               |       | 22         |     |
| Item 4.           |       | Submission of Matters to a  Vote of Security Holders                                                                            |       | 22         |     |
| **PART II**  |       |                                                                                                                            |       |       |     |
| Item 5.           |       | Market for Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities             |       | 23         |     |
| Item 6.           |       | Selected Consolidated Financial  Data                                                                                           |       | 26         |     |
| Item 7.           |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations       |       | 29         |     |
| Item 7A.          |       | Quantitative and Qualitative  Disclosures About Market Risk                                                                     |       | 46         |     |
| Item 8.           |       | Financial Statements and  Supplementary Data                                                                                    |       | 46         |     |
| Item 9.           |       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure                  |       | 46         |     |
| Item 9A.          |       | Controls and Procedures                                                                                                         |       | 46         |     |
| Item 9B.          |       | Other Information                                                                                                               |       | 47         |     |
| **PART III** |       |                                                                                                                            |       |       |     |
| Item 10.          |       | Directors and Executive  Officers of the Registrant                                                                             |       | 47         |     |
| Item 11.          |       | Executive Compensation                                                                                                          |       | 48         |     |
| Item 12.          |       | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                  |       | 48         |     |
| Item 13.          |       | Certain Relationships and  Related Transactions                                                                                 |       | 48         |     |
| Item 14.          |       | Principal Accounting Fees  and Services                                                                                         |       | 48         |     |
| **PART IV**  |       |                                                                                                                            |       |       |     |
| Item 15.          |       | Exhibits, Financial  Statement Schedules                                                                                        |       | 49         |     |
| **SIGNATURES**    |       | 50                                                                                                                              |       |
| **EXHIBIT INDEX** |       | 52                                                                                                                              |       |
|                   |            |                                                                                                                                 |            |            |          |            |  |

 

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**PART I**

***Item 1.****                          Business*

*Certain statements in this Annual Report on Form 10-Kare “forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended (the “Securities Act”), and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Thesestatements involve a number of risks, uncertainties and other factors thatcould cause our actual results, performance or achievements to be materiallydifferent from any future results, performance or achievements expressed orimplied by these forward-looking statements. Factors which could materiallyaffect such forward-looking statements can be found in the section entitled “RiskFactors” in Part 1, Item 1A. in this Annual Report on Form 10-K.Investors are urged to consider these factors carefully in evaluating theforward-looking statements and are cautioned not to place undue reliance onsuch forward-looking statements. The forward-looking statements made herein areonly made as of the date hereof and we will undertake no obligation to publiclyupdate such forward-looking statements to reflect subsequent events orcircumstances.*

*Referencesin this Annual Report on Form 10-K to “Clayton,” the “Company,” “we,”“us” or “our” are to Clayton Holdings, Inc., a Delaware corporation, andits subsidiaries.*

**Overview**

We provide a fullsuite of outsourced services, mortgage-related analytics and specializedconsulting services for buyers and sellers of, and investors in,mortgage-related loans and securitizations. Our services include:

·       transactionmanagement, which consists of due diligence and mortgage processing servicesfor buyers of mortgage loans (conduit support services);

·       professionalstaffing;

·       complianceproducts and services;

·       oversightand reporting on mortgage-backed securities (credit risk management andsurveillance); and

·       specializedloan servicing services (special servicing), and consulting services.

We use proprietary technology and processes to providethese services throughout the full lifecycle of a loan, from loan origination,aggregation and securitization to the surveillance and administration of loansand securities.

We provide a majority of our services to participantsin the non-agency mortgage-backed securities, or MBS, market and the non-conformingmortgage loan market. We have long-standing client relationships with many ofthe leading capital markets firms, banks and lending institutions, includingthe largest MBS issuers/dealers, mortgage and bond insurance companies andfixed income investors. We believe that we are a leading provider of theseservices to our clients due to our 16 years of experience, our deep knowledgeof the industry and our database of non-conforming loan transactions. During2006, we performed detailed analyses on over 940,000 loans totaling over $170.0billion in principal value, which represented approximately 9.1% of the totalprincipal balance of U.S. non-conforming mortgage loan originations over suchperiod. As of December 31, 2006, we were monitoring over $418.0 billion inloans underlying MBS, which represented 22.8% of the total outstanding U.S.non-agency MBS at such date.

Conforming residential mortgage loans are loans thatadhere to the underwriting guidelines of the government sponsored entities, orGSEs, such as the Government National Mortgage Association (Ginnie Mae), theFederal National Mortgage Association (Fannie Mae) or the Federal Home LoanMortgage Corporation (Freddie Mac). Non-conforming residential mortgage loansare loans that do not meet the 

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underwriting guidelines ofthe GSEs, typically because of one or a combination of the following: loansize, borrower credit profile, loan to value ratio, documentation or type ofloan.

MBS issued by GSEs are referred to as agency MBS, andhave historically comprised a majority of the residential MBS that have beenissued. A large segment of the MBS market includes private-label, ornon-agency, issuers such as capital markets firms and banks.

We generate the majority of our revenue from theservices we provide to support the large non-agency MBS and non-conformingmortgage loan markets. In 2006, the aggregate principal value of new issuancesof non agency MBS was $1,146 billion, up from $136 billion in 2000, althoughthe 2006 total was down slightly from $1,191 billion in 2005. The principalbalance of non-conforming mortgage loan originations was $1.9 trillion in 2006,up from $390 billion in 2000. Securitization rates for non-conforming mortgageloans have increased from 34.6% in 2000 to 58.8% in 2006. We believe the volumeof non-agency MBS securitizations and non-conforming mortgage loan originationswill be lower in 2007 than in 2006. We expect these markets will have moderategrowth over the long term. We believe there will be continued demand for andavailability of new loan products and increased home ownership driven in partby first-time homeowners, minorities and immigrants. Further, we believe thatseveral trends support the demand for our services, including the growth inoutsourced services by capital markets firms and other major mortgage loanmarket participants, the increased complexities and requirements of federal,state and local regulations applicable to the mortgage loan industry, investors’growing demand for loan performance data, fueled in part by the downturn in thenon-prime mortgage loan market and the movement by buyers toward purchasingsmaller pools of loans from a larger number of sellers.

As a result of the growth in non-conforming mortgageloan originations and the concurrent growth in, and market demand for,non-agency MBS, loan buyers, sellers and MBS investors seek specializedoutsourced services, information-based analytics and specialty consulting whenbuying, selling or servicing mortgage-related loans and securities.

We have achieved strongfinancial results, with revenue increasing from $52.1 million in fiscal 2002 to$239.2 million in fiscal 2006. Income from operations increased from $9.8million in fiscal 2002 to $22.5 million in fiscal 2006.

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**Our ServiceOfferings**

Ourservices, as depicted in the following diagram, support the principal stages inthe lifecycle of a mortgage loan.

****

**TransactionManagement**

Transaction managementservices have historically constituted a majority of our business. We provide afull range of outsourced transaction management services to our clients,including due diligence, compliance services, conduit support services andstaffing. We combine our extensive knowledge of, and experience in, loanorigination, servicing, securitization and project management with an approachtailored to our clients’ needs. Through our consulting business we adviseclients on issues related to business process improvement, risk management,regulatory compliance, and technology enablement. For the years ended December 31,2006, 2005 and 2004, transaction management revenue accounted for 79.9%, 83.6%and 88.4%, respectively, of total revenue.

***Due Diligence Services***

Our due diligence services primarily help loan buyersand sellers make better decisions on how they price portfolios and manage risk.We consult with our clients to customize the scope of each due diligenceassignment based on factors such as the client’s history and experience withthe seller, the size and experience of the seller, the representations andwarranties to be provided to the buyer, the type of loan and the quality of thedata. We provide our services through our internal proprietary systems includingthe Clayton Loan Analysis System, or CLAS, our High Cost Analyzer, or HCA, ourpool of independent loan review specialists and our employees. We provide duediligence services on residential, commercial and consumer loans.

The followingsummary describes several key services available in a representativetransaction involving due diligence on residential loans, which constitute amajority of the loans we review:

·       *Data Integrity:*   We verify andenhance data presented to us by the seller. We accomplish this through the useof electronic checks and edits, manual data integrity checks and datacomparison.

·       *Credit Underwriting:*   Aided by CLAS,we review and assess the credit quality of each loan by re-underwriting it tothe seller’s origination guidelines and/or buyer’s credit guidelines. We assign

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preliminary credit eventgrades of 1, 2 or 3 (which denote, respectively, whether the loan is withinbenchmark guidelines, outside of the guidelines but should be considered forpurchase based upon compensating factors, or outside of the guidelines andshould be rejected) to each loan and then subsequently reconcile thedifferences, if any, between the buyer and the seller.

·       *Regulatory Compliance:*   We reviewloans for regulatory compliance using the proprietary compliance module of ourCLAS system. This module, which incorporates relevant laws and regulations andis monitored by our internal compliance specialists and periodically reviewedby our external legal counsel, filters loan data against relevant federal,state and local high cost and predatory lending regulations (including the HomeOwnership and Equity Protection Act and Truth in Lending Act) for the presenceof material exceptions. The module then renders a decision and assigns apreliminary compliance event grade indicating whether the loans are compliant,need additional review due to lack of evidentiary documentation or contain acompliance exception to be addressed. After reconciliation, we assign finalevent grades to the loans and deliver the results to the buyer.

·       *Fraud:*   We have developed a fraudreview methodology that combines our proprietary process with vendor-basedfraud detection solutions. We can also integrate the results from a loan buyer’spreferred fraud detection vendor into our system. Our review process includes averification of borrower identity, residence, employment, property and closingprocedures. We also perform a legal document review of the note, mortgage, riders,title and mortgage insurance details. We review loans for possible fraud andflag those indicating characteristics requiring further evaluation. The flaggedloans are thoroughly researched and the results are reported to the buyer (andif the buyer permits, the seller). If items can be cured, the relevant loansare marked for purchase by the buyer. Items which remain open are reported tothe buyer for further evaluation.

·       *Property Valuations:*   In addition toproviding various property valuation management services, we also use thirdparty valuation providers and internal resources to revalue or perform anadditional review of the property. Our objective is to assess and enhance thelevel of confidence in property values*.*Wereport to the buyer those loans with collateral value variances outside ofpre-determined tolerance levels.

·       *Trailing Document Collection:*   Wemanage the collection of any additional documentation required to underwriteloans presented to the buyer for purchase. Missing documents are identifiedduring the initial file review and the applicable loans are flagged asappropriate. These loans are forwarded to our resolutions team which initiatesthe curing process. The team reviews the trailing documentation and through adesignated client service manager, informs the potential buyer (and if thebuyer permits, the seller) if the documentation provided was sufficient toclear a pending condition.

Presently, the majority ofour due diligence services is conducted at our loan sellers’ facilities by ourindependent loan review specialists. Our centralized underwriting facilities inShelton, Connecticut and Tampa, Florida replicate the capabilities of anon-site due diligence team, while limiting related travel costs. Clients mayship loan files electronically or by conventional mail delivery to thesefacilities. Our acquisition of substantially all of the assets of NISYS, Inc.in March 2005 enhanced our ability to move our process to a paperlessenvironment, increasing the efficiency with which we deliver our services andthe ability to deliver our services from a centralized platform. Thecentralized underwriting facilities provide us and our clients with significantcost-savings, and we expect to shift a greater volume of due diligence servicesto centralized underwriting operations in the future.

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***Conduit Support Services***

Our conduit support services provide the technologyand systems required to manage key aspects of a buyer’s loan acquisitionpipeline, including overall process management, due diligence, fulfillment,funding and integration with third-party service providers. Typically, conduitsact as the financial intermediary between loan originators and investors. Weprovide our clients with a flexible processing platform which can be readilymodified to support their purchase of individual mortgage loans and small andmid-size mortgage pools from a variety of originators, regardless of volume.

In addition to thedue diligence services described above, we may perform the followingoperational functions as part of our conduit support services:

·       *Creation of a Loan Servicing and Custodian Data Set:*   Tofacilitate the purchase of loans, we collect all data fields required by athird party to begin servicing the loans which are purchased through theconduit as well as those required by the custodian. This data set is convertedinto the format required by the servicer or custodian and subsequentlydelivered to the servicer or custodian on a timely basis.

·       *Loan File Management:*   We manage themaintenance, access and delivery of original loan files including copying,imaging and/or storage.

·       *Seller Support Desk:*   We maintain aseller support desk where sellers can call to discuss individual loan statusand issues, as well as commitment status.

·       *Reporting:*   Reports and loan status are made availablefor both the buyer and the related seller via our password protected website,clayton.com. The website enables the user to view current and archived duediligence results, stratify portfolios and perform in-depth analysis, andmanage master commitment contracts associated with a set of mortgagedeliveries.

***Professional Staffing Services***

Through our staffingservices, clients obtain access to qualified independent mortgage loanprofessionals to augment their staffs on both a long- and short-term basis.Clients can utilize these mortgage loan professionals to manage specialprojects and satisfy cyclical or unforeseen demand, while reducing humanresource cost and risk. We typically provide these services to our clients aspart of an existing or potentially broader relationship.

***Compliance Products***

We provide our proprietarycompliance testing engine through the High Cost Analyzer suite, or HCA, tomarket participants including loan originators. HCA is an on-line tool that isused to verify that loans comply with the most recent and relevant predatorylending regulations at the federal, state and local levels. Our team ofcompliance specialists regularly update HCA and it is reviewed periodically byexternal legal counsel. HCA’s unique filtering approach can test and identifyall loans for additional detailed analysis, as necessary, to ensure compliancewith new or changing predatory lending regulations. Originators have begun totest for loan compliance as a safeguard against originating a loan that willnot be funded due to non-compliance and to mitigate the potential decreasedvalue of selling a non-compliant loan into the secondary market.

**Surveillance andSpecial Servicing**

Our surveillance andspecial servicing businesses extend our services beyond the origination processto the later stages in the life of a loan, including ongoing monitoring andmanagement of loans in the securitization process. These services also provideperformance data which we believe, when linked to data 

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collectedin our up-front transaction management services, will allow our clients to moreeffectively assess risk at the point of underwriting/origination.

***Credit Risk Management and Surveillance***

Through Clayton Fixed Income Services, formerly TheMurrayhill Company, we provide surveillance and credit risk management servicesto MBS underwriters, issuers, services and investors. These services consist ofoversight and reporting on predominantly residential non-agency MBS. Thesecredit risk management and surveillance services are typically contract-basedfor the remaining life of the security. Frequently, our efforts result in cashrecoveries and uncover costly systemic errors for our clients.

Our credit riskmanagement activities are centered on seven core processes, and may include anyof the following:

·       *Data Verification*.   We conduct aninitial review and verification of key mortgage loan data provided by servicersor other third parties.

·       *Loan-level Surveillance.*   Ouranalysts utilize a proprietary risk-filtering technology to identify loans thatpresent a higher degree of risk to the performance of the transactions. Forexample, our technology searches for loans with significant declines in value,indications of fraud, lengthy foreclosure timelines and loans withcharacteristics that do not fit the applicable criteria of the securitization.Such loans receive increased oversight that proactively mitigatessecuritization losses.

·       *Loan Repurchases.*   We identify loansthat may be subject to repurchase or replacement as a result of a failure tomeet the applicable securitization criteria and such loans may be repurchasedor replaced by the seller. We also facilitate the repurchase process in certaininstances.

·       *Loss Analysis.*   We scrutinize lossesin the portfolio searching for miscellaneous processing errors, such asduplicate fees, high escrow advances, overstated legal fees and questionablebroker fees.

·       *Prepayment Premium Analysis*.   Frequently,the securitizations that we monitor contain loans with prepayment penalties. Wemonitor the loans that have been paid in full to ensure that any applicablepenalties are collected and remitted properly.

·       *Mortgage Insurance Analysis*.   Manyloans within the securitizations that we monitor have mortgage insurance. Weoversee these loans to ensure that coverage is accurate, claims are filed andprocessed in a timely manner and proceeds are collected and remitted properly.

·       *Remittance Reconciliation*.   We revieweach cash remittance to ensure that it reconciles with the monthly loan leveldata.

One of our signature services is the Clayton FixedIncome Services “Value Add” notification which we send to clients to notifythem of situations in which we have uncovered errors resulting in savings tothe MBS investor. During 2004, through our Value Add notifications, we notifiedclients of more than $48.0 million in potential increased collections orcost savings. During 2006 and 2005, we sent Value Add notifications identifyingerrors representing more than $143.8 million and $79.6 million,respectively, in potential savings.

We also evaluate servicers for operational qualityusing our proprietary benchmarking methodology that gauges a servicer’soperational quality relative to its servicing volume and its industry peers. Weregularly consult with servicers to help them improve their operations andenhance the overall performance of the pools of loans they service and thecorresponding MBS.

For the years ended December 31,2006, 2005 and 2004, surveillance revenue accounted for 14.6%, 12.2% and 7.8%,respectively, of total revenue.

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***Special Servicing***

Our special servicing activities facilitate themanagement and disposition of sub-performing and non-performing loans.Sub-performing and non-performing loans are typically classified as loans wherethe borrower/obligor is over 30 days delinquent, and include loans forwhich the lienholder may, in the future, take possession through foreclosureproceedings. We believe that this service is countercyclical to our originationfocused services as economic conditions which typically have a negative impacton origination volume also tend to lead to rising delinquencies and defaults.

Our services include comprehensive loan management fordefaulted and delinquent loans, collection management and oversight, lossmitigation, foreclosure and bankruptcy administration, eviction and real estateowned (REO) disposition oversight. We use our proprietary Mortgage AssetRecovery System, or MARS, to assess risk and value enhancement alternatives,and to identify optimal asset disposition methods.

In August 2005, we signed an agreement with aunit of a major capital markets institution to perform servicing management forconforming and non-conforming mortgage loans. The agreement contained anexclusivity provision that expired in February 2007. Pursuant to thisagreement, we entered into a subservicing agreement with a major mortgageservicing company that acts as a front end servicer on loans that are owned byour client. The front end servicer handles the collection and application ofpayments on mortgage loans, as well as accounting and administrative functions.

The services wedirectly provide include:

·       oversightof transfer of loan documents and data to the servicer;

·       frontend servicer collection oversight;

·       lossmitigation;

·       investorreporting review and reconciliation;

·       foreclosuremanagement and monitoring;

·       evictioninitiation and monitoring;

·       bankruptcymanagement and monitoring;

·       preliminaryproperty preservation and security; and

·       REOreferral and monitoring.

For the years ended December 31,2006, 2005 and 2004, special servicing revenue accounted for 5.5%, 4.2% and3.8%, respectively, of total revenue.

**CompetitiveStrengths**

We believe that wehave developed a strong reputation among our clients and that we have thefollowing competitive strengths:

·       *Long-term Relationships with Industry Participants.*   Weprovide our services to the leading buyers and sellers of, and investors in,residential and commercial loan portfolios and securities. Our clients includemajor capital markets firms, banks and lending institutions, including thelargest MBS issuers/dealers, mortgage and bond insurance companies and fixedincome investors. During 2006, 2005 and 2004, we worked with each of the 10largest non-agency MBS underwriters, as ranked by *Inside MBS & ABS*, which accounted for 73%, 73% and78% of total underwriting volume during those respective periods.

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·       *Deep Market Expertise, Experienced Professionals andProprietary Technology.*    As a pioneer in providing outsourcedmortgage loan related services to institutional participants in the mortgageindustry, we have developed considerable industry experience and a largedatabase of loan information. We believe that we were the first significantservice provider in the industry to build a technology platform to refine thedue diligence process from a primarily manual process to a highly automated,computer-driven review. Our highly trained and experienced professionals assistclients across all stages of the loan lifecycle, and can access our experience,process and data, which we refer to as our intellectual capital, from thousandsof historical transactions to strengthen their recommendations and analysis.

·       *Comprehensive Suite of Outsourced Services andMortgage-Related Analytics.*   We provide a comprehensive suiteof outsourced services, mortgage-related analytics and specialized consultingservices to the mortgage loan and MBS industries. Our services and informationsupport the lifecycle of a loan from origination through maturity, with dataand analytics aggregated and utilized by us and our clients. Our servicescombine our core expertise in transaction management and due diligence and oursophisticated technology.

·       *Scalable and Flexible Operating Model.*   Weoperate a highly scalable and flexible operating model based on a proprietarytechnology platform, large database of mortgage loan information and aflexible, mobile workforce of experienced, qualified and trained independentloan review specialists. We have invested significant time and money developingour technology platform, which is capable of analyzing high volumes of data andgenerating accurate information and reports for our clients. With a substantialdatabase of information already amassed and an advanced technology platform inplace, we believe we are well-positioned to profitably grow our business.

·       *Critical Position at the Nexus of Loan Buyers,Sellers and Investors.*   Our comprehensive suite of outsourcedservices, industry experience, large database of loan information, numerous andlong-standing relationships with leading capital market participants and strongreputation have positioned us at the nexus of mortgage loan portfolio buyers,sellers and investors. Through the services we provide, we perform necessaryfunctions across the lifecycle of a loan and effectively act as a facilitatorfor the loan buyer and investor communities.

Through the combination ofour due diligence and surveillance business units, we are able to link loanorigination data with ongoing loan performance data to enable sophisticateddata aggregation, dynamic reporting capabilities and advanced loan analytics.This seamless delivery of a broad spectrum of centralized services andinformation that supports the lifecycle of a loan helps our clients make betterbuying decisions.

**Clients**

Since 1990, our clients have included many of theleading capital markets firms, banks and lending institutions, mortgage andbond insurance companies, MBS issuers/dealers, conduits and fixed incomeinvestors.

For the year ended December 31, 2006, revenuefrom our largest two clients, Deutsche Bank and Morgan Stanley, accounted foran aggregate of 23.8% of our total revenue. Each of these clients accounted formore than 10% of our total revenue.

For the year endedDecember 31, 2005, revenue from our largest two clients, Lehman Brothersand Morgan Stanley, accounted for an aggregate of 24.1% of our total revenue.Each of these clients accounted for more than 10% of our total revenue.

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**Segment Information**

Note 18, SegmentInformation, to the Consolidated Financial Statements provides financialinformation about our segments. Beginning October 1, 2006, we havereclassified our financial information for the last three fiscal years to reflectour new internal organization by transaction management, special servicing andsurveillance segments. During 2006, we restructured the management andoperations of our businesses and realigned our segment reporting to match thesechanges.

**Financial Informationabout Geographic Areas**

We have no materialforeign operations.

**InformationTechnology**

***Proprietary Technology***

We use proprietary technology to improve quality andproductivity, facilitate client interaction, organize knowledge and capture thefull value of data collected. Our technology is supported by a networkinfrastructure that is designed to securely handle large amounts of data. Ourproprietary technology applications include:

*ClaytonLoan Analysis System, CLAS Conduit and CLAS Reporting Tool.**  *Our due diligence process utilizesthe CLAS application. CLAS collects data and verifies it for accuracy duringthe on-site and centralized underwriting loan file review process.Additionally, CLAS accommodates all mortgage loan and other asset types and isa customizable application that gathers appropriate data depending on the scopeof the project. CLAS verifies and tests the reasonableness and accuracy of allcaptured data. The system also has the ability to produce reports that identifyemerging trends, while providing a real-time overview of asset quality.

*HighCost Analyzer.**  *HCAis a web-based application derived from CLAS that helps market participantsidentify loans that exceed federal, state and local predatory lendingthresholds. Our experienced compliance professionals monitor changes in lawsand regulations and update HCA accordingly. In addition, HCA is integrated witha leading on-line publisher of reference information and forms for theresidential mortgage lending industry. This integration provides direct accessto applicable predatory lending legislation, and streamlines the researchprocess for compliance professionals.

*Scout.**  *Scout is an application thatsupports image-enabled due diligence. Scout accepts electronic images throughsecure file transfer protocol (sftp), DVD and CD. Images are processed, indexedand presented in our customized web-based viewer. In addition, the systemutilizes OCR (Optical Character Recognition) to capture data from the loanimages and present the data to a team for verification of accuracy. Scout thentransfers data to CLAS and pre-populates fields based on the data collected.

*Clayton.com.**  *Clayton.com facilitates dataconversion, analysis and electronic due diligence. Clayton.com is our portalthrough which clients, employees and our independent loan review specialistsaccess reports and communicate with each other on transactions they are managing.Our conduit support services also use clayton.com to provide information toloan buyers and sellers as to the status of the loan acquisition process.

*MortgageAsset Recovery System.**  *MARSis a proprietary servicing platform that assesses risk and value enhancementalternatives and identifies the optimal asset disposition methods for bothperforming and non-performing loans.

*Clayton Fixed IncomeServices Report Archive.**  *Report Archive is a secure web-based application usedby our clients to download prior and current Credit Risk Manager reports forindividual securitizations.

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***Technology Infrastructure***

Our technology infrastructure is comprised ofnetworks, data centers, and multiple independent local area networks located inShelton, Connecticut; Tulsa, Oklahoma; Indianapolis, Indiana; Tampa, Florida;Denver, Colorado; and Costa Mesa, California. Our business applications run onboth shared and dedicated platforms, and when necessary, are accessible fromeach of our operating locations. These interlinked networks and data centersincrease system availability in the event of an unplanned businessinterruption.

Our architecture accommodates high volumes oftransactions and load balance processing across multiple servers, assuringavailability in the event of a single component hardware or system failure. Byutilizing clustering and load balancing technologies, each web, application anddatabase tier can scale horizontally as transactional volume increases overtime.

Our primary data center islocated in Shelton, Connecticut. Our application, network and voiceinfrastructure are housed in a secure, environmentally controlled data centerwith 24-hour system monitoring and threshold alerting. Access to thefacilities is controlled through the use of individually issued magnetic accesssecurity cards. We use proprietary network security architecture withprocedural requirements for network address translation, port filtering andredirection. We employ a redundant firewall infrastructure for layered networktraffic management. In the event of power failure, our data center is protectedby uninterruptible power supply battery backup and a natural gas powergenerator. We also utilize redundant telecommunications lines to ensure highavailability for our voice and data networks. We maintain physical, electronicand procedural safeguards to store and secure client information fromunauthorized access and use, alteration and destruction. Our own policies andprocedures have been developed to protect the confidentiality of clientinformation and to comply with relevant rules and regulations, whilemeeting our clients’ service requirements.

**IntellectualProperty**

We rely on copyright and trade secret law to protectour technology. Additionally, we have developed a number of brands that haveaccumulated substantial recognition in the marketplace, and we rely ontrademark law to protect our rights in that area. We intend to continue ourpolicy of taking all measures we deem necessary to protect our copyright, tradesecret and trademark rights. We regard our internally-developed software asproprietary and utilize a combination of copyright, trade secret laws, internalsecurity practices and employee non-disclosure agreements for intellectualproperty protection. We believe that we hold all proprietary rights necessaryto conduct our business.

In 2001, CFIS filed two patent applications (each withmultiple claims) related to data filtering technology. The first patent relatesto analyzing investment data in a manner that provides a single comprehensivetool for filtering a loan pool to identify characteristics of the loan pool andthe loans in the pool. The second patent relates to an invention that providesmethods useful for the surveillance of loan pools and investing in loan pools,including a method for generating a loss list, for estimating a loss for aloan, and for determining a probability of loss for a loan. These two patentapplications are pending.

In 2004, CFIS filed aprovisional patent application related to its Question Portal, a secure,internet-accessible site that enables us to communicate directly with partiesto a securitization (including servicers, master servicers, and insurancecompanies). The Question Portal technology enables instant communication,tracks all questions and responses and provides a variety of analytics on thetypes of issues, aging of issues and response times of our and a serviceprovider’s personnel. In 2005, we filed a non-provisional patent applicationfor the Question Portal. The application is pending.

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**Competition**

The market for ourservices is highly fragmented, highly competitive and rapidly changing. Wecompete with several providers of due diligence services, the four largestpublic accounting firms, and other providers focused on technology products,staffing services, portfolio management, credit risk management andsurveillance services. Although several organizations compete with us acrossmultiple business lines, we believe no firm competes with us across all of theservice offerings that we provide. We believe the following are the principalfactors by which providers of information-based analytics and knowledge-basedservices to the MBS market compete for business:

·       qualityand depth of underlying databases;

·       breadthof services offered;

·       clientservice and support;

·       proprietarynature of methodologies, databases and technical platform;

·       recognitionas industry leader and developer of the industry standard;

·       levelof brand recognition and credibility as a participant in the secondary market;and

·       performance track recordfor services provided on transactions executed.

**GovernmentRegulation**

Our business is subject tocertain federal, state and local laws and regulations. In particular, oursubsidiaries that provide mortgage loan servicing services are subject tolicensure as a mortgage loan servicer and collection agency in certain states. Asa licensee, these subsidiaries must comply with certain state laws, includingstate collection laws. In addition, these subsidiaries are subject to certainother federal, state and local laws and regulations, including Regulation AB,the Real Estate and Settlement Procedures Act and Regulation X, the EqualCredit Opportunity Act and Regulation B, the Fair Housing Act, the Fair DebtCollection Practices Act, the Fair Credit Reporting Act, Title V of theGramm-Leach-Bliley Act of 1999, and state privacy and data security laws.

**Employees andIndependent Loan Review Specialists**

As of December 31,2006, we employed 589 persons on a full-time basis. In addition, during 2006,we used the services of 1,935 independent loan review specialists and otherqualified independent mortgage loan professionals to perform transaction duediligence and other services for our clients. None of our employees orindependent loan review specialists is represented by a union or is covered bya collective bargaining agreement. We believe that our relations with ouremployees and independent loan review specialists are good. A majority of ourindependent loan review specialists are employed by a professional employeeorganization and assigned to us upon our request. The independent loan reviewspecialists then undergo our thorough training program. The professionalemployee organization assumes responsibility for all payroll, benefits andworkers compensation obligations in connection with the independent loan reviewspecialists. Our agreement with the professional employee organization may beterminated by either party, with or without cause, with 90 days prior writtennotice. Our agreement with the professional employee organization provides uswith staffing flexibility and a greater ability to manage labor and overheadcosts.

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***Item 1A.****                  RiskFactors*

*Set forthbelow are certain risk factors that could harm our business, results ofoperations and financial condition. You should carefully read the followingrisk factors, together with the financial statements, related notes and otherinformation contained in this Annual Report on Form 10-K. ThisAnnual Report on Form 10-K contains forward-looking statements thatcontain risks and uncertainties. Please refer to the discussion of “Forward-LookingStatements” on page two of this Annual Report on Form 10-K inconnection with your consideration of the risk factors and other importantfactors that may affect future results described below.*

**Risks Related toOur Business and Industry**

***Adverse changes inthe mortgage-backed securities, or MBS, market, particularly in the non-agencyor non-conforming sector, the mortgage lending industry or the housing marketcould result in a reduced demand for our services.***

Our business is driven inpart by the MBS market, and in particular the non-agency market, themortgage lending industry and the housing market, each of which is highlysensitive to trends in the general economy, including interest rates, economicconditions, taxation policies, availability of credit, employment levels,stringency of underwriting guidelines and wage and salary levels. Adversechanges in any of these trends, the recent downturn in the non-prime mortgageloan market, including the failure of additional non-prime lenders, or adecline in the sale of both new and existing homes or in home values, could lessenthe demand for mortgage loans, which could result in a reduced demand for ourservices and diminish our revenues. A material reduction in the number of loansavailable for securitization may cause our clients to engage us for fewerservices, which could have an adverse effect on our business and results ofoperations.

***Our profitabilitycan be affected by fluctuations in the volume of activity in the non-primemortgage lending market.***

A large portion of ourrevenue is generated by various services performed for buyers of, or investorsin, non-prime mortgages. Recently, several non-prime mortgage companies haveencountered financial difficulties as a result of increased incidences ofdelinquencies, early payment defaults, first payment defaults and fraud. As aresult, certain buyers of, and some investors in, non-prime mortgages haveadjusted their investment allocations away from non-prime MBS, begun demandinga higher risk premium for their investment or insisted that non-prime lenderstighten their underwriting standards. These developments may, and in some caseshave, increased the cost of capital for non-prime lenders or inhibited theirability to sell their products. As a result, the number of non-prime mortgagesthat are being originated may be reduced. This, in turn, may reduce the volumeof non-prime loans that are being securitized by our customers. Securitizationvolumes are also affected by other factors including the relative demands forsuch loans and mortgage-backed securities evidencing interests in such loans,the cost of credit enhancements, investor perceptions of such loans andmortgage-backed securities, and the risks posed by such products. A sustainedreduction in the volume of securitizations of non-prime mortgages may cause ourclients to engage us for fewer services, which could have an adverse effect onour business and results of operations.

***Higher rates ofloss in pools of loans that we service could result in lower demand for ourservices and damage to our reputation as a loan servicer.***

We are in the business of servicing non-performingmortgage loans. If we experience higher-than-expected levels of loss severityin pools of loans that we service, the demand for our services may be reduced,which would result in a loss of future servicing income and may damage ourreputation as a loan servicer and may impair our ability to attract newclients.

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***A sustaineddownturn in the residential mortgage loan origination business, which is acyclical industry, may adversely affect our business and harm ouroperations.***

The residential mortgagelending origination business has historically been a cyclical industry. Theresidential mortgage lending industry experienced rapid growth from 2001through 2005 due, in large part, to declining interest rates. In 2006, theindustry experienced a slight decline, and is expected to further decline inthe near-term. During periods of rising interest rates, mortgage loan originationsgenerally decrease, as higher interest rates provide reduced economicincentives for borrowers to refinance their existing mortgages. An extendeddecrease in mortgage loan originations may lead to fewer issuances ofmortgage-backed securities and, consequently, demand for our transactionmanagement services may be materially reduced. Our historical performancemay not be indicative of results that would occur in a rising interestrate environment during which our results of operations may be materiallyadversely affected.

***The market for ourservices is highly competitive, and if we are not able to compete effectively,our business and results of operations may be adversely affected.***

The market for ourservices is highly fragmented, intensely competitive and subject to rapidchange. Our existing competitors, or future competitors, may have greatername recognition, larger client bases, better technology or data, easier accessto data, lower priced services or greater financial, technical, personnel orother resources than we have. We compete with several providers of duediligence services, including large accounting firms and other providersfocused on technology products, staffing services, surveillance and specialservicing. Larger competitors with greater technical, personnel and financialresources may be better able to respond to the need for technologicalchanges, compete for skilled professionals, build upon efficiencies based on alarger volume of loan transactions, fund internal growth and compete for marketshare generally. Among the ways in which we may encounter new or increasedcompetition is the hiring or establishment by a competitor of a pool of skilledoffshore workers that can provide many of the same services that we provide atsubstantially lower cost. Also, we may face competition from our clientsif they choose to provide such services internally, as opposed to outsourcingthese services to us, and from third parties who decide to expand theirservices, either organically or through merger or acquisition, to include someor all of the services that we provide. Increased competition could result inlower revenues and higher expenses, which could have an adverse effect on ourbusiness and results of operations.

***The loss of one ormore of our largest clients could adversely affect our business and results ofoperations.***

For the year ended December 31, 2006, revenuefrom our largest two clients, Deutsche Bank and Morgan Stanley, accounted foran aggregate of 23.8% of our total revenue. Each of these clients accounted formore than 10% of our total revenue. We have experienced similar levels ofcustomer concentration in prior years and we expect these levels ofconcentration to continue into the foreseeable future. While we havelong-standing relationships with our major clients, we generally do not havelong-term contracts with these or our other clients. As a result, such clientscould significantly decrease or cease their business with us upon limited or nonotice. Any loss of major clients or a reduction in the type or scope ofservices for which such clients engage us could adversely affect our businessand results of operations.

Additionally, there hasbeen, and may continue to be, substantial merger, acquisition andconsolidation activity in the banking and financial services industry. Thefinancial services industry includes many of our largest clients, and theseclients may seek to diversify their service providers by utilizing ourcompetitors to perform certain services that we provide. If our clientsmerge with or are acquired by other entities that are not our clients, or thatuse fewer of our services, they may discontinue or reduce their use of ourservices. Finally, the larger banks or financial institutions resulting frommergers or consolidations could decide to internally perform some or allof the services that we currently provide or may provide in 

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thefuture, and thus terminate our engagements or decrease the level or volume ofservices we provide. Any of these developments could have an adverse effect onour business and results of operations.

***If we areinefficient in delivering services to our customers, our profit marginsmay decrease and we may not be able to compete effectively.***

The success of ourbusiness depends on delivering high-quality services to our clients in a timelymanner. Our independent loan review specialists are a key component of ourability to deliver services. If we do not properly manage the activities of ourindependent loan review specialists and we experience a decrease in theirproductivity, especially in connection with client engagements that are billedon a per file basis, our profit margins will be adversely affected. In orderto maintain our profit margins in times of decreased productivity, wemay increase the cost of our services to clients, which could result inreduced demand for our services and/or termination of client engagements withus. A reduction in services, a premature termination of engagements or ourinability to increase prices could have an adverse effect on our business andresults of operations.

***Clients canterminate engagements with us at any time.***

A majority of ourtransaction management engagements are project-based. Therefore, theutilization of our independent loan review specialists depends on our abilityto secure additional engagements on a continual basis. Also, if a clientterminates an engagement and we are unable to re-deploy our independent loanreview specialists on another engagement within a short period of time, the independentloan review specialists may seek other opportunities for their services,which would increase our labor, recruiting and training costs and could have anadverse effect on our business and results of operations.

***Maintaining ourprofessional reputation is critical to our future success, and any damage toour reputation may adversely affect our business and results ofoperations.***

Our ability to secure newengagements and recruit and retain qualified employees and independent loanreview specialists depends heavily on our strong reputation in the mortgageloan industry. Because we obtain a majority of our new engagements fromexisting clients, a client’s dissatisfaction with our performance couldseriously impair our ability to secure new engagements from that client and itsaffiliates. Diminution of our business reputation for any reason could make itsubstantially more difficult for us to compete successfully for newengagements.

***Our engagementsmay result in professional liability.***

Our services typicallyinvolve difficult analytical assignments and carry risks of professional andother liability. Many of our engagements involve matters that could have animpact on our clients’ businesses. For example, our clients depend on us toaccurately evaluate compliance with underwriting and regulatory criteria inconnection with their analysis of mortgage securities. If a client incurslosses as a result of the services we provide, the client could threaten orbring litigation in order to recover damages or to contest its obligation topay all or part of our fees. In some cases, a client may seek torecover its losses pursuant to indemnification rights. Litigation alleging thatwe performed negligently or otherwise breached our obligations to the clientcould expose us to significant liabilities and tarnish our reputation. Inaddition to the costs associated with litigation and claims, the perceivedexposure to professional liability may make it more expensive to obtainand maintain insurance, including errors and omissions insurance. While we havenot experienced any such claims or been subject to litigation to date, any suchoccurrence could have an adverse effect on our business and results ofoperations.

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***If we are not ableto maintain accurate, comprehensive or reliable systems and data, we couldexperience reduced demand for our services.***

Our success depends on ourclients’ confidence in the comprehensiveness, accuracy and reliability of ourproprietary systems, transaction data and database of loan information.Additionally, we must continuously monitor changes to state predatory lendingregulations, and update our compliance software and data accordingly. The taskof establishing and maintaining accurate and reliable systems and data is acontinuous, complex, multi-step process. If our data, including the data weobtain from third parties, is not current, accurate, comprehensive or reliableor if there is an error in our systems resulting from events such as miscodingof rules or miscalculations of critical data elements, we could experiencedamage to our reputation or be subject to legal action, either of which couldresult in reduced demand for our services.

***Our business couldbe adversely affected if we are unable to safeguard the security and privacy ofthe personal financial information we receive.***

In connection with ourloan file due diligence reviews and other consulting and advisory services thatwe provide to third parties relating to mortgage loans and mortgage-backedsecurities, we have access to personal financial information of the borrowers.This personal financial information is highly sensitive and confidential. If weor a third party were to misappropriate this information, we potentially couldbe subject to both private and public legal actions. Although we have policiesand procedures designed to safeguard confidential information, we cannot assureyou that these policies and safeguards are sufficient to prevent themisappropriation of confidential information or that our policies and safeguardswill be deemed compliant with any existing or future federal or state laws orregulations governing privacy.

***An interruption in or breach of our informationsystems may result in lost business.***

We rely heavily uponinformation systems to conduct our business. As we implement our growthstrategy this reliance will increase. Any failure or interruption, or breach insecurity, of our information systems or the third party information systems onwhich we rely could significantly impede our ability to operate our business.Although such failures, interruptions or breaches have not occurred in thepast, we cannot assure you that one will not happen in the future, or if theydo occur that we or the third parties on whom we rely will adequately addressthem. We have implemented precautionary measures to avoid systems outages andto minimize the effects of any data systems interruptions, but we have notinstituted fully redundant systems. If we do not build and maintain redundantsystems for our data, current clients may terminate their engagements withus and potential clients may utilize one of our competitors for theirservice needs. The occurrence of any failure, interruption or breach couldsignificantly harm our business. We may be required to expend significantcapital and other resources to license encryption technology and additionaltechnologies to protect against security breaches or to alleviate problemscaused by any breach. We may be liable for any breach in our security andany breach could harm our reputation, reduce demand for our services or causeclients to terminate their relationships with us.

***If we lose theservices of certain key executive officers, we may not be able to executeour business strategy, manage our growth or compete effectively.***

Our future success dependsin large part on the continued service of our key executive officers,including Frank P. Filipps, our Chief Executive Officer, D. Keith Johnson,our President and Chief Operating Officer and Frederick C. Herbst, ourChief Financial Officer. Although we have employment and non-competitionagreements with these executive officers, these individualsmay nevertheless leave us. We cannot assure you that these executiveofficers can be replaced with equally skilled and experienced professionals.Because these executive officers would be difficult to replace, the loss oftheir services could have an adverse effect on our business and results ofoperations.

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***Our business couldsuffer if we are unable to recruit and retain qualified independent loan reviewspecialists.***

Our business requires usto continually recruit and retain highly qualified and experienced independentloan review specialists to perform due diligence and transaction relatedservices. Our failure to recruit and retain a significant number of qualifiedindependent loan review specialists could limit our ability to accept orcomplete engagements and adversely affect our business and results of operations.We face significant competition for these specialists from our directcompetitors as well as other companies that seek highly qualified, highlyeducated candidates. Additionally, our competitors currently solicit andmay hire our independent loan review specialists after they have completedour thorough training program. Competition for these independent loan reviewspecialists may increase labor and training costs, which could have anadverse effect on our business and results of operations.

***Efforts to expand our product offerings beyond ourcurrent markets may not succeed.***

We have focused on sellingour services primarily in the residential non-agency MBS market. Although wecurrently offer services for other consumer and commercial loan types andrelated securities, we may expand further into these and other assetclasses or geographic regions. Efforts to expand our product offerings beyondthe principal market that we currently serve, however, may divertmanagement resources from existing operations and require us to commitsignificant financial resources to developing new product offerings, whichcould have a material adverse effect on our business and results of operations.Moreover, efforts to expand beyond our existing markets may not result inthe creation of new products that achieve market acceptance, create additionalrevenues or become profitable.

***We may make acquisitions that prove unsuccessfulor strain or divert our resources.***

We intend to consideracquisitions of other companies in our industry that could complement ourbusiness, including the acquisition of entities that would expand our serviceofferings, increase our market share or offer access to other asset classesthat we do not currently serve. We have limited experience in completingacquisitions of other businesses. If we do acquire other businesses, wemay not be able to successfully integrate these businesses with our ownand we may be unable to maintain our standards, controls and policies. Wemay fail in our attempt to integrate acquired companies and businesses insuch a way that we can realize cross-selling opportunities and other synergies.Further, acquisitions may place additional constraints on our resources bydiverting the attention of our management from our business operations. Throughacquisitions, we may enter areas in which we have no or limitedexperience, and an acquisition may be unsuccessful in accomplishing theintended benefits of the transaction. Moreover, any acquisition may resultin substantial transaction-related expenses, a potentially dilutive issuance ofequity securities, the incurrence of debt or amortization of expenses andrelated intangible assets, all of which could have an adverse effect on ourbusiness and results of operations.

***We may not be able to manage our growth or meetmarketplace demands effectively.***

We have expandedsignificantly in the last few years and intend to maintain our focus on growth.However, our growth will place additional demands on our resources and wecannot be sure that we will be able to manage our growth effectively. In orderto successfully manage our growth, we may need to:

·       expand and enhance ouradministrative infrastructure;

·       continue to improve ourmanagement, financial and information systems and controls; and

·       recruit, train, manage andretain our employees and our independent loan review specialists effectively.

Continued growth couldplace a strain on our management, operations and financial resources. Inaddition, this growth may adversely affect our ability to service thedemands of our clients or the quality of 

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serviceswe provide. If we are unable to meet these demands, our competitors may beable to gain a greater market share in the transaction management and creditrisk surveillance services market generally, as well as gain a greater share ofour clients’ business. We cannot assure you that our infrastructure,operational, financial and management controls, reporting systems andprocedures, facilities and personnel will be adequate to support our futureoperations or to effectively adapt to future growth. Our expected additionalheadcount and capital investments will increase our costs, which will make itmore difficult for us to offset any future revenue shortfalls by offsettingexpense reductions in the short term. If we cannot manage our growtheffectively, our business and results of operations may be adverselyaffected.

***Changes in theregulation of our business and our failure to comply with applicable laws andregulations may adversely affect our business and results of operations.***

Our business is subject tovarious federal, state and local laws and regulations. Proposals for furtherregulation and changes in existing regulation that affect our business areregularly being introduced and passed in state legislatures and the U.S.Congress. Proposals that are now receiving a great deal of attention includeconsumer protection initiatives relating to privacy and security of customerinformation, and predatory lending regulations. It is possible that one or moreother legislative proposals or regulatory changes may be adopted thatwould have an adverse effect on our business. For example, any changes to thecurrent predatory lending regulations may increase our costs in connectionwith updating and conforming our High Cost Analyzer compliance application, or,conversely, reduce demand for our compliance related services. Our failure tocomply with these laws and regulations could harm our client relationships orour reputation, inhibit our ability to obtain new engagements, and expose us toclass action lawsuits, breach of contract claims, and governmentalproceedings, all of which could have an adverse effect on our business andresults of operations.

***Third partiesmay claim we are infringing their intellectual property rights, ormay infringe upon or design around our intellectual property rights.***

Our competitive position depends largely upon ourproprietary products, processes and services. Third parties, however,may claim that we or our products, systems or operations infringe theirintellectual property rights, and we may be unaware of intellectualproperty rights of others that may cover some aspects of our technology,products or services. Any litigation regarding trademarks, copyrights or otherintellectual property rights could be costly and time consuming, and divert ourmanagement and key personnel from operating our business. If any third partyhas a meritorious or successful claim that we are infringing their intellectualproperty rights, we may be forced to change our products or services or tocompensate such third parties, which may be costly or impractical. Whilewe have not experienced any material claims or been subject to litigation todate, any such occurrence could have an adverse effect on our business andresults of operations.

Our success andcompetitive position depend in part on our ability to obtain and maintainintellectual property rights protecting our products and services. We rely on acombination of copyrights, trademarks, service marks, trade secrets,confidentiality provisions and licensing arrangements to establish and protectour intellectual property and proprietary rights. We have received federaltrademark registrations for CLAYTON and BEYOND DILIGENT, and have filed federaltrademark applications to help protect certain trademarks that we use inconjunction with our business, including HIGH COST ANALYZER, HIGH COST FOCUS,CLAS, MASTEREPORTER and our Clayton logo. Our pending applications may notbe registered by the U.S. Patent and Trademark Office, and third partiesmay challenge the validity or scope of the trademark applications orregistrations. Despite our proprietary rights, there can be no assurance thatothers will not develop similar products, duplicate our products or designaround our products.

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***Our loan agreementcontains operating and financial covenants that may restrict our businessand financing activities.***

We have enteredinto a senior loan agreement providing for a $150.0 million term loan anda $50.0 million revolving line of credit. As of December 31, 2006,the unpaid principal balance of our term loan was $64.6 million. Among otherthings, this senior loan agreement restricts our ability to:

·       incur or guarantyadditional indebtedness;

·       make capital expenditures;

·       create liens;

·       enter into transactionswith affiliates;

·       make loans or investments;

·       sell assets;

·       pay dividends or makedistributions on, or repurchase, our stock; or

·       consolidate or merge withother entities.

In addition, our senior creditfacility requires us to maintain specified financial covenants, which we havecomplied with as of December 31, 2006. The operating and financialrestrictions and covenants in this credit facility, as well as any futurefinancing agreements, may restrict our ability to finance our operations,engage in business activities or expand or pursue our business strategies. Ourability to comply with our obligations under the credit facility may beaffected by events beyond our control. We may not be able to meet thoseobligations. A breach of any of our obligations under the credit facility couldresult in a default, cause any future indebtedness under the revolving line ofcredit that may be outstanding to become immediately due and payable, andterminate all commitments to extend further credit. We cannot assure you thatwe will have sufficient assets to repay our credit facility upon any default.If we were unable to repay any outstanding indebtedness, the bank could proceedagainst the collateral granted to them to secure that indebtedness. We havepledged substantially all of our assets, including certain intellectualproperty, as collateral under the credit facility.

***We have begun to,and will in the future, incur significant increased costs as a result of ouroperating as a public company, and our management will be required to devotesubstantial time and expense to various compliance issues.***

We became a publiclytraded company on March 24, 2006. As a result of becoming apublicly-traded company, we have begun to, and will in the future, incursubstantial additional legal, accounting, and other expenses that we did notincur as a private company. In addition, the Sarbanes-Oxley Act of 2002, alongwith rules promulgated by the SEC and the Nasdaq Global Market, the marketon which our stock trades, have imposed significant new requirements on publiccompanies, including many changes involving corporate governance. Managementand other Company personnel have already begun, and will be required tocontinue, to devote a substantial amount of time to ensuring our compliancewith these regulations. Accordingly, our legal and accounting expenses willsignificantly increase, and certain corporate actions will become moretime-consuming and costly. For example, these regulations may make it moredifficult to attract and retain qualified members of our board of directors andvarious corporate committees, and obtaining director and officer liabilityinsurance will be more expensive.

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***If we have materialweaknesses in our internal controls or the actions we have taken to remediatepreviously identified inadequacies in our internal controls prove ineffective,there could be an adverse effect on our financial reporting.***

Continued improvement ofour internal controls and procedures will be required in order for us to managefuture growth successfully and operate effectively as a public company. Thecontinued improvement of our internal controls, as well as compliance with theSarbanes Oxley Act of 2002, including management’s preparation of its report onour internal control over financial reporting and our independent auditor’sattestation thereof in our Annual Report on Form 10-K for the fiscalyear ending December 31, 2007, is, and will continue to be, costly andwill place a significant burden on management. We have had only limitedoperating experience with the improvements we have made to remediate thepreviously identified significant deficiencies and material weakness in ourinternal controls. We cannot assure you that the remedial measures we havetaken or any future measures will enable us to provide accurate and timelyfinancial reports. Any failure to improve our internal controls and procedurescould result in delays or inaccuracies in reporting financial information, ornon-compliance with SEC reporting and other regulatory requirements, any ofwhich could adversely affect our business and results of operation.

**Risks Related tothe Common Stock and Our Capital Structure**

***There is a limitedhistory of a trading market for our common stock, and the market price of ourcommon stock may be highly volatile or may decline regardless of ouroperating performance.***

There has only been apublic market for our common stock since the completion of our initial publicoffering in late March 2006. The trading market in our common stockmay be volatile. The market prices of the securities of newly publiccompanies have been volatile, and have been known to decline rapidly. Broadmarket and industry conditions and trends may cause fluctuations in themarket price of our common stock, regardless of our actual operatingperformance.

***Future sales of ourshares could adversely affect the market price of our common stock.***

Our stockholders that held our stock prior to ourinitial public offering now hold a significant percentage of ouroutstanding shares of common stock. Any sale (or any distributions bypartnership stockholders to their limited partners followed by a sale) by us orour current stockholders of our common stock in the public market, or theperception that sales could occur, could adversely affect the prevailing marketprice for our common stock.

Substantially all of theholders of our common stock prior to our initial public offering have rights,subject to some limited conditions, to demand that we file a registrationstatement on their behalf to register their shares or that we include theirshares in a registration statement that we file on our behalf or on behalf ofother stockholders. If such demand rights are exercised pursuant to the termsand conditions of the registration rights agreement, we will incur significantexpenses in connection with the filing of such registration statement.Additionally, the filing of a registration statement at the request of thestockholders may divert the attention of our senior management from ourbusiness operations.

***Our directors andcertain significant stockholders exercise significant control overClayton.***

Our directors, andsignificant stockholders and their affiliates, including TA Associates,collectively control a significant percentage of our outstanding commonstock. As a result, these stockholders, if they act together, are able toinfluence our management and affairs and all matters requiring stockholderapproval, including the election of directors and approval of significantcorporate transactions. This concentration of ownership may have theeffect of delaying or preventing a change in control of Clayton and mightaffect the market price of our common stock.

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***We may requireadditional capital in the future, which may not be available to us.Issuances of our equity securities to provide this capital may dilute yourownership in us.***

We may need toraise additional funds through public or private debt or equity financings inorder to:

·       take advantage of expansionopportunities;

·       acquire complementarybusinesses or technologies;

·       develop new services andproducts; or

·       respond to competitivepressures.

Any additional capitalraised through the issuance of our equity securities may dilute yourpercentage ownership interest in us. Furthermore, any additional financing wemay need may not be available on terms favorable to us or at all. Theunavailability of needed financing could adversely affect our ability toexecute our growth strategy.

***Provisions in ourcertificate of incorporation and by-laws may deter third parties fromacquiring us.***

Our certificate ofincorporation and by-laws contain provisions that may make the acquisitionof Clayton more difficult without the approval of our board of directors,including the following:

·       our board of directors isdivided into three classes serving staggered three-year terms;

·       only our board of directorsmay call special meetings of our stockholders;

·       our stockholdersmay take action only at a meeting of our stockholders and not by writtenconsent;

·       we have authorized undesignated preferred stock,the terms of which may be established and shares of which may beissued without stockholder approval;

·       stockholder approval of amendments of our certificateof incorporation or by-laws requires a vote of 75% of our outstanding shares;

·       vacancies on the board of directors may befilled only by the directors;

·       our directors may be removed only for causeby the affirmative vote of the holders of 75% of the votes that allstockholders would be entitled to cast in the election of directors; and

·       we require advance notice for stockholderproposals.

These anti-takeoverdefenses could discourage, delay or prevent a transaction involving a change incontrol of Clayton. These provisions could also discourage proxy contests andmake it more difficult for you and other stockholders to elect directors ofyour choosing and cause us to take other corporate actions that you desire.

***Section 203 of the Delaware General CorporationLaw may delay, defer or prevent a change in control that our stockholdersmight consider to be in their best interests.***

We are subject to Section 203of the Delaware General Corporation Law which, subject to certain exceptions,prohibits “business combinations” between a Delaware corporation and an “interestedstockholder,” which is generally defined as a stockholder who becomes abeneficial owner of 15% or more of a Delaware corporation’s voting stock for athree-year period following the date that such stockholder became an interestedstockholder absent prior approval of our board of directors. Section 203could have the effect of delaying, deferring or preventing a change in controlthat our stockholders might consider to be in their best interests.

21

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***Item 1B.***                  UnresolvedStaff Comments

None.

***Item 2.***                          Properties

Our headquarters arelocated in Shelton, Connecticut, and we have additional offices in Denver,Colorado; Tampa, Florida; Dallas, Texas; Irving, Texas; Costa Mesa, California;Tulsa, Oklahoma; and Indianapolis, Indiana. All of our offices and facilitiesare leased. We do not consider any specific leased facility to be material toour operations. We believe that equally suited facilities are available inseveral other areas throughout the U.S.

Thefollowing table summarizes information with respect these facilities:

| **Location**           | ** ** | ** **                              | ** ** | **Principal Activities** | ** ** | **Area (sq. feet)** | ** ** | **Lease Expiration Date** | ** **       |
|------------------------|------------|-----------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|-------------------------------------|------------------|
| Shelton, Connecticut   |       | Headquarters                            |       |                          | 66,000     |                          |       |                                | 2010 and 2013(1) |   |   |
| Denver, Colorado       |       | CFIS corporate offices  and operations  |       |                          | 46,086     |                          |       |                                | 2009             |   |   |
| Tampa, Florida         |       | Centralized underwriting                |       |                          | 20,152     |                          |       |                                | 2007             |   |   |
| Tampa, Florida         |       | Centralized underwriting                |       |                          | 51,134     |                          |       |                                | 2017             |   |   |
| Dallas, Texas          |       | Conduit services and  backup facilities |       |                          | 20,024     |                          |       |                                | 2008             |   |   |
| Irving, Texas          |       | Commercial due diligence  services      |       |                          | 5,126      |                          |       |                                | 2008             |   |   |
| Costa Mesa, California |       | Sales and administration                |       |                          | 5,467      |                          |       |                                | 2009             |   |   |
| Tulsa, Oklahoma        |       | First Madison Services  operations      |       |                          | 10,419     |                          |       |                                | 2007             |   |   |
| Indianapolis, Indiana  |       | Support for centralized  underwriting   |       |                          | 6,003      |                          |       |                                | 2011             |   |   |
| Indianapolis, Indiana  |       | Support for centralized underwriting    |       |                          | 8,625      |                          |       |                                | 2009             |   |   |

----

(1)          Welease two floors in an office building in Shelton, Connecticut. The lease forone floor expires in 2010 and the lease for the other floor expires in 2013.

***Item 3.***                          LegalProceedings

From time to time, we maybe a party to various claims, suits and complaints. Currently, there are nosuch claims, suits or complaints that, in our opinion, would have a materialadverse effect on our business, results of operations and financial condition.

***Item 4.***                          Submissionof Matters to a Vote of Security Holders

No matters were submitted to a vote of our securityholders through a solicitation of proxies or otherwise during the quarterlyperiod ended December 31, 2006.

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**PART II**

***Item 5.****                          Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities*

**Market Information**

Our common stock is listed and has been traded on theNasdaq Global Market under the symbol “CLAY” since our initial public offeringon March 24, 2006. Prior to that time there was no public market for ourcommon stock.

Thefollowing table sets forth the high and low closing prices of our common stock,as reported by the Nasdaq Global Market, for each of the periods listed.

| ** **                                      | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------------------|------------|----------|------------|---------|------------|
| **2006**                                        |       |     |       |    |       |
| First Quarter  (commencing March 24, 2006) |       | $        | 22.49      |    | $          | 19.75 |   |
| Second Quarter                                  |       | $        | 23.33      |    | $          | 11.45 |   |
| Third Quarter                                   |       | $        | 13.53      |    | $          | 10.29 |   |
| Fourth Quarter                                  |       | $        | 18.94      |    | $          | 11.66 |   |
| **2007**                                        |       |     |       |    |       |
| First Quarter (through  March 16, 2007)    |       | $        | 24.30      |    | $          | 15.18 |   |

 

**Holders**

As of February 28, 2007 there were 16holders of record of our common stock.

**Dividends**

Our board of directors will have discretion indetermining whether to declare or pay dividends, which will depend upon ourfinancial condition, results of operations, capital requirements and such otherfactors as the board of directors deems relevant. Prior to TA Associates’acquisitions of Clayton Services and CFIS, Clayton Services and CFIS wereorganized as S-corporations and each regularly paid dividends to theirstockholders. We currently anticipate that we will retain future earnings forthe development, operation and expansion of our business. Moreover, our seniorloan agreement relating to our senior credit facility imposes restrictions onour ability to declare and pay dividends.

On December 8, 2005,in connection with our recapitalization, we paid an aggregate dividend of$55.85 million to the holders of our series A convertible preferredstock and series B convertible preferred stock. This dividend reduced theaggregate redemption amount that will be paid to holders of our outstandingpreferred stock upon the completion of this offering by $55.85 million.This dividend to our preferred stockholders was a one-time, special dividendand we do not expect to declare any dividends on our preferred stock in thefuture.

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**Securities Authorized For Issuance Under Equity Compensation Plans**

Thefollowing table sets forth information regarding securities authorized forissuance under our equity compensation plans as of December 31, 2006.

| **Plan Category**                                         | ** ** | ** ** | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                              | ** ** | **(c)**                                                                                                          | ** ** |
| Equity compensation  plans approved by security holders(1)     |       |       | 1,470,774  |                                                                                                                                                 |       |                                                                                                             | $          | 6.33                                                                                                                                                                                                             |       |   |   | 1,584,130 |   |   |
| Equity compensation  plans not approved by security holders(2) |       |       | —     |                                                                                                                                                 |       |                                                                                                             | —     |                                                                                                                                                                                                             |       |   | — |   |   |
| Total                                                          |       |       | 1,470,774  |                                                                                                                                                 |       |                                                                                                             | $          | 6.33                                                                                                                                                                                                             |       |   |   | 1,584,130 |   |   |

----

(1)          Includes our 2005 Stock Option and Grant Planand our 2006 Stock Option and Incentive Plan.

(2)          There are no equitycompensation plans in place not approved by shareholders.

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**Performance Graph**

*This performance graph shall not be deemed ‘‘filed’’with the SEC or subject to Section 18 of the Exchange Act, nor shall it bedeemed incorporated by reference in any of our filings under the Securities Actof 1933, as amended.*

Thefollowing line graph compares the cumulative total stockholder return on ourcommon stock with the cumulative total return of the Russell 2000 Index and theDow Jones Wilshire 5000 Financials Index for the period beginning on March 24,2006, the date of our initial public offering, and ending on December 31,2006. We obtained this information from sources that we believe to be reliable,but we do not guarantee its accuracy or completeness. The comparison assumesthe investment of $100 in our common stock and each of the foregoing indicesand reinvestment of all dividends. The total return performance shown on thegraph is not necessarily indicative of future total return performance.

****

| ** **                          | ** ** | **3/24/2006** | ** ** | **3/31/2006** | ** ** | **6/30/2006** | ** ** | **9/30/2006** | ** ** | **12/31/2006** | ** ** |
|-------------------------------------|------------|---------------|------------|---------------|------------|---------------|------------|---------------|------------|----------------|------------|
| Clayton  Holdings, Inc.        |       | $             | 100.00     |          | $          | 100.38        |       | $             | 62.14      |           | $          | 59.86 |   |   | $ | 89.10 |   |   |
| Russell 2000  Index                 |       | 100.00        |       | 101.56        |       | 96.45         |       | 96.88         |       |           | 105.50     |   |   |
| D J Wilshire 5000  Financials Index |       | 100.00        |       | 104.60        |       | 104.08        |       | 111.50        |       |           | 119.57     |   |   |
|                                     |            |               |            |               |            |               |            |               |            |                |            |  |  |  |  |  |  |  |

 

**Recent Sales of Unregistered Securities**

We did not sell anyunregistered securities during the fiscal year ended December 31, 2006.

**Use of Proceeds from Registered Securities**

Not applicable.

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**Purchases of Equity Securities by the Issuer and Affiliated Purchasers**

None.

***Item 6.****                          SelectedFinancial Data*

The following selected consolidated financial datashould be read in conjunction with the section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” in Part II,Item 7. of this Annual Report on Form 10-K and the section entitled “FinancialStatements and Supplementary Data” in Part II, Item 8. of this AnnualReport on Form 10-K.

In accordance with U.S. GAAP relating tocompanies under common control prior to their combination, the financialstatements of the previously separate companies under common control arerestated on a combined basis from the dates of their respective acquisitions bythe controlling entity. Accordingly, for accounting purposes, the date of ourinception was May 24, 2004, the date that TA Associates acquired CFIS, thefirst of the combined entities that were brought under common control. Ourconsolidated results of operations presented on a “Successor Basis” include theaccounts of the holding companies of each of Clayton Services and itssubsidiaries, including First Madison, and CFIS, formerly The MurrayhillCompany, beginning from the dates of the acquisitions of controlling interestsby TA Associates, which were August 2, 2004 and May 24, 2004,respectively. Our consolidated results of operations for the period from January 1,2004 through August 1, 2004, are prepared on a “Predecessor Basis,” andreflect solely the financial position and results of operations of ClaytonServices. *See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Other Factors AffectingComparability.”*

The data presented on a “Successor Basis” for theyears ended December 31, 2006 and 2005 and the period from inceptionthrough December 31, 2004, and as of December 31, 2006, 2005 and 2004is derived from our audited consolidated financial statements includedelsewhere in this Annual Report on Form 10-K. The data presented ona “Predecessor Basis” for the period from January 1, 2004 through August 1,2004 and for the years ended December 31, 2003 and 2002, and as of December 31,2003 and 2002, is derived from our audited consolidated financial statementsthat are not included elsewhere in this Annual Report on Form 10-K.Results for the year ended December 31, 2006 are not necessarilyindicative of results expected for any other future period.

26

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**SELECTED CONSOLIDATED FINANCIAL DATA**

| ** **                                         | ** ** | **Successor**                                                                                       | ** ** | **Predecessor**                           | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                         | ** ** | **Year ended December 31,**                                                          | ** ** | **Inception  through  December 31,** | ** ** | **January 1, 2004  through** | ** ** | **Year ended December 31,** | ** ** |
| ** **                                         | ** ** | **2006**                                                                                            | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **August 1, 2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                         | ** ** | **(Amounts in thousands, except share and per share data)** | ** ** |
| **CONSOLIDATED STATEMENT OF  INCOME:**             | ** ** | ** **                                                                                          | ** ** | ** **                                | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Revenue                                            |       | $                                                                                                   | 239,195    |                                      | $          | 207,502 |   |   | $ | 79,805 | ** ** |   |   | $ | 76,339 | ** ** |   | $ | 85,228 |   | $ | 52,098 |   |
| Cost of services:                                  |       |                                                                                                |       |                                      |       |   |   | ** ** |   |   |   | ** ** |   |   |   |   |   |
| Compensation expense                               |       | 119,050                                                                                             |       | 99,675                                    |       |   | 37,252 | ** ** |   |   | 35,502 | ** ** |   | 39,436 |   | 22,048 |   |
| Travel and related expenses                        |       | 26,110                                                                                              |       | 29,787                                    |       |   | 13,892 | ** ** |   |   | 15,494 | ** ** |   | 17,204 |   | 9,036 |   |
| Other direct costs                                 |       | 9,707                                                                                               |       | 6,066                                     |       |   | 1,304 | ** ** |   |   | 2,668 | ** ** |   | 3,821 |   | 3,709 |   |
| Total cost of services                             |       | 154,867                                                                                             |       | 135,528                                   |       |   | 52,448 | ** ** |   |   | 53,664 | ** ** |   | 60,461 |   | 34,793 |   |
| Gross profit                                       |       | 84,328                                                                                              |       | 71,974                                    |       |   | 27,357 | ** ** |   |   | 22,675 | ** ** |   | 24,767 |   | 17,305 |   |
| Operating expenses                                 |       |                                                                                                |       |                                      |       |   |   | ** ** |   |   |   | ** ** |   |   |   |   |   |
| Salaries and benefits                              |       | 23,166                                                                                              |       | 18,911                                    |       |   | 6,553 | ** ** |   |   | 3,783 | ** ** |   | 4,403 |   | 3,861 |   |
| Other selling, general and administrative expenses |       | 20,206                                                                                              |       | 17,181                                    |       |   | 6,417 | ** ** |   |   | 4,276 | ** ** |   | 3,960 |   | 2,615 |   |
| Depreciation and amortization                      |       | 7,917                                                                                               |       | 4,694                                     |       |   | 1,115 | ** ** |   |   | 792 | ** ** |   | 1,163 |   | 1,051 |   |
| Amortization of intangibles                        |       | 10,299                                                                                              |       | 10,175                                    |       |   | 4,509 | ** ** |   |   | — | ** ** |   | — |   | — |   |
| Impairment of intangibles                          |       | 279                                                                                                 |       | 1,632                                     |       |   | — | ** ** |   |   | — | ** ** |   | — |   | — |   |
| Total operating expenses                           |       | 61,867                                                                                              |       | 52,593                                    |       |   | 18,594 | ** ** |   |   | 8,851 | ** ** |   | 9,526 |   | 7,527 |   |
| Income from operations                             |       | 22,461                                                                                              |       | 19,381                                    |       |   | 8,763 | ** ** |   |   | 13,824 | ** ** |   | 15,241 |   | 9,778 |   |
| Other income                                       |       | —                                                                                              |       | —                                    |       |   | — | ** ** |   |   | — | ** ** |   | 315 |   | 315 |   |
| Interest expense, net                              |       | 8,031                                                                                               |       | 8,189                                     |       |   | 3,066 | ** ** |   |   | 178 | ** ** |   | 268 |   | 82 |   |
| Loss from extinguishment of debt                   |       | 886                                                                                                 |       | 2,991                                     |       |   | — | ** ** |   |   | — | ** ** |   | — |   | — |   |
| Income before provision for income taxes           |       | 13,544                                                                                              |       | 8,201                                     |       |   | 5,697 | ** ** |   |   | 13,646 | ** ** |   | 15,288 |   | 10,011 |   |
| Income tax expense (benefit)                       |       | 5,668                                                                                               |       | 3,153                                     |       |   | 2,354 | ** ** |   |   | 260 | ** ** |   | (62 | ) | (48 | ) |
| Net income                                         |       | $                                                                                                   | 7,876      |                                      | $          | 5,048 |   |   | $ | 3,343 | ** ** |   |   | $ | 13,386 | ** ** |   | $ | 15,350 |   | $ | 10,059 |   |
| Pro forma net income(1)                            |       |                                                                                                |       |                                      |       |   |   | ** ** |   |   | $ | 8,324 | ** ** |   | $ | 9,326 |   | $ | 6,107 |   |
| Pro forma net income per  share(2)                 |       |                                                                                                |       |                                      |       |   |   | ** ** |   |   |   | ** ** |   |   |   |   |   |
| Basic                                              |       | $                                                                                                   | 0.43       |                                      | $          | 0.42 |   |   | $ | 0.37 | ** ** |   |   | $ | 0.82 | ** ** |   | $ | 0.92 |   | $ | 0.60 |   |
| Diluted                                            |       | $                                                                                                   | 0.41       |                                      | $          | 0.41 |   |   | $ | 0.37 | ** ** |   |   | $ | 0.82 | ** ** |   | $ | 0.92 |   | $ | 0.60 |   |
| Pro forma weighted  average shares(2)              |       |                                                                                                |       |                                      |       |   |   | ** ** |   |   |   | ** ** |   |   |   |   |   |
| Basic                                              |       | 18,497,195                                                                                          |       | 11,888,671                                |       |   | 9,034,350 | ** ** |   |   | 10,162,309 | ** ** |   | 10,162,309 |   | 10,162,309 |   |
| Diluted                                            |       | 19,281,552                                                                                          |       | 12,304,627                                |       |   | 9,095,537 | ** ** |   |   | 10,162,309 | ** ** |   | 10,162,309 |   | 10,162,309 |   |
| *(Amounts  in thousands)*                          | * *   | * *                                                                                            | * *   | * *                                  | * *   | * * | * * | ** ** | * * | * * | * * | ** ** | * * | * * | * * | * * | * * |
| **ADDITIONAL DATA:**                               | ** ** | ** **                                                                                          | ** ** | ** **                                | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |
| Adjusted EBITDA(3)                                 |       | $                                                                                                   | 40,956     |                                      | $          | 35,882 |   |   | $ | 14,387 | ** ** |   |   | $ | 14,616 | ** ** |   | $ | 16,719 |   | $ | 11,144 |   |

 

| ** **                                     | ** ** | **Successor**                         | ** ** | **Predecessor** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|-----------------|------------|
| ** **                                     | ** ** | **As of December 31,** | ** ** |
| ** **                                     | ** ** | **2006**                              | ** ** | **2005**        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)**  | ** ** |
| **SELECTED CONSOLIDATED BALANCE  SHEET DATA:** | ** ** |                                  | ** ** | ** **      |       |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                     |       |                                  | $          | 22,882          | ** ** |   |   | $ | 7,209 | ** ** |   | $ | 12,450 |   | $ | 4,669 |   | $ | 67 |   |
| Accounts  receivable, net                      |       |                                  | 37,452     | ** **      |       |   | 37,205 | ** ** |   | 21,658 |   | 22,047 |   | 13,148 |   |
| Unbilled  receivables, net                     |       |                                  | 14,951     | ** **      |       |   | 14,926 | ** ** |   | 17,655 |   | 9,049 |   | 5,739 |   |
| Goodwill                                       |       |                                  | 73,402     | ** **      |       |   | 69,843 | ** ** |   | 46,179 |   | — |   | — |   |
| Intangibles  assets, net                       |       |                                  | 75,007     | ** **      |       |   | 84,740 | ** ** |   | 96,522 |   | — |   | — |   |
| Total assets                                   |       |                                  | 262,913    | ** **      |       |   | 247,505 | ** ** |   | 218,247 |   | 42,554 |   | 22,138 |   |
| Revolving credit  facility and term loans      |       |                                  | 64,599     | ** **      |       |   | 150,000 | ** ** |   | 41,777 |   | 10,429 |   | 1,100 |   |
| Subordinated and  senior subordinated notes    |       |                                  | —     | ** **      |       |   | — | ** ** |   | 29,486 |   | — |   | — |   |
| Series A  convertible preferred stock     |       |                                  | —     | ** **      |       |   | 12,258 | ** ** |   | 27,190 |   | — |   | — |   |
| Series B  convertible preferred stock     |       |                                  | —     | ** **      |       |   | 43,867 | ** ** |   | 74,513 |   | — |   | — |   |
| Total stockholders’  equity               |       |                                  | 157,729    | ** **      |       |   | 12,542 | ** ** |   | 7,224 |   | 25,771 |   | 16,421 |   |
|                                                |            |                                       |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)                As an S-corporation, our Predecessor was not subject tocorporate level Federal income taxes. For comparison purposes, for allPredecessor periods we have presented pro forma net income, which reflectsincome taxes assuming we had been a C-corporation during such periods andassuming a combined tax rate of 39.0% for Federal and state income taxes. Thepro forma net income information is unaudited.

(2)                For all Predecessor periods, pro forma net income pershare and pro forma weighted average shares assume we had been a C-corporationsince the beginning of the period presented. The pro forma net income per shareand pro forma weighted average shares information is unaudited. For allSuccessor periods, pro forma net income per share and pro forma weightedaverage shares are the actual net income per share and weighted average sharesfor the period presented.

(3)                Earnings Before Interest, Taxes,Depreciation and Amortization (“EBITDA”) represents income from operationsbefore interest expense, income taxes, depreciation and amortization. For theyear ended December 31, 2006, EBITDA has been adjusted for loss fromextinguishment of debt and impairment of intangibles. For the year ended December 31,2005, EBITDA has been adjusted for loss from extinguishment of debt and 

27

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impairment ofintangibles. EBITDA does not represent and should not be considered as analternative to net income or cash flow from operations, as determined by U.S.GAAP. We present Adjusted EBITDA because we believe that it is widely acceptedthat EBITDA provides useful information regarding our operating results. Werely on Adjusted EBITDA primarily as an operating performance measure in orderto review and assess our operations and our management team. For example, ourmanagement incentive compensation is based in part upon our achieving minimumEBITDA targets for a given year. Our loan covenants with our primary lender aremeasured using EBITDA as a key liquidity measure. We believe that it is usefulto investors to provide disclosures of our operating results on the same basisas that used by our management. We also believe that it can assist investors incomparing our performance to that of other companies on a consistent basiswithout regard to depreciation, amortization, interest or income taxes, whichdo not directly affect our operating performance. EBITDA has limitations as ananalytical tool, and you should not consider it in isolation, or as asubstitute for analysis of our results as reported under U.S. GAAP. Some ofthese limitations are:

·         EBITDA does not reflect our cashexpenditures, or future requirements, for capital expenditures or contractualcommitments;

·         EBITDA does not reflect changes in, orcash requirements for, our working capital needs;

·         EBITDA does not reflect the significantinterest expense, or the cash requirements necessary to service interest orprincipal payments, on our debts;

·         Although depreciation and amortization arenon-cash charges, the assets being depreciated and amortized will often have tobe replaced in the future, and EBITDA does not reflect any cash requirementsfor such replacements; and

·         Other companies in our industry maycalculate EBITDA differently than we do, limiting its usefulness as acomparative measure.

A reconciliationof Adjusted EBITDA to income before provision for income taxes is set forthbelow:

| ** **                               | ** ** | **Successor**                              | ** ** | **Predecessor**                           | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **Year ended December 31,** | ** ** | **Inception  through  December 31,** | ** ** | **January 1, 2004  through August 1,** | ** ** | **Year ended December 31,** | ** ** |
| ** **                               | ** ** | **2006**                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                               | ** ** | **(Dollars in thousands)**       | ** ** |
| Income before provision for income taxes |       |                                       | $          | 13,544                                    |       |   |   | $ | 8,201 |   |   |   | $ | 5,697 |   |   |   | $ | 13,646 |   |   |   | $ | 15,288 |   |   |   | $ | 10,011 |   |   |
| Interest expense, net                    |       |                                       | 8,031      |                                      |       |   | 8,189 |   |   |   | 3,066 |   |   |   | 178 |   |   |   | 268 |   |   |   | 82 |   |   |
| Loss on extinguishment of debt           |       |                                       | 886        |                                      |       |   | 2,991 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Impairment of intangibles                |       |                                       | 279        |                                      |       |   | 1,632 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Depreciation and amortization            |       |                                       | 18,216     |                                      |       |   | 14,869 |   |   |   | 5,624 |   |   |   | 792 |   |   |   | 1,163 |   |   |   | 1,051 |   |   |
| Adjusted EBITDA                          |       |                                       | $          | 40,956                                    |       |   |   | $ | 35,882 |   |   |   | $ | 14,387 |   |   |   | $ | 14,616 |   |   |   | $ | 16,719 |   |   |   | $ | 11,144 |   |   |

 

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***Item 7.****                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations*

*You should read the following discussion inconjunction with our consolidated financial statements and related notesthereto. In addition to historical information, this discussion containsforward-looking statements that involve risks, uncertainties and assumptionsthat could cause actual results to differ materially from management’sexpectations. Factors that could cause such differences include those describedin “Risk Factors” in Part 1, Item 1A. in this Annual Report on Form 10-K.*

**Overview**

We provide a fullsuite of outsourced services, mortgage-related analytics and specializedconsulting services for buyers and sellers of, and investors in,mortgage-related loans and securitizations. Our services include transactionmanagement, which consists of due diligence and mortgage processing servicesfor buyers of mortgage loans (conduit support services), professional staffingservices, and compliance products and services, oversight and reporting onmortgage-backed securities (credit risk management and surveillance), andspecialized loan servicing (special servicing) and consulting services. Weprovide a majority of our services to participants in the non-agency mortgage-backedsecurities, or MBS, market and the non-conforming mortgage loan market. Webelieve that several trends support the demand for our services, including:

·       the growth in outsourcedservices by capital markets firms and other major mortgage loan marketparticipants;

·       the increased complexitiesand requirements of federal, state and local regulations applicable to themortgage loan industry;

·       investors’growing demand for operational risk assessment and loan performance data; and

·       buyers purchasing smallerpools of loans from a larger number of sellers, increasing the need for ourconduit support services.

Our revenue is also driven by non-agency MBS issuanceand the aggregate number of non-conforming mortgage loan originations. Changesin the volume of non-agency MBS issuances and non-conforming mortgage loanoriginations may impact the number of loans for which we perform ourservices, leading to a corresponding change in gross revenue. We areincreasingly utilizing our centralized underwriting facilities toperform our services which should reduce the amount of per loantravel expenses.

We believe the volume ofnon-agency MBS securitizations and non-conforming mortgage loan originationswill be lower in 2007 than in 2006. We expect these markets will experiencemoderate growth over the long term. We believe there will be continued demandfor and availability of new loan products and increased home ownership drivenin part by first-time homeowners, minorities and immigrants. We face anumber of risks in our industry and the market for our services is highlycompetitive. Our business is driven in part by the MBS market, themortgage lending industry and the housing market, each of which is highlysensitive to trends in the general economy, including interest rates, perceivedand actual economic conditions, taxation policies, availability of credit,employment levels, more strict underwriting guidelines and wage and salarylevels. Adverse changes in any of these trends, the recent downturn in the non-primemortgage loan market, including the failure of additional non-prime lenders, ora decline in the sale of both new and existing homes or in home values, couldlessen the demand for mortgage loans, which could result over time in a reduceddemand for our services and diminish our revenue. A material reduction in thenumber of loans available for securitization may cause our clients toengage us for fewer services, which could have an adverse effect on ourbusiness and results of operations. Moreover, the majority of our business isgenerated through our largest 20 clients. The loss of one or more of theseclients could adversely affect our business and results of operations. Lastly,we are dependent on our independent loan 

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reviewspecialists to perform our services. Our business could suffer if we areunable to recruit and retain additional qualified independent loan reviewspecialists.

**Basis ofPresentation**

We were formed as aDelaware corporation in March 2005, following the combination of theholding companies of each of Clayton Services and its subsidiaries, includingFirst Madison, and CFIS, formerly The Murrayhill Company, or Murrayhill. Priorto the combination, each holding company was controlled by investment fundsaffiliated with TA Associates. In accordance with US GAAP relating to companiesunder common control prior to their combination, the financial statements ofthe previously separate companies under common control are restated on acombined basis from the dates of their respective acquisitions by thecontrolling entity. Accordingly, for accounting purposes, the date of ourinception was May 24, 2004, the date that investment funds affiliated withTA Associates acquired CFIS, the first of the combined entities that werebrought under common control.

**Other FactorsAffecting Comparability**

Our consolidated financial statements present theresults of operations of Clayton Services and CFIS each as of the date of itsacquisition by TA Associates as well as the results of our Predecessor, ClaytonServices, on a stand-alone basis prior to its acquisition by TA Associates. Assuch, the results of operations in the periods covered by our consolidatedfinancial statements may not be directly comparable.

The Predecessor’sconsolidated financial results do not reflect the effects of:

·       theacquisitions of each of CFIS and Clayton Services by TA Associates, whichresulted in $83.9 million of amortizable intangible assets, which is beingamortized over an average life of 12.0 years;

·       additionaldebt of $74.5 million incurred as a result of the acquisitions of each ofCFIS and Clayton Services by TA Associates, which resulted in increasedinterest expense;

·       revenues,expenses and operational results of CFIS and First Madison;

·       transactionrelated expenses incurred in connection with the combination of CFIS andClayton Services into Clayton Holdings;

·       additionalexpenses incurred in preparation for becoming a public company including auditfees, professional fees, increased directors and officers insurance, boardcompensation and expenses related to hiring additional personnel and expandingour administrative functions;

·       increaseddepreciation as a result of investment in our technology and financial andadministrative infrastructure in preparation for becoming compliant with therequirements of the Sarbanes-Oxley Act of 2002; and

·       a C-corporation taxstructure, which results in Federal income taxes being incurred by us, whereaspreviously our Predecessor elected to be taxed as an S-corporation and did notpay corporate level Federal income taxes.

**Critical AccountingPolicies**

*Basis ofPresentation*

In preparing our financial statements in conformitywith US GAAP, we have to make estimates and assumptions about future eventsthat affect the amounts of reported assets, liabilities, revenues and expenses,as well as the disclosure of contingent assets and liabilities in the financialstatements and accompanying notes. Some of our accounting policies require theapplication of significant judgment by 

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management in theselection of appropriate assumptions for determining these estimates. By theirnature, these judgments are subject to an inherent degree of uncertainty;therefore, we cannot assure you that actual results will not differsignificantly from estimated results. We base these judgments on our historicalexperience, management’s forecasts and other available information, asappropriate.

Our most criticalaccounting policies, which reflect significant management estimates andjudgment in determining reported amounts in the consolidated financialstatements are as follows:

*Revenue Recognition*

Revenue is recognized when persuasive evidence of anarrangement exists, the service has been performed, the fee is fixed anddeterminable, and collection of the resulting receivable is reasonably assured.

We derive most of our revenue from professionalservice activities. Revenue consisting of billed fees and pass-through expensesis recorded as work is performed and expenses are incurred. Revenue alsoincludes expenses billed to clients, which include travel and otherout-of-pocket expenses, and other reimbursable expenses.

We record provisions forfee adjustments and discretionary pricing adjustments as a reduction ofrevenue. Revenue recognized, but not yet billed to clients, has been recordedas unbilled receivables in the Company’s consolidated balance sheets.

*Stock-BasedCompensation*

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Accounting for Stock Based Compensation” which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. This standard requires an issuer to measure the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award. This eliminates the exception toaccount for such awards using the intrinsic method previously allowable underAccounting Principles Board (“APB”) Opinion No. 25. In March 2005,the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-Based Payment,”which expresses views of the SEC Staff about the application of SFAS No. 123(R).SFAS No. 123(R) became effective for annual reporting periodsbeginning on or after June 15, 2005. We previously adopted the fair valuerecognition provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation,” for all awards granted to employees. On January 1, 2006 weadopted SFAS No. 123(R) and it did not have a material impact on ourfinancial statements.

According to the provisions of incentive stock optionagreements between the Company and its employees, the vesting term for certainoptions outstanding as of the date of the IPO accelerated by either one year ortwenty percent, varying in accordance with the terms of the employee’s specificincentive stock option agreement. In addition, 130,208 of performance basedoptions became immediately vested. Therefore, on March 29, 2006, werecognized $611,696 of additional compensation expense from this acceleratedvesting.

Options to purchase230,000 shares were granted in the year ended December 31, 2006 with anaverage exercise price of $14.54 per share.

*Valuation ofLong-lived Assets Excluding Goodwill*

We evaluate all of ourlong-lived assets, including intangible assets other than goodwill and fixedassets, periodically for impairment in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-lived Assets (SFAS No. 144).SFAS No. 144 requires that long-lived assets be evaluated for impairmentwhen events or changes in facts and circumstances indicate that their carryingvalue may 

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not berecoverable. If events or circumstances indicate that the carrying value of anasset may not be recoverable, we assess the recoverability of identifiedintangible assets by comparing the projected undiscounted net cash flowsassociated with the related asset or group of assets over their remaining livesagainst their respective carrying amounts. The amount of impairment will be measuredas the difference between the carrying value and the fair value of the impairedasset. An impairment will be recorded as an operating expense in the period ofthe impairment and as a reduction in the carrying value of that asset.

*Accounts Receivable*

We are required toestimate the collectibility of accounts receivable. A considerable amount ofjudgment is required in assessing the likelihood of realization of receivables. Relevant assessment factors include thecreditworthiness of the customer, our prior collection history with thecustomer and related aging of past due balances. Specific accounts receivableare evaluated when we believe a customer may not be able to meet its financialobligations due to a deterioration of its financial condition or its creditratings. The allowance requirements are based on the best facts available andare re-evaluated and adjusted on a regular basis and as additional informationis received.

*Intangible Assets*

Intangible assets consist of customer relationships,technology, trade name and trademarks, non-competition agreements and excess ofcost over fair value of net assets acquired, or goodwill. Customerrelationships are the value of the specifically acquired customerrelationships. Technology is the value of recreating the completed technologyinfrastructure. Trade name and trademarks are the value inherent in therecognition of “Clayton” and the other names that we use. The value of thenon-competition agreements are an appraisal of potential lost revenues that wouldarise from an individual initiating a competing enterprise.

Except for goodwill, trade names and trademarks, allintangible assets are stated at cost less accumulated amortization. The costsattributable to the identified intangibles were based on a number ofsignificant assumptions as determined by the Company and its independentappraisal expert. Identifiable intangible assets with finite lives areamortized under the straight-line method over their applicable estimated usefullives.

The Company adopted SFAS No. 142 “Goodwill andOther Intangible Assets” (“SFAS No. 142”), which provides, among otherthings, that goodwill and intangibles with indefinite lives are no longeramortized but are reviewed for impairment at least annually (beginning with thefirst anniversary of the acquisition date). Annual impairment tests wereconducted for Clayton Services and CFIS in 2006 and there was no impairment togoodwill or intangibles with indefinite lives of either entity.

In December 2006, the Company recorded an impairmentcharge of $279,458 to reflect the write-off of certain customer relationshipsassociated with portfolio management.

In October 2005, theCompany’s Board of Directors approved the discontinuance of the use of thetrade name “Murrayhill” and the Company recorded an impairment charge of$1,631,700.

*Income Taxes*

Our effective tax rate is based on pre-tax income,statutory tax rates and tax planning strategies. Significant managementjudgment is required in determining the effective tax rate and in evaluatingour tax position.

Our accompanying Consolidated Balance Sheets includecertain deferred tax assets resulting from deductible temporary differences,which are expected to reduce future taxable income. These assets are based onmanagement’s estimate of realizability based upon forecasted taxable income.Realizability of 

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these assets is reassessedat the end of each reporting period based upon our forecast of future taxableincome and available tax planning strategies, and may result in the recording ofa valuation reserve. Failure to achieve forecasted taxable income could affectthe ultimate realization of certain deferred tax assets.

Management has discussedthe development and selection of these critical accounting estimates with theAudit Committee of our Board of Directors and our Audit Committee has reviewedour disclosures relating to them.

**Revenue**

We generate a majority of our revenue by providingprofessional outsourced services across the lifecycle of a mortgage loan.

Our transaction management services are provided under“time-and-materials” or per file billing arrangements. Under “time-and-materials”arrangements, we bill our clients on an hourly basis with travel and otherreimbursable expenses passed through and recognized as revenue. Under per filebilling arrangements, we bill our clients for each file reviewed with traveland other reimbursable expenses passed through separately or included in theper file rate. Revenues consisting of billed fees and pass-through expenses,which include travel and other reimbursable expenses, are recorded as work isperformed and expenses are incurred. Revenues recognized, but not yet billed toclients, have been recorded as unbilled receivables in our consolidated balancesheets. For the years ended December 31, 2006 and 2005, transactionmanagement revenue accounted for 79.9% and 83.6%, respectively, of totalrevenue.

Our credit risk management, surveillance and specialservicing services provide a revenue stream which is generally recurring innature. In a typical MBS transaction for which we provide surveillanceservices, we are engaged by the trustee of an MBS issuance to provide ourservices over the life of the trust and are paid monthly directly from the cashflow of the trust. A majority of our surveillance revenue is based upon anegotiated rate multiplied by the outstanding principal balance of theunderlying mortgage loans in the MBS issuance. These fees are recognized eachmonth as services are rendered. Our special servicing activities are conductedunder annual or multi-year contracts for which we typically receive revenue ona per loan per month basis as well as incentive fees. For the years ended December 31,2006 and 2005, surveillance and special servicing services revenue accountedfor 20.1% and 16.4%, respectively, of total revenue.

For the year ended December 31, 2006 revenue fromour largest two clients, Morgan Stanley and Deutsche Bank, accounted for anaggregate of 23.8% of total revenue. Each of these clients accounted for morethan 10% of our total revenue.

For the year ended December 31,2005, revenue from our largest two clients, Lehman Brothers and Morgan Stanley,accounted for an aggregate of 24.1% of total revenue.  Each of these clients accounted for more than10% of our total revenue.

**Cost of Services**

*CompensationExpense*

Compensation expenseconsists primarily of compensation for independent loan review specialists andemployees directly involved in the delivery of our services, which include ourclient service managers who manage our engagements. Compensation expense alsoincludes payroll related benefits for our direct employees. The professionalswe retain from a professional employment organization, including ourindependent loan review specialists, do not receive any employee benefits fromus and are only compensated for actual hours worked. Our direct cost ofoperations does not include an allocation of overhead costs.

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*Travel and RelatedExpenses*

Travel and relatedexpenses consist of expenses incurred in enabling employees and independentloan review specialists to travel to clients’ sites and are comprised ofairfare, hotel and car rental expenses. A majority of these expenses is eitherdirectly billed to clients or included in the per file rates charged. As such,these expenses are directly or indirectly included in our revenue.

*Other Direct Costs*

Other direct costs includethe cost of third party mortgage loan services (primarily collateral appraisalfees), outside support for our compliance services used in connection with ourloan reviews, independent loan review specialist training and miscellaneousnon-billable transaction costs.

**Operating Expenses**

Operating expenses primarily consist of corporateoverhead costs not directly associated with a specific transaction or contract,such as salaries and benefits, marketing and administrative expenses,professional fees and depreciation and amortization expenses.

In connection withbecoming a public company, we have incurred significant additional operatingexpenses such as increased audit fees, professional fees, directors andofficers’ insurance costs, compensation for our board of directors, andexpenses related to hiring additional personnel and expanding ouradministrative functions. Many of these expenses either were not incurred orwere incurred at a lower level by us as a private company.

*Salaries andBenefits*

Salaries and benefitsconsist of employee compensation for those employees who are not directlybillable to a particular assignment including costs of administrative, finance,human resources, technology, marketing, business development and executivepersonnel.

*Other Selling,General and Administrative Expenses*

Other selling, general andadministrative expenses consist of costs such as rent and utilities, marketing,advertising and promotion expenses, non-reimbursable travel and entertainment,information technology, insurance, education, training and hiring expensesother than for independent loan review specialists and professional feesconsisting of legal, accounting and other consulting fees in connection withthe ongoing operation of our business including audit and Sarbanes-Oxley Act of2002 compliance.

*Depreciation andAmortization*

We incur depreciation andamortization expenses for costs related to the capitalization of property andequipment and software developed for internal use on a straight-line basis overthe estimated useful lives of the assets, which range from three to sevenyears. Leasehold improvements and assets under capital lease are amortized overthe shorter of the estimated useful life of the asset or the lease term.

*Treatment ofGoodwill and Amortization of Intangibles*

We also incur amortization expenses for costs relatedto the capitalization of identifiable intangible assets including customerrelationships, technology and non-competition agreements.

We account for acquisitions of companies in accordancewith Statement of Financial Accounting Standards (SFAS) No. 141, *Business Combinations* (SFAS No. 141).We allocate purchase price to tangible assets, intangible assets, andliabilities based on fair values with the excess of purchase price amount being

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allocated to goodwill. Theallocation of the purchase price to these intangible assets is based on anumber of significant assumptions as determined by us and in the case ofmaterial acquisitions our independent appraisal expert, including evaluationsof the future income producing capabilities of these assets and related futureexpected cash flows. We also make estimates about the useful lives of theacquired intangible assets. Should different conditions result in thedetermination that the value of the goodwill and acquired intangible assets hasbeen impaired, we could incur write-downs of goodwill or intangible assets, orchanges in the estimation of useful lives of those intangible assets. Inaccordance with SFAS No. 142, *Goodwilland Other Intangible Assets* (SFAS No. 142), goodwill is notamortized, but is subject to annual impairment testing which is discussed ingreater detail below.

In accordance with SFAS No. 142, goodwill issubject to annual impairment tests or on a more frequent basis if events orconditions indicate that goodwill may be impaired. Goodwill is tested forimpairment at a level of reporting referred to as a reporting unit. The firststep of our annual test is to compare the fair value of our shares to thecarrying value of our net assets of the reporting unit. If we determine thatour carrying value exceeds our fair value, we would conduct a second step tothe goodwill impairment test. The second step compares the implied fair valueof the goodwill (determined as the excess fair value over the fair valueassigned to our other assets and liabilities) to the carrying amount ofgoodwill. When the carrying amount of goodwill exceeds the implied fair valueof goodwill, an impairment loss is recognized.

We evaluate all of ourlong-lived assets, including intangible assets other than goodwill and fixedassets, periodically for impairment in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-lived Assets* (SFAS No. 144). SFAS No. 144 requiresthat long-lived assets be evaluated for impairment when events or changes infacts and circumstances indicate that their carrying value may not berecoverable. If events or circumstances indicate that the carrying value of anasset may not be recoverable, the amount of impairment will be measured asthe difference between the carrying value and the fair value of the impairedasset. An impairment will be recorded as an operating expense in the period ofthe impairment and as a reduction in the carrying value of that asset. In December 2006,the Company recorded an impairment charge of $279,458 to reflect the write-offof certain customer relationships associated with portfolio management. In October 2005,the Company’s Board of Directors approved the discontinuance of the use of thetrade name “Murrayhill” and the Company recorded an impairment charge of$1,631,700.

**Net InterestExpense**

Net interest expense consists of interest paid on ourdebt net of interest received on our cash balances.

Interest expense for the year ended December 31,2006 primarily consisted of interest on our term loan, amortization of debtissuance costs related to the term loan and revolving line of credit, andinterest on our revolving line of credit. Our term loan had a balance at January 1,2006 of $150,000,000, and $64,598,998 at December 31, 2006.

Interest expense for the year ended December 31,2005 primarily consisted of interest on our prior term loan, which had abalance of $37,750,000 at the start of the period, and interest on 12% seniorsubordinated and 12% subordinated notes issued to TA Associates and our othernoteholders in connection with the acquisitions of Clayton Services and CFIS, respectively,by investment funds affiliated with TA Associates. Our term loan had a balanceat January 1, 2005 of $37,750,000. The combined balance of the 12% seniorsubordinated and 12% subordinated notes at January 1, 2005 was$29,486,478. The remaining balances of the prior term loan, the 12% seniorsubordinated notes and the 12% subordinated notes were repaid with the proceedsfrom our $150,000,000 term loan on December 8, 2005.

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**Loss fromExtinguishment of Debt**

On March 29, 2006,following our initial public offering, we repaid $70,000,000 of the outstandingbalance on our $150,000,000 term loan and the entire $7,400,000 outstandingbalance on our revolving line of credit. Due to the prepayment of $70,000,000on our term loan, we wrote-off a portion of the debt issuance costs on the termloan and recognized a loss from extinguishment of debt of $746,002. On December 11,2006, we repaid an additional $15,000,000 of the outstanding balance on theterm loan. Due to this repayment, we wrote-off an additional portion of thedebt issuance costs on the term loan and recorded a loss from extinguishment ofdebt of $139,943.

**Results ofOperations**

Thefollowing table sets forth certain operating data as a percentage of totalrevenue for the periods indicated:

| ** **                                         | ** ** | **Successor**                            | ** ** | **Predecessor**                          | ** ** |
|----------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                                         | ** ** | **Year  Ended  December 31,  2006** | ** ** | **Year  Ended  December 31,  2005** | ** ** | **Inception  Through  December 31,  2004** | ** ** | **January 1,  2004  Through  August 1,  2004** | ** ** |
| Revenue                                            |       |                                     | 100.0      | %                                        |       |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |
| Cost of services:                                  |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Compensation expense                               |       |                                     | 49.8       | %                                        |       |   | 48.0 | % |   |   | 46.7 | % |   |   | 46.5 | % |   |
| Travel and related expenses                        |       |                                     | 10.9       | %                                        |       |   | 14.4 | % |   |   | 17.4 | % |   |   | 20.3 | % |   |
| Other direct costs                                 |       |                                     | 4.1        | %                                        |       |   | 2.9 | % |   |   | 1.6 | % |   |   | 3.5 | % |   |
| Total cost of services                             |       |                                     | 64.7       | %                                        |       |   | 65.3 | % |   |   | 65.7 | % |   |   | 70.3 | % |   |
| Gross profit                                       |       |                                     | 35.3       | %                                        |       |   | 34.7 | % |   |   | 34.3 | % |   |   | 29.7 | % |   |
| Operating expenses:                                |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Salaries and benefits                              |       |                                     | 9.7        | %                                        |       |   | 9.1 | % |   |   | 8.2 | % |   |   | 5.0 | % |   |
| Other selling, general and administrative expenses |       |                                     | 8.5        | %                                        |       |   | 8.3 | % |   |   | 8.0 | % |   |   | 5.6 | % |   |
| Depreciation and amortization                      |       |                                     | 3.3        | %                                        |       |   | 2.3 | % |   |   | 1.4 | % |   |   | 1.0 | % |   |
| Amortization of intangibles                        |       |                                     | 4.3        | %                                        |       |   | 4.9 | % |   |   | 5.6 | % |   |   | 0.0 | % |   |
| Impairment on intangibles                          |       |                                     | 0.1        | %                                        |       |   | 0.8 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |
| Total operating expenses                           |       |                                     | 25.9       | %                                        |       |   | 25.4 | % |   |   | 23.2 | % |   |   | 11.6 | % |   |
| Income from operations                             |       |                                     | 9.4        | %                                        |       |   | 9.3 | % |   |   | 11.1 | % |   |   | 18.1 | % |   |
| Other income                                       |       |                                     | 0.0        | %                                        |       |   | 0.0 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |
| Interest expense,  net                             |       |                                     | 3.3        | %                                        |       |   | 3.9 | % |   |   | 3.8 | % |   |   | 0.2 | % |   |
| Loss from  extinguishment of debt                  |       |                                     | 0.4        | %                                        |       |   | 1.4 | % |   |   | 0.0 | % |   |   | 0.0 | % |   |
| Income before provision for income taxes           |       |                                     | 5.7        | %                                        |       |   | 4.0 | % |   |   | 7.3 | % |   |   | 17.9 | % |   |
| Income tax  expense                                |       |                                     | 2.4        | %                                        |       |   | 1.6 | % |   |   | 2.9 | % |   |   | 0.3 | % |   |
| Net income                                         |       |                                     | 3.3        | %                                        |       |   | 2.4 | % |   |   | 4.4 | % |   |   | 17.6 | % |   |
| Pro forma net  income(1)                           |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |   | 10.9 | % |   |

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(1)*         *Asan S-corporation, our Predecessor was not subject to corporate level Federalincome taxes. For comparison purposes, for all Predecessor periods we havepresented pro forma net income, which reflects income taxes assuming we hadbeen a C-corporation during such periods and assuming a combined tax rate of39.0% for Federal and state income taxes. The pro forma income taxes andpro forma net income information are unaudited.

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***Comparison of Years Ended December 31, 2006 and2005***

**Revenue**

Our consolidated revenuewas $239.2 million for fiscal 2006, an increase of $31.7 million or 15.3%,compared to revenue of $207.5 million for fiscal 2005*.*The increase was primarily due to anincrease in volume in our conduit support services, special servicing andprofessional staffing services businesses as well as growth in our surveillanceservices due in part to an increased joint sales effort following thecombination of Clayton Fixed Income Services, Inc. (CFIS) and Clayton. Revenuefor fiscal 2006 included $6.5 million from CLS, following the Company’sacquisition of substantially all of the assets of that business in February 2006.Due to growth in our non-loan related services, our total revenues per loanincreased 13.6%. The number of loans serviced during 2006 increased 1.4% ascompared to fiscal 2005 as growth in our conduit support services offset areduction in loans serviced in our core due diligence business. Revenues per loan in our core due diligence businesswere flat during the period as increased revenue per loan from appraisalsoffset the impact of an increase in the percentage of loans serviced in ourcentral underwriting facility and an increase in the prevalence of other filereviews, in which we verify a limited number of data points in a loan file.

***Transaction Management***

Transaction managementrevenue was $191.1 million for fiscal 2006, an increase of $17.7 million or10.2%, compared to revenue of $173.4 million for fiscal 2005*.*The increase was primarily due to growthin our conduit support services and professional staffing services businessesand the acquisition of CLS. These increases were partially offset by areduction in revenue from our due diligence business due to a reduction in thenumber of loans serviced.

***Special Servicing***

Special servicing revenuewas $13.1 million for fiscal 2006, an increase of $4.3 million or 48.9%,compared to revenue of $8.8 million for fiscal 2005*.*The increase was primarily due to anincrease in monthly management and incentive fees from a special servicingcontract that commenced during the second half of 2005 and growth in ourreverse mortgage servicing operations.

***Surveillance***

Surveillance revenue was$35.0 million for fiscal 2006, an increase of $9.7 million or 38.3%, comparedto revenue of $25.3 million for fiscal 2005*.*The increase was primarily due to an increase in the valueof assets monitored.

**Cost of Services**

Our cost of services was $154.9 million for fiscal2006, an increase of $19.4 million or 14.3%, compared to cost of services of$135.5 million for fiscal 2005. This increase was attributable to the specificfactors discussed below.

*CompensationExpense.**  *Compensationexpense was $119.0 million for fiscal 2006, an increase of $19.4 millionor 19.5%, compared to compensation expense of $99.7 million for fiscal2005*.*The increase was primarilydue to the growth in our conduit support services, surveillance services,professional staffing services, special servicing and consulting businesses, aswell as the acquisition of CLS.

*Traveland Related Expenses.**  *Traveland related expenses were $26.1 million for fiscal 2006, a decrease of$3.7 million or 12.4%, compared to travel and related expenses of$29.8 million for fiscal 2005. Travel expenses per loan decreased by13.6%, as reduced travel expenses per loan in our core due diligence businessoffset increased travel expense in our non-loan related professional staffingservices 

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business. Travel expensesper loan in our core due diligence business declined due to an increase in thepercentage of loans serviced in our central underwriting facility.

*Other Direct Costs.**  *Other direct costs were$9.7 million for fiscal 2006, an increase of $3.6 million or 60.0%,compared to other direct costs of $6.1 million for fiscal 2005. Theincrease was primarily due to an increase in third-party appraisal fees due toan increase in appraisal revenue in our due diligence business.

**Operating Expenses**

Operating expenses were $61.9 million for fiscal 2006,an increase of $9.3 million or 17.7%, compared to operating expenses of$52.6 million for fiscal 2005. This increase was attributable to thespecific factors discussed below.

*Salariesand Benefits.**  *Salariesand benefits were $23.2 million for fiscal 2006, an increase of$4.3 million or 22.8%, compared to salaries and benefits of$18.9 million for fiscal 2005. Salaries and benefits expense for fiscal2006 included $0.6 million of expense related to the acceleration of vesting ofcertain stock options as a result of the Company’s initial public offering in March 2006.The remaining increase was primarily due to the costs of additionaladministrative, finance, human resources, technology and executive personnelwhich were added in preparation for becoming a public company and following theacquisition of CLS.

*OtherSelling, General and Administrative Expenses.**  *Other selling, general andadministrative expenses were $20.2 million for fiscal 2006, an increase of $3.0million or 17.4%, as compared to selling, general and administrative expensesof $17.2 million for fiscal 2005.** **This increase was dueto general increases in occupancy, corporate governance, insurance, recruiting,relocation, non-reimbursable travel and telecommunications costs relating togrowth in our business, the acquisition of CLS, and becoming a public company. Theseincreases were partially offset by reduced consulting expenses and professionalfees.

*Depreciationand Amortization.**  *Depreciationand amortization was $7.9 million for fiscal 2006, an increase of $3.2 millionor 68.1%, compared to depreciation and amortization of $4.7 million forfiscal 2005*.*This increase wasprimarily due to depreciation recorded on additional property and equipment andsoftware developed for internal use. These additions were made to enhance ourcorporate infrastructure and technology platform in support of the growthin business operations and in preparation for becoming a public company.

*Amortizationof Intangibles.**  *Amortizationof intangibles was $10.3 million for fiscal 2006, an increase of $0.1 millionor 1.0%, compared to amortization of intangibles of $10.2 million for fiscal2005.

*Impairment of Intangibles.**  *Impairmentof intangibles was $0.3 million in fiscal 2006, representing the write off in December 2006of certain customer relationships. In October 2005, we discontinued theuse of the trade name “Murrayhill,” and recorded an impairment charge of $1.6million.

**Interest Expense,net**

Interest expense, net was $8.0million for fiscal 2006, a decrease of $0.2 million or 2.4%, compared tointerest expense, net of $8.2 million for fiscal 2005*.*This decrease was due to decreasedborrowings under our credit facilities primarily due to the prepayment of $70.0million owed under our senior term loan following our initial public offeringin March 2006 and higher interest income, partially offset by increasedborrowings outstanding under our credit facilities during the first threemonths of the year prior to our initial public offering. *See “—Liquidity and Capital Resources.”*

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**Loss fromExtinguishment of Debt**

Loss from extinguishmentof debt for fiscal 2006 was $0.9 million due to the write-off of debt issuancecosts as a result of $15.0 million prepayment during the fourth quarter of 2006and a $70.0 million prepayment on our term loan following our initial publicoffering. Loss from extinguishment of debt was $3.0 million in 2005. Inconnection with the execution of our new credit agreement in December 2005,we wrote off unamortized deferred financing costs and paid prepayment feesrelated to our previous debt facilities aggregating $3.0 million. *See “—Liquidity and Capital Resources.”*

**Income Taxes**

Income taxes for fiscal2006 were $5.7 million, an increase of $2.5 million or 78.1%, compared toincome taxes of $3.2 million for fiscal 2005. This increase was primarilydue to changes in taxable income and the effective tax rate. The effective taxrate for 2006 was 41.9% as compared with 38.5% for 2005. This increase wasprincipally due to the establishment of tax reserves and a change in the mix ofearnings.

**Comparison of YearsEnded December 31, 2005 and 2004**

References to results ofoperations for the year ended December 31, 2004 in the following analysisinclude the results of Clayton Services for the entire period and the resultsof CFIS from May 24, 2004 (the date of acquisition of a controllinginterest by TA Associates) through December 31, 2004. References toresults of operations for the year ended December 31, 2005 in thefollowing analysis include the combined results of Clayton Services and CFIS forthe entire period.

**Revenue**

Our revenue was $207.5million for fiscal 2005, an increase of $51.4 million or 32.9%, compared torevenue of $156.1 million for fiscal 2004. Excluding revenue of approximately$25.0 million and $11.8 million attributable to CFIS for fiscal 2005 and 2004,respectively, revenue for fiscal 2005 was $182.5 million, an increase of 26.5%,compared to $144.3 million for fiscal 2004. The increase was primarily due to a25.1% increase in the number of loans for which we performed services. Theincrease in the number of loans for which we performed services was primarilydue to an increase in the issuance of non-agency mortgage backed securitieswhich was influenced by the market factors described earlier. In addition,there was an increase in volume in conduit support services as well as growthin our surveillance services due in part to an increased joint sales effortfollowing the combination of CFIS and Clayton.

***Transaction Management***

Transaction managementrevenue was $173.4 million for fiscal 2005, an increase of $35.3 million or25.6%, compared to revenue of $138.1 million for fiscal 2004*.*The increase was primarily due to higherrevenue from our due diligence business due to an increase in the number ofloans serviced and growth in our conduit support services.

***Special Servicing***

Special servicing revenuewas $8.8 million for fiscal 2005, an increase of $2.9 million or 49.2%,compared to revenue of $5.9 million for fiscal 2004*.*Excludingrevenue of approximately $5.1 million and $2.4 million attributable to FirstMadison Services, Inc. (FMS) for fiscal 2005 and 2004, respectively,special servicing revenue for fiscal 2005 was $3.7 million, an increase of $0.2million or 5.7%, as compared to $3.5 million for fiscal 2004.

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***Surveillance***

Surveillance revenue was$25.3 million for fiscal 2005, an increase of $13.2 million or 109.1%, comparedto revenue of $12.1 million for fiscal 2004*.*Excluding revenue of approximately $25.0 million and $11.8million attributable to CFIS for fiscal 2005 and 2004, respectively,surveillance revenue for fiscal 2005 was flat compared to fiscal 2004.

**Cost of Services**

Our cost of services was $135.5 million for fiscal2005, an increase of $29.4 million or 27.7%, compared to cost of services of$106.1 million for fiscal 2004. Excluding cost of services of approximately$7.0 million and $3.2 million attributable to CFIS for fiscal 2005 and 2004,respectively, cost of services for fiscal 2005 was $128.5 million, an increaseof 24.9%, compared to $102.9 million for fiscal 2004. This increase wasattributable to the specific factors discussed below.

*CompensationExpense.**  *Compensationexpense was $99.7 million for fiscal 2005, an increase of $26.9 million or37.0%, compared to compensation expense of $72.8 million for fiscal 2004.Excluding compensation expense of approximately $6.9 million and $3.2 millionattributable to CFIS for fiscal 2005 and 2004, respectively, compensationexpense for fiscal 2005 was $92.8 million, an increase of 33.2%, compared to$69.6 million for fiscal 2004. The majority of this cost was variable based onthe number of loans for which we performed services. The increase was primarilydue to a 25.1% increase in the number of loans for which we performed servicesas well as a 6.5% increase in the compensation expense per loan. The increasein compensation expense per loan was due primarily to increased training andretention costs for independent loan review specialists, up front costs tosupport a significant increase of a major conduit services client andcompensation expense associated with the growth of non-loan count services,including surveillance services and special servicing.

*Traveland Related Expenses.**  *Travel and related expenses were $29.8 million for fiscal2005, an increase of $0.4 million or 1.4%, compared to travel and relatedexpenses of $29.4 million for fiscal 2004. Travel and related expensesattributable to CFIS during fiscal 2005 and 2004 were immaterial. The increasewas primarily due to a 25.1% increase in the number of loans for which weperformed services. This increase was partially offset by an 18.9% decrease intravel expense per loan. The reduced travel and related expenses per loan werea result of increasing the number of loans reviewed by us at our centralizedunderwriting facilities.

*Other Direct Costs.**  *Other direct costs were $6.1million for fiscal 2005, an increase of $2.1 million or 52.7%, compared toother direct costs of $4.0 million for fiscal 2004. Other direct costsattributable to CFIS during fiscal 2005 and 2004 were immaterial. The increase isprimarily due to increased vendor appraisal fees, legal fees paid in support ofour compliance services and increased shipping and supply costs.

**Operating Expenses**

Operating expenses were $52.6 million for fiscal 2005,an increase of $25.2 million or 91.6%, compared to operating expenses of $27.4million for fiscal 2004. Excluding operating expenses of approximately $11.8million and $5.8 million attributable to CFIS for fiscal 2005 and 2004,respectively, operating expenses for fiscal 2005 were $40.8 million, anincrease of 89.0%, compared to $21.6 million for fiscal 2004. This increase wasattributable to the specific factors discussed below.

*Salariesand Benefits.**  *Salaries and benefits were $18.9 million for fiscal 2005, anincrease of $8.6 million or 83.0%, compared to salaries and benefits of $10.3million for fiscal 2004. Excluding salaries and benefits of approximately $5.5million and $2.9 million attributable to CFIS for fiscal 2005 and 2004,respectively, salaries and benefits for fiscal 2005 were $13.4 million, anincrease of 81.7%, compared to 

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$7.4million for fiscal 2004. This increase was primarily due to the costs ofadditional administrative, finance, human resources, technology and executivepersonnel which were added in preparation for becoming a public company.

*OtherSelling, General and Administrative Expenses.**  *Other selling, general andadministrative expenses were $17.2 million for fiscal 2005, an increase of $6.5million or 60.7%, compared to selling, general and administrative expenses of$10.7 million for fiscal 2004. Excluding other selling, general andadministrative expenses of approximately $2.7 million and $1.7 millionattributable to CFIS for fiscal 2005 and 2004, respectively, other selling,general and administrative expenses for fiscal 2005 were $14.5 million, anincrease of 61.0%, compared to $9.0 million for fiscal 2004. This increase waspartially due to specific increases in professional fees consisting of legal,accounting and other consulting fees in connection with the ongoing operationof our business including audit and Sarbanes-Oxley Act of 2002 compliance, andpartially due to general increases in occupancy, telephone, non-reimbursabletravel, insurance, professional, and advertising and promotion costs relatingto growth in our business.

*Depreciationand Amortization.**  *Depreciation and amortization was $4.7 million for fiscal2005, an increase of $2.8 million or 146.1%, compared to depreciation andamortization of $1.9 million for fiscal 2004. Excluding depreciation andamortization of approximately $0.4 million and $0.2 million attributable toCFIS for fiscal 2005 and 2004, respectively, depreciation and amortization forfiscal 2005 was $4.3 million, an increase of 160.3%, compared to $1.7 millionfor fiscal 2004. This increase was primarily due to depreciation recorded onadditional property and equipment and software developed for internal use.These additions were made to enhance our corporate infrastructure andtechnology platform in support of the growth in the business operations and inpreparation for becoming a public company.

*Amortizationof Intangibles.**  *Amortization of intangibles was $10.2 million for fiscal2005, an increase of $5.7 million or 125.7%, compared to amortization ofintangibles of $4.5 million for fiscal 2004. This increase was due toamortization of intangible assets created in connection with the acquisition ofCFIS and Clayton Services by TA Associates. Amortization of such intangiblesbegan in May 2004.

*Impairment of Intangibles.**  *Impairment of intangibles was$1.6 million in fiscal 2005. In October 2005, we discontinued the use ofthe trade name “Murrayhill,” and recorded an impairment charge of $1.6 million.

***Interest Expense, net***

Interest expense, net was$8.2 million for fiscal 2005, an increase of $5.0 million or 152.4%, comparedto interest expense, net of $3.2 million for fiscal 2004. The increase wasprimarily due to interest expense incurred in connection with the issuance ofsenior subordinated debt in connection with the acquisition of CFIS by TAAssociates in May 2004 and the issuance of subordinated debt in connectionwith the acquisition of Clayton Services by TA Associates in August 2004,the establishment of the revolving line of credit and term loan inAugust 2004 and the completion of a new credit agreement in December 2005.See *“—Liquidity and Capital Resources.”*

***Loss from Extinguishment of Debt***

Loss from extinguishmentof debt was $3.0 million in 2005. In connection with the execution of our newcredit agreement in December 2005, we wrote off unamortized deferredfinancing costs and paid prepayment fees related to our previous debtfacilities aggregating $3.0 million.

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***Income Taxes***

Income taxes for fiscal2005 were $3.2 million, an increase of $0.6 million or 23.1%, compared toincome taxes of $2.6 million for fiscal 2004. As an S-corporation, ourPredecessor was not subject to corporate level Federal income taxes for theperiod January 1, 2004 through August 1, 2004.

**Liquidity andCapital Resources**

Historically, we have financed our growth from cashflow from operations and bank borrowings. We believe that funds generated fromoperations, together with existing cash and available borrowings under ourcredit agreement, will be sufficient to finance our current operations, plannedcapital expenditures and internal growth at least through the next twelvemonths. On March 29, 2006, we issued 8,625,000 shares of common stock, including1,125,000 shares issued through the exercise of the underwriters’over-allotment option, at a price of $17.00 per share through our initialpublic offering of common stock.

On February 28, 2006, the Company’s Board ofDirectors approved a 1-for-4 reverse stock split. All share and pershare amounts in the accompanying consolidated financial statements have beenretroactively adjusted for all periods of the Successor presented, to giveeffect to the reverse stock split.

Immediately priorto the completion of the offering, the following transactions occurred:

·       all of our 357,020outstanding shares of class B common stock converted into 357,020 sharesof common stock.

·       our series Aconvertible preferred stock converted into 2,206,308 shares of common stock and8,825,241 shares of series A redeemable preferred stock.

·       our series Bconvertible preferred stock converted into 6,046,371 shares of common stock and24,185,493 shares of series B redeemable preferred stock.

Our net proceeds of$131.8 million, net of $14.8 million of offering expenses and the underwritingdiscount, were used to:

·       redeem $52.8 million ofredeemable preferred stock that resulted from the conversion of our Series Aconvertible preferred stock and Series B convertible preferred stockimmediately prior to the completion of the initial public offering.

·       repay $70.0 million owedunder the senior term loan portion of our credit facility.

·       repay $7.4 million owedunder the revolving credit portion of our credit facility.

·       fund $1.6 million ofworking capital.

On February 3, 2006, we acquired substantiallyall of the assets and assumed certain liabilities of CLS (formerly known asMortgage Resource Network) for an aggregate purchase price and fees aggregatingapproximately $5.3 million. Working capital was used to fund the acquisition ofsuch assets and assumed liabilities. CLS is engaged in the business ofproviding outsourced mortgage processing and fulfillment services to themortgage industry, including mortgage brokers, lenders and securitizers.

Our operating activities provided cash of $35.8million, $3.9 million and $28.8 million in fiscal 2006, 2005 and 2004,respectively. Cash provided from operations is generated primarily from netincome and the timing of accounts receivable collections and disbursements ofaccounts payable. Cash provided from operations in 2006 was generated from netincome of $7.9 million plus $20.9 million of non cash charges plus $7.0 millionfrom a net decrease in current assets, primarily due to an increase inaccrued expenses and a decrease in prepaid taxes and prepaid expenses. Cashprovided by operations in 2005 resulted from $5.0 million of net incomeplus $19.3 million of non cash charges and was negatively impacted by a netincrease in operating assets of $20.4 million primarily from an increase in thebalance of accounts 

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receivable****as a result of an increase in the amountof time receivables remained outstanding. Cash provided from operations in 2004was generated from net income of $16.7 million plus $6.7 million of non cashcharges plus $5.4 million from a net decrease in current assets, primarilydue to an increase in accrued expenses partially offset by an increase inunbilled receivables. We believe cash flow from operations will be sufficient tofinance our current operations for the next twelve months.

Our investing activities used cash of $14.3 million,$35.2 million and $129.6 million in fiscal 2006, 2005 and 2004, respectively.Cash used in investing activities in 2006 primarily consisted of the CLSacquisition and capital expenditures. Cash used in investing activities in 2005primarily consisted of capital expenditures and the acquisition ofsubstantially all of the assets of NISYS, Inc. Cash used in investingactivities in 2004 primarily consisted of capital expenditures and TAAssociates’ acquisition of CFIS and Clayton Services.

Our financing activities used cash of $5.9 million infiscal 2006 and provided cash of $26.1 million and $111.6 million in fiscal2005 and 2004, respectively. The principal uses of cash in financing activitiesin 2006 were the redemption of preferred stock and repayments of outstandingdebt under our credit facility described above. This was partially offset bythe proceeds from the initial public offering described above and, to a lesserextent, borrowings under our revolving credit agreement. The principal sourcesof cash from financing activities in 2005 were borrowings under our priorrevolving credit agreement, partially offset by loan repayments and distributionsto shareholders. The principal sources of cash from financing activities in2004 were thenet proceeds from the issuance by CFIS of $10.0 million of 12% seniorsubordinated convertible notes on May 24, 2004 to investment fundsaffiliated with TA Associates, the issuance by Clayton Services of $20.0million of 12% subordinated notes on August 2, 2004 to investment fundsaffiliated with TA Associates and other investors, including a member of oursenior management, and the incurrence of senior debt under our prior revolvingcredit and term loan facilities.

Cash paid for interestexpense was $7.8 million, $8.0 million and $2.3 million in fiscal 2006, 2005and 2004, respectively. In 2006, the majority of interest expense was paid onborrowings outstanding under our term loan. In 2005 and 2004, the majority ofinterest expense was paid on borrowings outstanding under our subordinatednotes, senior subordinated notes, prior revolving line of credit and prior termloan.

***Credit Agreement***

On December 8, 2005, we entered into a$190.0 million senior credit facility. The credit facility provided for a$150.0 million term loan, and a revolving credit facility of$40.0 million. The credit facility also provided us with an option,subject to the consent of the lenders, to increase the revolving creditfacility by $10.0 million to an aggregate of $50.0 million. We exercised theoption to increase our revolving credit facility on January 11, 2006 and April 28,2006, and amended our credit facility to increase the revolving loan facilityby $5.0 million on each date, for an aggregate revolving credit facilityof $50.0 million as of April 28, 2006. Following our initial publicoffering in March 2006, we prepaid $70.0 million outstanding under theterm loan and repaid $7.4 million outstanding under the revolving creditfacility. In December 2006, we prepaid an additional $15.0 millionoutstanding under the term loan. An additional $5.0 million was repaid in February 2007.

The credit agreement terminates on December 8,2011. Principal repayments on the term loan of $162,718 are required on aquarterly basis for each quarter through 2010, and the remaining principalbalance at the end of 2010 is repayable in equal quarterly installments during2011. This facility can be used to fund acquisitions requiring cash, as well asto fund short-term liquidity needs. Liquidity needs occasionally arise as aresult of differences in the timing between collecting our accounts receivableand making disbursements to support our operations.

The credit agreement is collateralized bysubstantially all of our assets. The agreement contains covenants which, amongother matters, require us to maintain certain levels of interest coverageratio, 

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fixed charge ratio andtotal leverage ratio. As of December 31, 2006, we were in compliancewith all debt covenants. In addition, the credit agreement places limitationson total annual capital expenditures, indebtedness, liens, dividends anddistributions, asset sales, transactions with affiliates, acquisitions andconduct of business, all as defined in the agreement. The credit agreement alsocontains provisions for an increased interest rate during periods of default.We do not believe that these covenants will affect our ability to operate ourbusiness.

Loans under the credit agreement bear interest at theapplicable LIBOR rate plus 3.0% or Prime Rate plus 2.0%, at our option. Inaddition, we are required to pay a commitment fee of 0.5% based on thecalculation of the excess of the revolving credit loan commitment over theoutstanding balance as defined. On March 15, 2007, the terms of the creditagreement were amended. The amendment lowered the interest rate on borrowingsunder the credit agreement from LIBOR plus 3.00% to LIBOR plus 1.75%, or PrimeRate plus 0.75%, at the Company’s option.

At December 31, 2006,there was an outstanding balance of $64.6 million under the term loan and nooutstanding balance under the revolving credit facility. In February 2007,the Company repaid $5.0 million outstanding under the term loan.

***Interest Rate Cap***

In September 2004, wepurchased an interest rate cap agreement to reduce the potential impact thatinterest rate increases could have on our floating-rate debt interest expense.The terms of the interest rate cap agreement, which expired on September 30,2006, provided that we would receive quarterly payments equal to the notionalamount multiplied by the difference by which LIBOR exceeds 5%. The initialpremium of $29,900 was recorded as an asset on the date of purchase. Subsequentdeclines in the fair value of this derivative were recorded as interest expense.In January 2006, the Company recorded interest expense of $1,915 to reducethe book value of this asset to zero. During the third quarter of 2006 theCompany received approximately $19,300 which was recorded as a reduction ofinterest expense.

**ContractualObligations**

Thefollowing table describes our cash commitments, in thousands, to settlecontractual obligations as of December 31, 2006.

| ** **                    | ** ** | **Payments Due in** | ** ** |
|-------------------------------|------------|-------------------------------|------------|
| ** **                    | ** ** | **Total**                     | ** ** | **Less Than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More Than 5   Years** | ** ** |
| Term loans and  loans payable |       | $                             | 64,599     |   |   | $ | 651 |   |   |   | $ | 1,302 |   |   | $ | 62,646 |   |   | $ | — |   |   |
| Capital lease  obligations    |       | 753                           |       |   | 278 |   |   |   | 364 |   |   | 111 |   |   | — |   |   |
| Operating lease  obligations  |       | 16,843                        |       |   | 3,367 |   |   |   | 5,443 |   |   | 2,694 |   |   | 5,339 |   |   |
| Total                         |       | $                             | 82,195     |   |   | $ | 4,296 |   |   |   | $ | 7,109 |   |   | $ | 65,451 |   |   | $ | 5,339 |   |   |

 

Interest payments due onthe above amounts total $24,331.

**Off-Balance-SheetArrangements**

As of December 31,2006, we did not have any significant off-balance-sheet arrangements, asdefined in Item 303(a)(4)(ii) of Regulation S-K of the SEC.

**Recently IssuedAccounting Pronouncements**

In March 2004, the Financial Accounting StandardsBoard (“FASB”) Emerging Issues Task Force (“EITF”) released Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” EITF 03-1 provides guidance for determining whetherimpairment 

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for certain debt andequity investments is other-than-temporary and the measurement of an impairedloss. The recognition and measurement requirements of EITF 03-1 wereinitially effective for reporting periods beginning after June 15, 2004.In September 2004, the FASB Staff issued FASB Staff Position (“FSP”) EITF03-1-1 that delayed the effective date for certain measurement andrecognition guidance contained in EITF 03-1. The FSP requires thatentities continue to apply previously existing “other-than-temporary” guidanceuntil a final consensus is reached. Management does not anticipate thatissuance of a final consensus will materially impact the Company’s financialcondition or results of operations.

In December 2004, the FASB issued SFAS No. 123(R),“Accounting for Stock Based Compensation” which establishes standards fortransactions in which an entity exchanges its equity instruments for goods orservices. This standard requires an issuer to measure the cost of employeeservices received in exchange for an award of equity instruments based on thegrant-date fair value of the award. This eliminates the exception to accountfor such awards using the intrinsic method previously allowable underAccounting Principles Board (“APB”) Opinion No. 25. In March 2005,the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-Based Payment,”which expresses views of the SEC Staff about the application of SFAS No. 123(R).In April 2005, the SEC issued a rule that SFAS No. 123(R) becameeffective for annual reporting periods beginning on or after June 15,2005. We previously adopted the fair value recognition provisions of SFAS No. 123,“Accounting for Stock-Based Compensation,” for all awards granted to employees.On January 1, 2006, the Company adopted SFAS No. 123(R) and SFAS123(R) did not have a material impact on our financial statements.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3.” SFAS No. 154 replaces APB Opinion No. 20,“Accounting Changes,” and FASB Statement No. 3, “Reporting AccountingChanges in Interim Financial Statements,” and changes the requirements for theaccounting for and reporting of a change in accounting principle. ThisStatement applies to all voluntary changes in accounting principle. It alsoapplies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. SFAS No. 154 is effective for fiscal years beginning after December 15,2005. The Company adopted SFAS No. 154 as of January 1, 2006. It didnot have a material impact on the Company’s financial condition or results ofoperations.

In June 2005, the FASB ratified the EmergingIssues Task Force Issue No. 05-06,*Determining the Amortization Period for Leasehold Improvements* (“EITF 05-06”).EITF 05-06 provides that the amortization period used for leaseholdimprovements acquired in a business combination or purchased after theinception of a lease be the shorter of (1) the useful life of the assetsor (2) a term that includes required lease periods and renewals that arereasonably assured upon the acquisition or the purchase. The Company adoptedEITF 05-06 as of June 29, 2005. It did not have a materialimpact on its consolidated financial position or results of operations.

In July 2006, the FASB issued FASB Interpretation(“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement 109.”  FIN 48, which clarifies Statement109, “Accounting for Income Taxes,” establishes the criterion that anindividual tax position has to meet for some or all of the benefits of thatposition to be recognized in the Company’s financial statements. On initialapplication, FIN 48 will be applied to all tax positions for which the statuteof limitations remains open. Only tax positions that meet themore-likely-than-not recognition threshold at the adoption date will berecognized or continue to be recognized.  The cumulative effect of applying FIN 48 willbe reported as an adjustment to retained earnings at the beginning of theperiod in which it is adopted. FIN 48 is effective for fiscal years beginningafter December 15, 2006.  TheCompany is currently assessing the impact of FIN 48 on its consolidatedfinancial position and results of operations.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.”   SFAS No. 157establishes a common definition for fair value to be applied to US GAAPguidance requiring use of fair 

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value, establishes aframework for measuring fair value, and expands disclosure about such fairvalue measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. The Company is currently assessing the impact ofSFAS No. 157 on its consolidated financial position and results ofoperations.

In September 2006, the Securities and ExchangeCommission (“SEC”) staff issued Staff Accounting Bulletin (“SAB”) 108 “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements.”  SAB108 requires that public companies utilize a “dual-approach” to assessing the quantitativeeffects of financial misstatements. This dual approach includes both an incomestatement focused assessment and a balance sheet focused assessment. Theguidance in SAB 108 must be applied to annual financial statements for fiscalyears ending after November 15, 2006. The Company adopted SAB 108effective December 31, 2006. The application of the guidance contained inSAB 108 did not have a material impact on the Company’s consolidated financialposition or results of operations.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities.”   SFAS No. 159permits entities to choose to measure many financial assets and financialliabilities at fair value. Unrealized gains and losses on items for which thefair value option has been elected are reported in earnings. SFAS No. 159is effective for fiscal years beginning after November 15, 2007. TheCompany is currently assessing the impact of SFAS No. 159 on itsconsolidated financial position and results of operations.

***Item 7A.****                  **Quantitative andQualitative Disclosures About Market Risk***

Changes in interest ratesimpact our interest income from cash and cash equivalents and our interestexpense on borrowings under our revolving line of credit and term loanfacilities, which carry interest rates that vary in direct relationship tochanges in LIBOR and the Prime Rate. We had $22.9 million of cash and cashequivalents and $64.6 million of floating rate indebtedness outstanding at December 31,2006. Based on the assets and liabilities as of December 31, 2006, andassuming the balances of these assets and liabilities remain unchanged for thesubsequent twelve months, a 1% increase or decrease in LIBOR and the Prime Ratewould change our net income by approximately $0.2 million.

***Item 8.****                          FinancialStatements and Supplementary Data*

Our consolidated financialstatements together with the related notes and the report of Grant Thornton LLPare set forth beginning on page F-1 of this Form 10-K.

***Item 9.****                          Changesin and Disagreements with Accountants on Accounting and Financial Disclosure*

None.

***Item 9A.****                  Controlsand Procedures*

**Disclosure Controlsand Procedures**

As required by Rule 13a-15under the Securities Exchange Act of 1934, as of the end of the period covered bythis report, we carried out an evaluation under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934). In designing and evaluating ourdisclosure controls and procedures, we and our management recognize that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving the desired control objectives, and ourmanagement necessarily was required to apply its judgment in evaluating andimplementing possible 

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controlsand procedures. Based upon that evaluation, our Chief Executive Officer andChief Financial Officer have concluded that they believe that as of the end ofthe period covered by this report, our disclosure controls and procedures wereeffective at the reasonable assurance level.

**Changes** inInternal Control Over Financial Reporting

There have been no changesin our internal control over financial reporting during the quarterly periodended December 31, 2006 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

***Item 9B.****                  OtherInformation*

This annual report doesnot include either management’s assessment on our internal control overfinancial reporting or an attestation of our independent, registered publicaccounting firm regarding internal control over financial reporting pursuant totemporary rules of the Securities and Exchange Commission that permit usto exclude these items until our Annual Report on Form 10-K for theperiod ending December 31, 2007.

**PART III**

Anything herein to the contrarynotwithstanding, in no event whatsoever are the sections entitled “Nominatingand Compensation Committee Report on Executive Compensation” and “AuditCommittee Report” to be incorporated by reference herein from our proxystatement in connection with our 2007 annual meeting of stockholders.

***Item 10.****                   Directorsand Executive Officers of the Registrant*

Certain informationrequired by this Item 10 relating to our directors and executive officers isincorporated by reference herein from our proxy statement in connection withour 2007 annual meeting of stockholders, which proxy statement will be filedwith the SEC not later than 120 days after the close of our fiscal year ended December 31,2006.

**Audit CommitteeFinancial Expert**

The Audit Committee of theBoard of Directors currently consists of Michael Sonderby, Brian Libman andFrank Raiter (Chairman). Mr. Sonderby joined the Audit Committee in February 2007,replacing Roger Kafker. Mr. Raiter joined the Audit Committee in December 2005,replacing Todd Crockett. Mr. Libman has served on the Audit Committeesince July 2005. Our Board of Directors has determined that Messrs. Sonderby,Libman and Raiter each meet the independence requirements promulgated by TheNasdaq Stock Market, Inc. (“Nasdaq”) and the Securities and ExchangeCommission (“SEC”), including Rule 10A-3(b)(1) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”). In addition,the Board of Directors has determined that each member of the Audit Committeeis financiallyliterate and that Messrs. Sonderby and Raiter qualify as “auditcommittee financial experts” under the rules of the SEC. Stockholdersshould understand that this designation is a disclosure requirement of the SECrelated to Messrs. Sonderby’s and Raiter’s experience and understandingwith respect to certain accounting and auditing matters. The designation doesnot impose upon Messrs. Sonderby and Raiter any duties, obligationsor liability that are greater than are generally imposed on other members ofthe Audit Committee and the Board of Directors, and designation as an auditcommittee financial expert pursuant to this SEC requirement does not affect theduties, obligations or liability of any other member of the Audit Committee orthe Board of Directors.

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**Code of Ethics**

The Company has adopted a “code of ethics,” as definedby regulations promulgated under the Securities Act of 1933, as amended, andthe Exchange Act, that applies to all of the Company’s directors and employeesworldwide, including its principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions. A current copy of the Code of Business Conduct is availableat the Corporate Governance section of the Company’s website at http://www.clayton.com.A copy of the Code of Business Conduct may also be obtained, free of charge,from the Company upon a request directed to: Clayton Holdings, Inc., 2Corporate Drive, Shelton, CT 06484, Attention: Secretary. The Company intendsto disclose any amendment to or waiver of a provision of the Code of BusinessConduct that applies to its principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions, by posting such information on its website available athttp://www.clayton.com.

For more corporategovernance information, you are invited to access the Corporate Governancesection of the Company’s website available at http://www.clayton.com.

***Item 11.****                   ExecutiveCompensation*

Certain informationrequired by this Item 11 relating to remuneration of directors and executiveofficers and other transactions involving management is incorporated byreference herein from our proxy statement in connection with our 2007 annualmeeting of stockholders, which proxy statement will be filed with the SEC notlater than 120 days after the close of our fiscal year ended December 31,2006.

***Item 12.****                   SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters*

Certain informationrequired by this Item 12 relating to security ownership of certain beneficialowners and management is incorporated by reference herein from our proxystatement in connection with our 2007 annual meeting of stockholders, whichproxy statement will be filed with the SEC not later than 120 days after theclose of our fiscal year ended December 31, 2006. For information onsecurities authorized for issuance under equity compensation plans, see thesection entitled “Market for Registrant’s Common Equity and RelatedStockholders Matters” in Part II, Item 5. in this Annual Report on Form 10-K.

***Item 13.****                   CertainRelationships and Related Transactions*

Certain informationrequired by this Item 13 relating to certain relationships and related transactionsis incorporated by reference herein from our proxy statement in connection withour 2007 annual meeting of stockholders, which proxy statement will be filedwith the SEC not later than 120 days after the close of our fiscal year ended December 31,2006.

***Item 14.****                   PrincipalAccounting Fees and Services*

Certain information required by this Item 14 regardingprincipal accounting fees and services is set forth under “Principal AccountingFees and Services” in our proxy statement in connection with our 2007 annualmeeting of stockholders, which proxy statement will be filed with the SEC notlater than 120 days after the close of our fiscal year ended December 31,2006.

48

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**PART IV**

***Item 15.****                   Exhibits,Financial Statement Schedules*

(a)          The following documentsare filed as part of this Form 10-K:

(1)          *FinancialStatements*:

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

| **Clayton Holdings, Inc. (Successor)—For the years ended  December 31, 2006 and 2005 and for the period from Inception through  December 31, 2004** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| **Clayton Services, Inc. (Predecessor)—For  the period from January 1, 2004 through August 1, 2004**                                           |       |       |
| Report  of Independent Registered Public Accounting Firm                                                                                                                |       | F-2        |
| Consolidated Balance  Sheets                                                                                                                                            |       | F-3        |
| Consolidated  Statements of Income                                                                                                                                      |       | F-4        |
| Consolidated  Statements of Changes in Stockholders’ Equity                                                                                                        |       | F-5        |
| Consolidated Statements  of Cash Flows                                                                                                                                  |       | F-6        |
| Notes to Consolidated  Financial Statements                                                                                                                             |       | F-7        |
| **Clayton Fixed Income Services  Inc. (f/k/a The Murrayhill Company)—For the period January 1, 2004  through May 23, 2004**                         | ** ** | ** ** |
| Report  of Independent Registered Public Accounting Firm                                                                                                                |       | F-40       |
| Consolidated  Statement of Income                                                                                                                                       |       | F-41       |
| Consolidated  Statement of Shareholders’ Equity                                                                                                                    |       | F-42       |
| Consolidated Statement  of Cash Flows                                                                                                                                   |       | F-43       |
| Notes to Consolidated  Financial Statements                                                                                                                             |       | F-44       |

 

(2)          *Index toFinancial Statement Schedules*:

Schedule II—Valuation and Qualifying Accounts

All other scheduleshave been omitted because the information required to be set forth therein isnot applicable or is shown in the accompanying Consolidated FinancialStatements or notes thereto.

(3)          *Exhibits*:Exhibits are as set forth in the section entitled “Exhibit Index” whichfollows the section entitled “Signatures” in this Annual Report on Form 10-K.Exhibits which are incorporated herein by reference can be inspected and copiedat the public reference rooms maintained by the SEC in Washington, D.C., NewYork, New York, and Chicago, Illinois. Please call the SEC at 1-800-SEC-0330for further information on the public reference rooms. SEC filings are alsoavailable to the public from commercial document retrieval services and at theWeb site maintained by the SEC at*http://www.sec.gov*.

49

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, as amended, the Registrant has duly caused this report to be signed onits behalf by the undersigned thereunto duly authorized.
| Date: March 23, 2007 |                        |                                                         |
|--------------------------------|-----------------------------|--------------------------------------------------------------|
|                           | CLAYTON HOLDINGS, INC. |
|                           | (Registrant)                |
|                           | By:                         | /s/ FREDERICK C. HERBST                                      |
|                           |                        | Frederick C. Herbst, *Chief  Financial Officer*              |
|                           |                        | *(Duly Authorized Officer and Principal Financial  Officer)* |

 

KNOWN ALL MEN BY THESE PRESENTS that each individualwhose signature appears below constitutes and appoints each of Frank P.Filipps, Frederick C. Herbst and Steven L. Cohen, and each of them singly, suchperson’s true and lawful attorney-in-fact and agent with full power of substitutionand resubstitution, for such person and in such person’s name, place and stead,in any and all capacities, to sign any and all amendments to this Annual Reporton Form 10-K, and to file the same, with all exhibits thereto, andall documents in connection therewith, with the Securities and ExchangeCommission, granting unto each said attorney-in-fact and agent full power andauthority to do and perform each and every act and thing requisite andnecessary to be done in and about the premises, as fully to all intents andpurposes as such person might or could do in person, hereby ratifying andconfirming all that any said attorney-in-fact and agent, or any substitute orsubstitutes of any of them, may lawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities and Exchange Act of 1934, as amended,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

|                          | **Signature** | ** **                                    | ** ** | ** **     | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------|---------------|-----------------------------------------------|------------|----------------|-----------|------------|------------|------------|----------|------------|
| /s/ FRANK P.  FILIPPS    | ** **    | Chief Executive  Officer and Director         | ** ** | March 23, 2007 |
| Frank  P. Filipps        |          | (Principal Executive  Officer)                |       |           |
| /s/ FREDERICK  C. HERBST |          | Chief Financial  Officer                      |       | March 23, 2007 |
| Frederick  C. Herbst     |          | (Principal Financial and  Accounting Officer) |       |           |
| /s/ TODD R.  CROCKETT    |          | Director                                      |       | March 23, 2007 |
| Todd R. Crockett         |          |                                          |       |           |
| /s/ MARGARET  SUE ELLIS  |          | Director                                      |       | March 23, 2007 |
| Margaret  Sue Ellis      |          |                                          |       |           |
| /s/ DAVID  GILBERT       |          | Director                                      | ** ** | March 23, 2007 |
| David Gilbert            |          |                                          | ** ** |           |
| /s/ ROGER B.  KAFKER     |          | Director                                      |       | March 23, 2007 |
| Roger B. Kafker          |          |                                          |       |           |

50

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| /s/ STEPHEN  M. LAMANDO                      |                     | Director |   | March 23, 2007 |
|----------------------------------------------|--------------------------|----------|--------|----------------|
| Stephen  M. Lamando                          |                     |     |   |           |
| /s/ BRIAN L.  LIBMAN                         |                     | Director |   | March 23, 2007 |
| Brian  L. Libman                             |                     |     |   |           |
| /s/ FRANK L.  RAITER                         |                     | Director |   | March 23, 2007 |
| Frank  L. Raiter                             |                     |     |   |           |
| /s/ MICHAEL M.  SONDERBY                     |                     | Director |   | March 23, 2007 |
| Michael M.  Sonderby                         |                     |     |   |           |
|                                         |                     |     |   |           |
| By:                                          | /s/ FREDERICK  C. HERBST |     |   |           | March 23, 2007 |
|     Frederick  C. Herbst |                     |     |   |           |
|     Attorney-In-Fact     |                     |     |   |           |
|                                              |                          |          |        |                |  |

 

51

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**EXHIBITINDEX**

| Number | ** ** | **Description**                                                                                                                            | ** ** | **Method of Filing**                                                                                                                                                                                                           |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1    |       | Form of Third Amended and Restated Certificate  of Incorporation of the Registrant                                                    |       | Incorporated by reference to Exhibit 3.1 to  Amendment No. 4 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on March 16, 2006    |
| 3.2    |       | Form of Fourth Amended and Restated Certificate  of Incorporation of the Registrant                                                   |       | Incorporated by reference to Exhibit 3.2 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006  |
| 3.3    |       | Amended and Restated By-laws of the Registrant                                                                                             |       | Incorporated by reference to Exhibit 3.3 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006  |
| 4.1    |       | Specimen Stock Certificate                                                                                                                 |       | Incorporated by reference to Exhibit 4.1 to  Amendment No. 4 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on March 16, 2006    |
| 4.2    |       | Registration Rights Agreement by and among the  Registrant, the Investors and the Founders named therein, dated as of  March 31, 2005 |       | Incorporated by reference to Exhibit 4.2 to our  Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                           |
| 10.1   |       | 2005 Stock Option and Grant Plan                                                                                                           |       | Incorporated by reference to Exhibit 10.1 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.2   |       | Form of Incentive Stock Option Agreement under  the 2005 Stock Option and Grant Plan                                                  |       | Incorporated by reference to Exhibit 10.2 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.3   |       | Form of Non-Qualified Stock Option Agreement  under the 2005 Stock Option and Grant Plan                                              |       | Incorporated by reference to Exhibit 10.3 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.4   |       | 2006 Stock Option and Incentive Plan                                                                                                       |       | Incorporated by reference to Exhibit 10.4 to  Amendment No. 4 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on March 16, 2006   |
| 10.5   |       | Form of Incentive Stock Option Agreement under  the 2006 Stock Option and Incentive Plan                                              |       | Incorporated by reference to Exhibit 10.5 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006 |

52

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| 10.6  |   | Form of Non-Qualified Stock Option Agreement  under the 2006 Stock Option and Incentive Plan                                      |   | Incorporated by reference to Exhibit 10.6 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006 |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.7  |   | Form of Restricted Stock Award Agreement under  the 2006 Stock Option and Incentive Plan                                          |   | Incorporated by reference to Exhibit 10.7 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006 |
| 10.8  |   | Stockholders Agreement by and among the Registrant,  the Investors and the Founders named therein, dated as of March 31, 2005     |   | Incorporated by reference to Exhibit 10.9 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.9  |   | Employment Agreement between the Registrant and  Frank Filipps, dated April 25, 2005                                              |   | Incorporated by reference to Exhibit 10.10 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.10 |   | Employment Agreement between the Registrant and  Frank Filipps, dated April 25, 2005                                              |   | Incorporated by reference to Exhibit 10.11 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.11 |   | Employment Agreement between Clayton  Services, Inc. and Stephen M. Lamando, dated June 29, 2004                             |   | Incorporated by reference to Exhibit 10.12 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.12 |   | Amended and Restated Non-Competition Agreement  between Clayton Services, Inc. and Stephen M. Lamando, dated  August 2, 2004 |   | Incorporated by reference to Exhibit 10.13 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.13 |   | Employment Agreement between the Registrant and  Frederick C. Herbst, dated September 19, 2005                                    |   | Incorporated by reference to Exhibit 10.14 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.14 |   | Employment Agreement between Clayton  Technologies, Inc. and Louis Iannaccone, dated September 15, 2004                      |   | Incorporated by reference to Exhibit 10.15 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.15 |   | Employee Agreement between Clayton  Technologies, Inc. and Louis Iannaccone, dated September 15, 2004                        |   | Incorporated by reference to Exhibit 10.16 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |
| 10.16 |   | Employment Agreement between Clayton  Services, Inc. and Steven L. Cohen, dated December 21, 2004                            |   | Incorporated by reference to Exhibit 10.17 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                         |

53

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| 10.17 |   | Agreement for the Protection of Trade Secrets  between Clayton Fixed Income Services Inc. and Margaret Sue Ellis, dated  May 24, 2004                                                                                                                                                                                                                                                                                                                                |   | Incorporated by reference to Exhibit 10.18 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18 |   | Form of Indemnification Agreement between the  Registrant and each of its Directors and certain of its executive officers                                                                                                                                                                                                                                                                                                                                            |   | Incorporated by reference to Exhibit 10.18 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006 |
| 10.19 |   | Credit Agreement by and among Clayton  Services, Inc., as Borrower, Madison Capital Funding LLC, as  Lender, Administrative Agent, Sole Lead Arranger and Joint Bookrunner,  JPMorgan Chase Bank, as Joint Bookrunner and Syndications Agent, and Merrill  Lynch Capital, as Documentation Agent, dated August 2, 2004                                                                                                                                     |   | Incorporated by reference to Exhibit 10.20 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.20 |   | Subordinated Note Purchase Agreement by and among  Clayton Services, Inc., as Borrower, GRP Holdings, Inc., Clayton  Technologies, Inc. and First Madison Services, Inc., as Guarantors,  and the Lamando Charitable Remainder Trust u/a May 15, 2004, TA  Subordinated Debt Fund, L.P., TA Investors II, L.P., Libman Family  Holdings LLC and Madison Capital Funding LLC, as Noteholders, dated  as of August 2, 2004          |   | Incorporated by reference to Exhibit 10.21 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.21 |   | Assignment of Lease between Clayton  Services, Inc., Robert D. Scinto and BrandDirect Marketing, Inc.,  dated August 31, 1999, and Commercial Lease between Robert D. Scinto and  BrandDirect Marketing, Inc. for 2 Corporate Drive, 3rd Floor, Shelton,  CT, dated March 5, 1999, and as amended on August 31, 1999,  February 10, 2004, March 31, 2004, August 30, 2004,  December 13, 2004 and January 11, 2004 |   | Incorporated by reference to Exhibit 10.30 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.22 |   | Commercial Lease between Clayton Services, Inc.  and Robert D. Scinto for 2 Corporate Drive, 8th Floor, Shelton, CT, dated  December 2, 2002                                                                                                                                                                                                                                                                                                                    |   | Incorporated by reference to Exhibit 10.31 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |
| 10.23 |   | Commercial Lease between Clayton Fixed Income  Services Inc. and Fifth Street—Denver Center, LLC for 1700 Lincoln  Street, Suite 1600, Denver, CO, dated April 1, 2003, and as amended  on March 15, 2004                                                                                                                                                                                                                                        |   | Incorporated by reference to Exhibit 10.32 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                          |

54

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| 10.24 |   | Sublease Agreement between Clayton  Services, Inc. and Employers Insurance Company of Wausau for 13101  Telecom Drive, Tampa Telecom Park, Temple Terrace, FL, dated  August 11, 2004                                                                                                                                                                               |   | Incorporated by reference to Exhibit 10.33 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                           |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25 |   | Waiver and Amendment No. 1 to Credit Agreement,  by and among Clayton Services, Inc., as Borrower, Madison Capital  Funding LLC, as Lender, Administrative Agent, Sole Lead Arranger and  Joint Bookrunner, JPMorgan Chase Bank, as Joint Bookrunner and Syndications  Agent, and Merrill Lynch Capital, as Documentation Agent, dated as of  October 25, 2005 |   | Incorporated by reference to Exhibit 10.34 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                           |
| 10.26 |   | Consent and Amendment Pertaining to Subordinated  Note Purchase Agreement by and between Clayton Services, Inc. and TA  Subordinated Debt Fund, L.P., dated as of November 2, 2005                                                                                                                                                                                  |   | Incorporated by reference to Exhibit 10.35 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                           |
| 10.27 |   | First Amendment to the Stockholders Agreement by and  among the Registrant, the Investors and the Founders named therein, dated as  of November 4, 2005                                                                                                                                                                                                                       |   | Incorporated by reference to Exhibit 10.36 to  our Registration Statement on Form S-1 (File No. 333-129526)  filed with the Securities and Exchange Commission on November 7, 2005                           |
| 10.28 |   | Sublease Agreement between Clayton  Services, Inc. and Rx Solutions, Inc. for 13101 Telcom Drive, Tampa  Telcom Park, Temple Terrace, FL, dated October 31, 2005.                                                                                                                                                                                                   |   | Incorporated by reference to Exhibit 10.36 to  Amendment No. 1 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on December 21, 2005 |
| 10.29 |   | Credit Agreement, dated as of December 8, 2005,  by and among the Registrant., as Company, the Lender listed therein, as  Lenders, BNP Paribas, as Administrative Agent and JPMorgan Chase  Bank, N.A., as Syndication Agent                                                                                                                                             |   | Incorporated by reference to Exhibit 10.36 to  Amendment No. 1 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on December 21, 2005 |
| 10.30 |   | First Amendment, dated as of January 11, 2006,  to Credit Agreement, dated as of December 8, 2005, by and among the  Registrant., as Company, the Lender listed therein, as Lenders, BNP Paribas,  as Administrative Agent and JPMorgan Chase Bank, N.A., as Syndication  Agent                                                                                     |   | Incorporated by reference to Exhibit 10.18 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006  |
| 10.31 |   | Form of Non-Qualified Stock Option Agreement  for Non-Employee Directors under the 2006 Stock Option and Incentive Plan                                                                                                                                                                                                                                                       |   | Incorporated by reference to Exhibit 10.18 to  Amendment No. 2 to our Registration Statement on Form S-1  (File No. 333-129526) filed with the Securities and Exchange  Commission on February 9, 2006  |

55

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| 10.32 |   | Employment Agreement between the Registrant and  David Keith Johnson, dated May 1, 2006                                                                                                                                                                             |   | Incorporated by reference to Exhibit 10.1 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on May 5, 2006      |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.33 |   | Separation Agreement between the Registrant and  Louis Iannaccone, dated October 18, 2006                                                                                                                                                                           |   | Incorporated by reference to Exhibit 10.1 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on October 16, 2006 |
| 10.34 |   | Lease, effective as of January 3, 2007, by and  between Clayton Services, Inc. and FOA for approximately 51,134 square  feet of office space located at 6302 East Dr. Martin Luther King, Jr.  Boulevard, Tampa, Florida, dated January 3, 2007 |   | Incorporated by reference to Exhibit 10.1 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 10.35 |   | Non-Employee Directors’ Compensation Plan                                                                                                                                                                                                                           |   | Incorporated by reference to Exhibit 10.2 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 10.36 |   | Form of Deferred Stock Unit Award Agreement                                                                                                                                                                                                                         |   | Incorporated by reference to Exhibit 10.2 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 10.37 |   | Amendment No. 1 to Employment Agreement between  the Registrant and Frederick C. Herbst dated January 30, 2007                                                                                                                                                 |   | Incorporated by reference to Exhibit 10.3 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 10.38 |   | Amendment No. 1 to Employment Agreement between  the Registrant and Steven L. Cohen dated January 30, 2007                                                                                                                                                     |   | Incorporated by reference to Exhibit 10.4 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 10.39 |   | Amendment No. 1 to Employment Agreement between  the Registrant and David Keith Johnson dated January 30, 2007                                                                                                                                                 |   | Incorporated by reference to Exhibit 10.5 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 10.40 |   | Amended and Restated Employment Agreement between  the Registrant and Kevin J. Kanouff, dated March 23, 2007                                                                                                                                                   |   | Filed herewith                                                                                                                                                                               |
| 10.41 |   | Amendment No. 1 to 2005 Stock Option and Grant  Plan                                                                                                                                                                                                                |   | Filed herewith                                                                                                                                                                               |
| 10.42 |   | Amendment No. 1 to 2006 Stock Option and  Incentive Plan                                                                                                                                                                                                            |   | Filed herewith                                                                                                                                                                               |
| 21.1  |   | List of Subsidiaries                                                                                                                                                                                                                                                     |   | Incorporated by reference to Exhibit 10.3 to  our Current Report on Form 8-K (File No. 000-51846)  filed with the Securities and Exchange Commission on February 2, 2007 |
| 23.1  |   | Consent of Grant Thornton LLP                                                                                                                                                                                                                                            |   | Filed herewith                                                                                                                                                                               |
| 24.1  |   | Power of Attorney                                                                                                                                                                                                                                                        |   | Included on signature page hereto                                                                                                                                                       |

56

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| 31.1 |   | Rule 13a-14(a)/15d-14(a) Certification  executed by Frank P Filipps, Chief Executive Officer and Director                            |   | Filed herewith |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|
| 31.2 |   | Rule 13a-14(a)/15d-14(a) Certification  executed by Frederick C Herbst, Chief Financial Officer                                      |   | Filed herewith |
| 32.1 |   | Section 1350 Certifications executed by  Frank P. Filipps, Chief Executive Officer and Frederick C. Herbst, Chief  Financial Officer |   | Filed herewith |

 

57

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**CLAYTON HOLDINGS,INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

| **Clayton Holdings, Inc. (Successor)—For the years ended  December 31, 2006 and 2005 and for the period from Inception through  December 31, 2004** | ** ** |   | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|------------|------------|
| **Clayton Services, Inc.  (Predecessor)—For the period from January 1, 2004 through August 1, 2004**                                           |       |   |       | ** ** |
| Report of Independent  Registered Public Accounting Firm                                                                                                                |       |   | F-2        | ** ** |
| Consolidated Balance Sheets                                                                                                                                             |       |   | F-3        | ** ** |
| Consolidated Statements of Income                                                                                                                                       |       |   | F-4        | ** ** |
| Consolidated Statements of Changes in  Stockholders’ Equity                                                                                                        |       |   | F-5        | ** ** |
| Consolidated Statements of Cash Flows                                                                                                                                   |       |   | F-6        | ** ** |
| Notes  to Consolidated Financial Statements                                                                                                                             |       |   | F-7        | ** ** |
| **Clayton  Fixed Income Services Inc. (f/k/a The Murrayhill Company)—For the period  January 1, 2004 through May 23, 2004**                         | ** ** |   | ** ** | ** ** |
| Report of Independent  Registered Public Accounting Firm                                                                                                                |       |   | F-40       | ** ** |
| Consolidated Statement of Income                                                                                                                                        |       |   | F-41       | ** ** |
| Consolidated Statement of Shareholders’  Equity                                                                                                                    |       |   | F-42       | ** ** |
| Consolidated Statement of Cash Flows                                                                                                                                    |       |   | F-43       | ** ** |
| Notes to Consolidated  Financial Statements                                                                                                                             |       |   | F-44       | ** ** |

 

F-1

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and StockholdersClayton Holdings, Inc.

We have audited the accompanying consolidated balancesheets of Clayton Holdings, Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005 (Successor Company balance sheets) and the related consolidatedstatements of income, changes in stockholders’ equity and cash flows for theyears ended December 31, 2006 and 2005 and for the period from inception (May 24,2004, the earlier date common control was established—see Note 1,Organization, Description of Business and Basis of Presentation,*Basis of Presentation* ) through December 31,2004 (Successor Company operations) and for the period from January 1,2004 through August 1, 2004 (Predecessor Company operations). Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the Successor Company consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of the Company as of December 31, 2006and 2005 and the results of its operations and its cash flows for the yearsended December 31, 2006 and 2005 and for the period from inception (May 24,2004, the earlier date common control was established—see Note 1,Organization, Description of Business and Basis of Presentation,*Basis of Presentation* ) through December 31,2004, in conformity with accounting principles generally accepted in the UnitedStates of America. Further, in our opinion, the Predecessor Companyconsolidated financial statements referred to above present fairly, in allmaterial respects, the results of its operations and its cash flows for theperiod from January 1, 2004 through August 1, 2004, in conformitywith accounting principles generally accepted in the United States of America.

Ouraudit was conducted for the purpose of forming an opinion on the basicfinancial statements taken as a whole. The Schedule II - Valuation andQualifying Accounts is presented for purposes of additional analysis and is nota required part of the basic financial statements. This schedule has beensubjected to the auditing procedures applied in the audit of the basicfinancial statements and, in our opinion, is fairly stated in all materialrespects in relation to the basic financial statements taken as a whole.
| /s/ GRANT THORNTON LLP |   |
|------------------------|--------|
| New York, New  York    |   |
| March 20,  2007   |   |

 

F-2

----

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                                                 | ** ** | **December 31,** | ** **  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                                                                                                                                                                                                 | ** ** | **2006**              | ** **  | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                 | ** ** | ** **            | ** **  | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                                            |       |                  |        |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                  |       | $                     | 22,881,553  |   | $ | 7,208,875 |   |
| Restricted cash                                                                                                                                                                                                                            |       | 11,738,871            |        | 4,966,839 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $191,569 and $72,264 as of December 31, 2006 and 2005,  respectively                                                                                                  |       | 37,452,008            |        | 37,205,223 |   |
| Unbilled receivables                                                                                                                                                                                                                       |       | 14,950,591            |        | 14,925,988 |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                  |       | 3,251,642             |        | 3,942,676 |   |
| Prepaid income taxes                                                                                                                                                                                                                       |       | 1,790,828             |        | 3,730,970 |   |
| Deferred tax assets                                                                                                                                                                                                                        |       | 571,835               |        | 165,566 |   |
| Due from affiliated entities                                                                                                                                                                                                               |       | —                |        | 23,434 |   |
| Total current assets                                                                                                                                                                                                                       |       | 92,637,328            |        | 72,169,571 |   |
| Property and equipment, net                                                                                                                                                                                                                |       | 20,364,866            |        | 18,175,717 |   |
| Goodwill                                                                                                                                                                                                                                   |       | 73,401,645            |        | 69,843,468 |   |
| Intangible assets, net                                                                                                                                                                                                                     |       | 75,007,322            |        | 84,739,774 |   |
| Other assets, net                                                                                                                                                                                                                          |       | 1,501,430             |        | 2,576,827 |   |
| Total assets                                                                                                                                                                                                                               |       | $                     | 262,912,591 |   | $ | 247,505,357 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                              | ** ** | ** **            | ** **  | ** ** | ** ** |
| Current  liabilities:                                                                                                                                                                                                                      |       |                  |        |   |   |
| Long-term debt and capital lease obligations, current  portion                                                                                                                                                                             |       | $                     | 928,633     |   | $ | 1,639,411 |   |
| Accounts payable and accrued expenses                                                                                                                                                                                                      |       | 22,831,882            |        | 18,842,078 |   |
| Servicer escrow liability                                                                                                                                                                                                                  |       | 11,738,871            |        | 4,966,839 |   |
| Total current liabilities                                                                                                                                                                                                                  |       | 35,499,386            |        | 25,448,328 |   |
| Long-term debt and capital lease obligations, net of  current portion                                                                                                                                                                      |       | 64,423,566            |        | 148,777,172 |   |
| Deferred tax liabilities                                                                                                                                                                                                                   |       | 4,088,816             |        | 3,381,001 |   |
| Deferred revenue                                                                                                                                                                                                                           |       | 203,729               |        | 217,888 |   |
| Deferred rent                                                                                                                                                                                                                              |       | 968,045               |        | 1,013,687 |   |
| Total liabilities                                                                                                                                                                                                                          |       | 105,183,542           |        | 178,838,076 |   |
| Commitments and  contingencies                                                                                                                                                                                                             |       |                  |        |   |   |
| Series A convertible preferred stock, par value  $0.01 per share, no shares authorized, issued and outstanding as of  December 31, 2006; 8,825,241 shares authorized, issued and outstanding  as of December 31, 2005       |       | —                |        | 12,258,319 |   |
| Series B convertible preferred stock, par value  $0.01 per share, no shares authorized, issued and outstanding as of  December 31, 2006; 24,185,493 shares authorized, issued and outstanding  as of December 31, 2005 |       | —                |        | 43,866,683 |   |
| Stockholders’ equity:                                                                                                                                                                                                                 |       |                  |        |   |   |
| Common stock, par value $0.01 per share, 150,000,000  and 60,000,000 shares authorized and 20,688,556 and 3,281,607 shares issued  and outstanding as of December 31, 2006 and December 31, 2005,  respectively                  |       | 206,886               |        | 32,816 |   |
| Class B common stock, par value $0.01 per share,  no shares authorized, issued and outstanding as of December 31,  2006; 357,020 shares authorized, issued and outstanding as of  December 31, 2005               |       | —                |        | 3,570 |   |
| Preferred stock, par value $0.01 per share,  10,000,000 shares authorized, no shares issued and outstanding as of  December 31, 2006                                                                                                  |       | —                |        | — |   |
| Additional paid-in capital                                                                                                                                                                                                                 |       | 141,255,632           |        | 4,115,827 |   |
| Retained earnings                                                                                                                                                                                                                          |       | 16,266,531            |        | 8,390,066 |   |
| Total stockholders’ equity                                                                                                                                                                                                            |       | 157,729,049           |        | 12,542,279 |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                           |       | $                     | 262,912,591 |   | $ | 247,505,357 |   |

 

The accompanying notes are an integral part of these statements.

F-3

----

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME**

| ** **                                         | ** ** | **Successor**                               | ** **  | **Predecessor** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|-------------|-----------------|------------|
| ** **                                         | ** ** | ** **                                  | ** **  | ** **      | ** ** | **For the period** | ** ** | **For the period** | ** ** |
| ** **                                         | ** ** | ** **                                  | ** **  | ** **      | ** ** | **from inception** | ** ** | **January 1, 2004** | ** ** |
| ** **                                         | ** ** | **Years ended December 31,** | ** **  | **through**     | ** ** | **through** | ** ** |
| ** **                                         | ** ** | **2006**                                    | ** **  | **2005**        | ** ** | **December 31, 2004** | ** ** | **August 1, 2004** | ** ** |
| Revenue                                            |       | $                                           | 239,194,933 |            | $          | 207,502,420 |   |   | $ | 79,804,531 |   |   |   | $ | 76,338,533 |   |   |
| Cost of services:                                  |       |                                        |        |            |       |   |   |   |   |   |   |   |   |
| Compensation expense                               |       | 119,049,789                                 |        | 99,674,973      |       |   | 37,251,852 |   |   |   | 35,502,050 |   |   |
| Travel and related expenses                        |       | 26,109,702                                  |        | 29,787,719      |       |   | 13,891,579 |   |   |   | 15,493,865 |   |   |
| Other direct costs                                 |       | 9,707,512                                   |        | 6,065,735       |       |   | 1,304,200 |   |   |   | 2,667,945 |   |   |
| Total cost of services                             |       | 154,867,003                                 |        | 135,528,427     |       |   | 52,447,631 |   |   |   | 53,663,860 |   |   |
| Gross profit                                       |       | 84,327,930                                  |        | 71,973,993      |       |   | 27,356,900 |   |   |   | 22,674,673 |   |   |
| Operating  expenses:                               |       |                                        |        |            |       |   |   |   |   |   |   |   |   |
| Salaries and benefits                              |       | 23,165,531                                  |        | 18,911,359      |       |   | 6,553,123 |   |   |   | 3,782,531 |   |   |
| Other selling, general and administrative expenses |       | 20,206,292                                  |        | 17,181,042      |       |   | 6,417,019 |   |   |   | 4,275,832 |   |   |
| Depreciation and amortization                      |       | 7,916,666                                   |        | 4,693,611       |       |   | 1,115,511 |   |   |   | 792,511 |   |   |
| Amortization of intangibles                        |       | 10,298,820                                  |        | 10,175,444      |       |   | 4,508,693 |   |   |   | — |   |   |
| Impairment of intangibles                          |       | 279,458                                     |        | 1,631,700       |       |   | — |   |   |   | — |   |   |
| Total operating expenses                           |       | 61,866,767                                  |        | 52,593,156      |       |   | 18,594,346 |   |   |   | 8,850,874 |   |   |
| Income from operations                             |       | 22,461,163                                  |        | 19,380,837      |       |   | 8,762,554 |   |   |   | 13,823,799 |   |   |
| Interest expense, net                              |       | 8,030,966                                   |        | 8,189,192       |       |   | 3,065,923 |   |   |   | 178,346 |   |   |
| Loss from  extinguishment of debt                  |       | 885,945                                     |        | 2,990,457       |       |   | — |   |   |   | — |   |   |
| Income before provision for income taxes           |       | 13,544,252                                  |        | 8,201,188       |       |   | 5,696,631 |   |   |   | 13,645,453 |   |   |
| Income tax expense                                 |       | 5,667,787                                   |        | 3,153,654       |       |   | 2,354,099 |   |   |   | 259,436 |   |   |
| Net income                                         |       | $                                           | 7,876,465   |            | $          | 5,047,534 |   |   | $ | 3,342,532 |   |   |   | $ | 13,386,017 |   |   |
| Earnings per  share:                               |       |                                        |        |            |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | $                                           | 0.43        |            | $          | 0.42 |   |   | $ | 0.37 |   |   |   | $ | 1.32 |   |   |
| Diluted                                            |       | $                                           | 0.41        |            | $          | 0.41 |   |   | $ | 0.37 |   |   |   | $ | 1.32 |   |   |
| Weighted average  shares outstanding:              |       |                                        |        |            |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | 18,497,195                                  |        | 11,888,671      |       |   | 9,034,350 |   |   |   | 10,162,309 |   |   |
| Diluted                                            |       | 19,281,552                                  |        | 12,304,627      |       |   | 9,095,537 |   |   |   | 10,162,309 |   |   |

 

The accompanying notes are an integral part of these statements.

F-4

----

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

| **Predecessor**             | ** ** | ** ** | ** ** | **Number of  shares** | ** ** | **Amount** | ** ** | **Additional  paid-in capital** | ** ** | **Retained  Earnings** | ** ** | **Stock  subscription  receivable** | ** ** | **Total**     | ** ** |
|-----------------------------|------------|------------|------------|----------------------------|------------|------------|------------|--------------------------------------|------------|------------------------|------------|-------------------------------------|------------|---------------|------------|
| Balance at  January 1, 2004 |       |       | 242        |                       |       |       | $          | 242                                  |       |                   |       | $                                   | 10,661,945 |          |       | $ | 15,109,032 |   |   | $ | (242 | ) |   | $ | 25,770,977 |   |
| Distributions               |       |       | —     |                       |       |       | —     |                                 |       |                   | —     |                                |       | (6,950,000.00 | )          |   | — |   |   | (6,950,000 | ) |
| Net income                  |       |       | —     |                       |       |       | —     |                                 |       |                   | —     |                                |       | 13,386,017    |       |   | — |   |   | 13,386,017 |   |
| Balance at August 1,  2004  |       |       | 242        |                       |       |       | $          | 242                                  |       |                   |       | $                                   | 10,661,945 |          |       | $ | 21,545,049 |   |   | $ | (242 | ) |   | $ | 32,206,994 |   |

 

| ** **                                                                                                                                   | ** ** | **Number of shares** | ** ** | **Value**         | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------|------------|
| **Successor**                                                                                                                                | ** ** | ** **                     | ** ** | **Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Additional paid-  in capital** | ** ** | **Retained  Earnings** | ** ** | **Total** | ** ** |
| Balance, May 24,  2004                                                                                                                       |       | —                         |       |              | —     |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   | $ | — |   |
| Issuance of common  stock for Clayton Fixed Income Services, Inc.                                                                            |       | 671,874                        |       |              | —     |   |   |   | 6,719 |   |   |   | — |   |   |   | 5,100,419 |   |   | — |   | 5,107,138 |   |
| Issuance of common  stock for Clayton Services, Inc.                                                                                         |       | 2,514,556                      |       |              | 357,020    |   |   |   | 25,145 |   |   |   | 3,570 |   |   |   | (1,739,930 | ) |   | — |   | (1,711,215 | ) |
| Exercise of  warrants                                                                                                                        |       | 90,564                         |       |              | —     |   |   |   | 906 |   |   |   | — |   |   |   | 359,677 |   |   | — |   | 360,583 |   |
| Stock based  compensation                                                                                                                    |       | —                         |       |              | —     |   |   |   | — |   |   |   | — |   |   |   | 124,509 |   |   | — |   | 124,509 |   |
| Net income                                                                                                                                   |       | —                         |       |              | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 3,342,532 |   | 3,342,532 |   |
| Balance, December  31, 2004                                                                                                                  |       | 3,276,994                      |       |              | 357,020    |   |   |   | 32,770 |   |   |   | 3,570 |   |   |   | 3,844,675 |   |   | 3,342,532 |   | 7,223,547 |   |
| Exercise of  options                                                                                                                         |       | 4,613                          |       |              | —     |   |   |   | 46 |   |   |   | — |   |   |   | 19,001 |   |   | — |   | 19,047 |   |
| Stock based  compensation                                                                                                                    |       | —                         |       |              | —     |   |   |   | — |   |   |   | — |   |   |   | 252,151 |   |   | — |   | 252,151 |   |
| Net income                                                                                                                                   |       | —                         |       |              | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 5,047,534 |   | 5,047,534 |   |
| Balance, December  31, 2005                                                                                                                  |       | 3,281,607                      |       |              | 357,020    |   |   |   | 32,816 |   |   |   | 3,570 |   |   |   | 4,115,827 |   |   | 8,390,066 |   | 12,542,279 |   |
| Issuance of common  stock                                                                                                                    |       | 8,625,000                      |       |              | —     |   |   |   | 86,250 |   |   |   | — |   |   |   | 131,752,558 |   |   | — |   | 131,838,808 |   |
| Conversion of  convertible preferred stock to redeemable preferred stock and common stock  and redemption of redeemable preferred stock, net |       | 8,252,679                      |       |              | —     |   |   |   | 82,527 |   |   |   | — |   |   |   | 3,277,523 |   |   | — |   | 3,360,050 |   |
| Conversion of  series B common stock                                                                                                         |       | 357,020                        |       |              | (357,020   | ) |   |   | 3,570 |   |   |   | (3,570 | ) |   |   | — |   |   | — |   | — |   |
| Stock based  compensation                                                                                                                    |       | —                         |       |              | —     |   |   |   | — |   |   |   | — |   |   |   | 1,201,693 |   |   | — |   | 1,201,693 |   |
| Exercise of stock  options                                                                                                                   |       | 172,250                        |       |              | —     |   |   |   | 1,723 |   |   |   | — |   |   |   | 908,031 |   |   | — |   | 909,754 |   |
| Net income                                                                                                                                   |       | —                         |       |              | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 7,876,465 |   | 7,876,465 |   |
| Balance, December  31, 2006                                                                                                                  |       | 20,688,556                     |       |              | —     |   |   |   | $ | 206,886 |   |   |   | $ | — |   |   |   | $ | 141,255,632 |   |   | $ | 16,266,531 |   | $ | 157,729,049 |   |
|                                                                                                                                              |            |                                |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of these statements.

F-5

----

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                         | ** ** | **Successor**                               | ** ** | **Predecessor** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-----------------|------------|
| ** **                                                                         | ** ** | ** **                                  | ** ** | ** **      | ** ** | **For the period** | ** ** | **For the period** | ** ** |
| ** **                                                                         | ** ** | ** **                                  | ** ** | ** **      | ** ** | **from inception** | ** ** | **January 1, 2004** | ** ** |
| ** **                                                                         | ** ** | **Years ended December 31,** | ** ** | **through**     | ** ** | **through** | ** ** |
| ** **                                                                         | ** ** | **2006**                                    | ** ** | **2005**        | ** ** | **December 31, 2004** | ** ** | **August 1, 2004** | ** ** |
| Cash flows from operating  activities:                                             |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Net income                                                                         |       | $                                           | 7,876,465  |            | $          | 5,047,534 |   |   | $ | 3,342,532 |   |   |   | $ | 13,386,017 |   |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Depreciation and  amortization                                                     |       | 7,916,666                                   |       | 4,693,611       |       |   | 1,115,511 |   |   |   | 792,511 |   |   |
| Amortization of  intangibles                                                       |       | 10,298,820                                  |       | 10,175,444      |       |   | 4,508,693 |   |   |   | — |   |   |
| Impairment of  intangibles                                                         |       | 279,458                                     |       | 1,631,700       |       |   | — |   |   |   | — |   |   |
| Amortization of  debt issuance cost                                                |       | 341,618                                     |       | 599,163         |       |   | 167,542 |   |   |   | — |   |   |
| Accretion of note                                                                  |       | —                                      |       | 85,468          |       |   | 20,224 |   |   |   | — |   |   |
| Loss from  extinguishment of debt                                                  |       | 885,945                                     |       | 1,679,650       |       |   | — |   |   |   | — |   |   |
| Stock based  compensation                                                          |       | 1,201,693                                   |       | 252,151         |       |   | 124,509 |   |   |   | — |   |   |
| Deferred income  taxes                                                             |       | 301,546                                     |       | (2,433,419      | )          |   | (56,261 | ) |   |   | 93,850 |   |   |
| Loss (gain) on  sale of fixed assets                                               |       | 14,139                                      |       | 141,325         |       |   | (5,200 | ) |   |   | 803 |   |   |
| Provision for  doubtful accounts                                                   |       | 352,534                                     |       | 245,839         |       |   | 85,437 |   |   |   | — |   |   |
| Changes in operating  assets and liabilities, net of business combinations:        |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Accounts  receivable                                                               |       | 353,625                                     |       | (15,793,277     | )          |   | (29,641 | ) |   |   | 2,472,875 |   |   |
| Unbilled  receivables                                                              |       | (24,604                                     | )          | 2,729,386       |       |   | (1,097,878 | ) |   |   | (6,564,031 | ) |   |
| Prepaid expenses  and other current assets                                         |       | 710,062                                     |       | (3,051,635      | )          |   | (285,353 | ) |   |   | 745,856 |   |   |
| Prepaid income  taxes                                                              |       | 1,940,142                                   |       | (3,415,403      | )          |   | (315,567 | ) |   |   | 41,264 |   |   |
| Due from (to) an  affiliated entity                                                |       | 23,434                                      |       | (274,158        | )          |   | (392,793 | ) |   |   | (632,071 | ) |   |
| Other assets, net                                                                  |       | 34,978                                      |       | (94,359         | )          |   | 16,747 |   |   |   | 13,552 |   |   |
| Accounts payable  and accrued expenses                                             |       | 4,364,724                                   |       | (152,457        | )          |   | 7,690,342 |   |   |   | 3,095,194 |   |   |
| Income taxes  payable                                                              |       | —                                      |       | —          |       |   | — |   |   |   | 74,509 |   |   |
| Deferred revenue                                                                   |       | (1,020,224                                  | )          | 1,452,067       |       |   | — |   |   |   | — |   |   |
| Deferred rent                                                                      |       | (45,642                                     | )          | 386,029         |       |   | 366,596 |   |   |   | 42,307 |   |   |
| Net cash provided  by operating activities                                         |       | 35,805,379                                  |       | 3,904,659       |       |   | 15,255,440 |   |   |   | 13,562,636 |   |   |
| Cash flows from investing  activities:                                             |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Proceeds from sale  of fixed assets                                                |       | 36,600                                      |       | 25,361          |       |   | 5,200 |   |   |   | — |   |   |
| Capital  expenditures                                                              |       | (8,957,096                                  | )          | (10,920,927     | )          |   | (4,960,726 | ) |   |   | (2,269,652 | ) |   |
| Cash acquired from  acquisition                                                    |       | —                                      |       | —          |       |   | 426,413 |   |   |   | — |   |   |
| Acquisition of  businesses                                                         |       | (5,344,970                                  | )          | (24,348,199     | )          |   | (122,814,500 | ) |   |   | — |   |   |
| Net cash used in  investing activities                                             |       | (14,265,466                                 | )          | (35,243,765     | )          |   | (127,343,613 | ) |   |   | (2,269,652 | ) |   |
| Cash flows from financing  activities:                                             |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Proceeds from  revolving credit facility                                           |       | 7,400,000                                   |       | 26,850,000      |       |   | 7,526,908 |   |   |   | — |   |   |
| Repayments of  revolving credit facility                                           |       | (7,400,000                                  | )          | (30,876,908     | )          |   | (3,500,000 | ) |   |   | (2,333,336 | ) |   |
| Repayments of  loans payable                                                       |       | —                                      |       | (75,166         | )          |   | (9,610 | ) |   |   | (13,050 | ) |   |
| Repayments of  capital lease obligations                                           |       | (288,656                                    | )          | (111,528        | )          |   | (119,977 | ) |   |   | (144,413 | ) |   |
| Proceeds from the  issuance of subordinated debt                                   |       | —                                      |       | —          |       |   | 20,000,000 |   |   |   | — |   |   |
| Repayment of  subordinated debt                                                    |       | —                                      |       | (29,990,000     | )          |   | — |   |   |   | — |   |   |
| Proceeds from the  issuance of the term loan                                       |       | —                                      |       | 150,000,000     |       |   | 40,000,000 |   |   |   | — |   |   |
| Repayment of term  loan                                                            |       | (85,401,003                                 | )          | (37,750,000     | )          |   | (2,250,000 | ) |   |   | — |   |   |
| Deferred charges  related to the issuance of debt                                  |       | (161,158                                    | )          | (2,390,484      | )          |   | (1,712,500 | ) |   |   | — |   |   |
| Proceeds from  issuance of common stock upon initial public offering               |       | 146,625,000                                 |       | —          |       |   | — |   |   |   | — |   |   |
| Underwriting  commissions and offering expenses                                    |       | (14,784,499                                 | )          | —          |       |   | — |   |   |   | — |   |   |
| Proceeds from the  issuance of convertible preferred stock, net of restricted cash |       | —                                      |       | 10,272,873      |       |   | 60,000,000 |   |   |   |   |   |   |
| Redemption of  convertible preferred stock                                         |       | (52,764,950                                 | )          | —          |       |   | — |   |   |   | — |   |   |
| Proceeds from the  exercise of stock options                                       |       | 413,135                                     |       | 19,047          |       |   | — |   |   |   | — |   |   |
| Excess tax  benefits from share-based compensation arrangements                    |       | 494,896                                     |       | —          |       |   | — |   |   |   | — |   |   |
| Distributions to  stockholders                                                     |       | —                                      |       | (59,850,000     | )          |   | (919,370 | ) |   |   | (4,950,000 | ) |   |
| Net cash (used in)  provided by financing activities                               |       | (5,867,235                                  | )          | 26,097,834      |       |   | 119,015,451 |   |   |   | (7,440,799 | ) |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | 15,672,678                                  |       | (5,241,272      | )          |   | 6,927,278 |   |   |   | 3,852,185 |   |   |
| Cash and cash  equivalents at the beginning of the period                          |       | 7,208,875                                   |       | 12,450,147      |       |   | 5,522,869 |   |   |   | 4,669,249 |   |   |
| Cash and cash  equivalents at the end of the period                                |       | $                                           | 22,881,553 |            | $          | 7,208,875 |   |   | $ | 12,450,147 |   |   |   | $ | 8,521,434 |   |   |
| Supplementary  disclosures of cash flow information:                               |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Cash paid during  the period for:                                                  |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Income taxes                                                                       |       | $                                           | 2,789,326  |            | $          | 8,953,352 |   |   | $ | 2,613,100 |   |   |   | $ | 15,581 |   |   |
| Interest                                                                           |       | $                                           | 7,760,873  |            | $          | 8,007,168 |   |   | $ | 2,124,429 |   |   |   | $ | 178,317 |   |   |
| Other noncash  investing and financing activities:                                 |       |                                        |       |            |       |   |   |   |   |   |   |   |   |
| Assets acquired  under capital lease                                               |       | $                                           | 600,503    |            | $          | 482,222 |   |   | $ | — |   |   |   | $ | — |   |   |
| Liabilities  assumed from acquisitions                                             |       | $                                           | 1,013,958  |            | $          | 401,664 |   |   | $ | — |   |   |   | $ | — |   |   |
| Stockholders’ loan  offset to distributions to stockholders                   |       | $                                           | —     |            | $          | — |   |   | $ | — |   |   |   | $ | 2,000,000 |   |   |
| Issuance of common  stock                                                          |       | $                                           | —     |            | $          | — |   |   | $ | 2,610,000 |   |   |   | $ | — |   |   |

 

The accompanying notes are an integral part of these statements.

F-6

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1—Organization,Description of Business and Basis of Presentation**

Clayton Holdings, Inc. (the “Company”) was formedon March 31, 2005 as a Delaware corporation. The Company was formed tocombine two companies which were under common control, GRP Holdings, Inc.(“GRP”), a Delaware corporation and TMHC Holdings, Inc. (“TMHC”) aDelaware corporation. GRP was formed to acquire Clayton Services, Inc. (“CSI”)and First Madison Services, Inc. (“FMS”) from unrelated parties on August 2,2004. TMHC was formed to acquire Clayton Fixed Income Services Inc., formerlyknown as “The Murrayhill Company”, (“CFIS”) from an unrelated party on May 24,2004. Each holding company was controlled by TA Associates (“TA”) prior to thecombination. In accordance with accounting principles generally accepted in theUnited States of America. (“US GAAP”), assets transferred between entitiesunder common control are accounted for at historical cost similar to a poolingof interests, and the financial statements of previously separate companies forperiods they were under common control are restated on a combined basis.

The Company provides a full suite of outsourcedservices, information-based analytics and specialty consulting for buyers andsellers of, and investors in, mortgage-related loans and securities and otherdebt instruments. The Company’s services include transaction management, whichconsists of due diligence, conduit support, professional staffing, complianceproducts and services as well as credit risk management and securitiessurveillance, and special servicing. The Company uses proprietary technologyand processes to provide these services across the lifecycle of a loan, fromloan origination, aggregation and securities issuance to the surveillance andadministration of loans and securities. The Company provides a majority of itsservices to participants in the non-agency segment of the mortgage-backedsecurities, or MBS, market and the non-conforming mortgage loan market.

As of December 31,2006, we have three reportable segments which we operate and manage asstrategic business units: Transaction Management, Special Servicing andSurveillance. Beginning October 1, 2006, we have reclassified ourfinancial information for the last three fiscal years to reflect our new internalorganization. During 2006, we restructured the management and operations of ourbusinesses and realigned our segment reporting to match these changes. For moreinformation concerning our business segments, see Note 18.

***Basis of Presentation***

The Company’s consolidated statements of income,stockholders’ equity and cash flows include the results of GRP and TMHCbeginning from the date of acquisition of a controlling interest by TA, whichwere August 2, 2004 and May 24, 2004, respectively. The consolidatedstatements of income, stockholders’ equity and cash flows for the periods priorto the date TA acquired a controlling interest in GRP are presented on aPredecessor basis and reflect solely the operations of CSI. For financialreporting purposes, the inception date is deemed to be May 24, 2004. Uponthe acquisition of the controlling interest by TA, the Company became theSuccessor to the business of the Predecessor.

The Company deems CSI, currently a wholly-ownedsubsidiary of GRP, to be the Predecessor as this entity has historicallyprovided the Company’s core transaction management services. For the periodspresented, the Predecessor would have represented over 80% of the revenues,assets and income before provision for income taxes of the combined entities.As such, the Company believes that for comparability purposes this entity isthe most relevant to present.

The consolidated statements of income, stockholders’equity and cash flows included herein include the results of the Predecessorwhich is solely comprised of CSI from January 1, 2004 to August 1,2004, and 

F-7

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Successor which includethe results of TMHC from May 24, 2004 to December 31, 2004 and GRPfrom August 2, 2004 to December 31, 2004. The consolidated statementsof income, stockholders’ equity and cash flows included herein for the yearsended December 31, 2006 and 2005 include the results of both TMHC and GRPfor the entire period.

In these notes to theconsolidated financial statements, references to the “Company” in respect oftime periods preceding the date of acquisition of a controlling interest in GRPby TA are references to CSI and its consolidated subsidiaries (collectively,the “Predecessor”), while such references to time periods commencing with theperiods subsequent to the date TA acquired a controlling interest in GRP andTMHC are references to Clayton Holdings, Inc. and its consolidatedsubsidiaries (collectively, the “Successor”).

***Initial Public Offering of Common Stock***

On March 29, 2006, the Company sold8,625,000 shares, inclusive of an over-allotment option of 1,125,000shares, of its common stock in an initial public offering (“IPO”) of commonstock at a price to the public of $17.00 per share, for net proceeds ofapproximately $131,800,000 after deducting the underwriting discount andapproximately $4,500,000 of offering expenses. The Company used approximately$130,200,000 of the proceeds to pay down indebtedness and to redeem alloutstanding shares of redeemable preferred stock, which were issued upon theconversion of the Company’s convertible preferred stock. The Company usedthe remaining approximately $1,600,000 for general corporate purposes. Aftergiving effect to this offering, the Company had 20,516,306 shares ofcommon stock outstanding.

On February 28, 2006,the Company’s Board of Directors approved a 1-for-4 reverse stocksplit. All share and per share amounts in the accompanying consolidatedfinancial statements have been retroactively adjusted for all periods of theSuccessor presented, to give effect to the reverse stock split.

**Note 2—Summary ofSignificant Accounting Policies**

Significant accountingpolicies followed by the Company, as summarized below, are in conformity withUS GAAP.

***Principles of Consolidation***

The consolidated financialstatements include the accounts of Clayton Holdings, Inc. and itswholly-owned subsidiaries (“the Company”). All significant intercompanytransactions and balances have been eliminated in consolidation.

***Use of Estimates***

The preparation of consolidated financial statementsin conformity with US GAAP requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses, as well as the disclosure of contingent assets and liabilities inthe financial statements and accompanying notes. Some of these accountingpolicies require the application of significant judgment by management in theselection of appropriate assumptions for determining these estimates. By theirnature, these judgments are subject to an inherent degree of uncertainty;therefore, the Company cannot give assurance that actual results will notdiffer significantly from estimated results. Management bases these judgmentson the Company’s historical experience, management’s forecasts and 

F-8

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

other available information,as appropriate. The most significant estimates reflected in the financialstatements include deferred tax assets and liabilities and related valuationallowances, income tax accruals, valuation allowance for accounts receivable,asset impairments, the valuation of stock options and the valuation ofintangible assets and assessments of their useful lives, and related partytransactions. Actual results could differ from estimated amounts. The Companyalso makes estimates in determining other ordinary accruals.

***Accounts Receivable and Allowance for DoubtfulAccounts***

The Company’s accounts receivable are due fromcustomers in the normal course of business. Credit decisions are made based onan evaluation of a customers’ financial condition. Accounts receivable aregenerally due within 30 days. Interest is not charged on delinquent payments.

The Company makesestimates to determine the amount of the allowance for doubtful accountsnecessary to reduce accounts receivable and unbilled receivables to their expectednet realizable value. The Company estimates the amount of the requiredallowance by reviewing the status of significant past-due receivables and byanalyzing historical bad debt trends and realization adjustments to revenue.Actual collection experience has not varied significantly from estimates, dueprimarily to credit policies, the controls and procedures designed to estimaterealization adjustments to revenues and a lack of concentrations of accountsreceivable. Accounts receivable balances are not collateralized.

***Deferred Financing Costs***

The Company amortizes thecosts that it incurs to obtain debt financing over the terms of the underlyingobligations using the effective interest method for the portion of the costsassociated with term loan debt and using the straight line method for theportion of the costs associated with the revolving credit facility. Theamortization of deferred financing costs is included in interest expense.Unamortized deferred financing costs are included in “other assets, net” in theaccompanying consolidated balance sheets. As a result of the Company’s IPO (seeNote 1) on March 29, 2006, the Company repaid $70,000,000 of principal onits term loan and wrote off a proportionate share of the unamortized deferredfinancing costs associated with the term loan. In addition, in December 2006,the Company repaid $15,000,000 of principal. A loss on extinguishment of$885,945 reflecting these write offs is reflected in the statement of incomefor the year ended December 31, 2006. In conjunction with the Companyentering into a new credit agreement on December 8, 2005 (SeeNote 9), the Company wrote off $1,229,338 in deferred financing costswhich were associated with the repaid obligations. Unamortized deferredfinancing costs at December 31, 2006 and 2005 were $1,287,694 and$2,354,099, respectively.

***Revenue Recognition***

Revenue is recognized when persuasive evidence of anarrangement exists, the service has been performed, the fee is fixed anddeterminable, and collection of the resulting receivable is reasonably assured.

The Company derives most of its revenues fromprofessional service activities. The majority of these activities are providedunder “time-and-materials” billing arrangements. Revenues consisting of billedfees and pass-through expenses are recorded as work is performed and expensesare incurred. Revenues also include expenses billed to clients, which includestravel and other out-of-pocket expenses, and other reimbursable expenses. Basedon aggregate volume of all travel expenses incurred for both corporate purposesand client service activities, the Company is eligible to receive certainretroactive volume 

F-9

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

discounts from several ofits travel providers. Such amounts are accrued as earned, are netted againsttravel and related expenses and historically have not been material.Pass-through expenses included in revenues of the Successor for the years endedDecember 31, 2006 and 2005 and from the date of inception through December 31,2004 were $26,109,702, $29,787,719 and $13,891,579, respectively. For theperiod January 1, 2004 through August 1, 2004, pass-through expensesincluded in revenues of the Predecessor were $15,493,865.

The Company recordsprovisions for fee adjustments and discretionary pricing adjustments as a reductionof revenues. Revenues recognized, but not yet billed to clients, have beenrecorded as unbilled receivables in the accompanying consolidated balancesheets.

***Cost of Services***

Direct cost of operationsconsists primarily of employee compensation and related payroll benefits, thecost of billable labor assigned to revenue-generating activities as well ascorresponding travel and related expenses incurred in providing such servicesto clients. Direct cost of operations does not include an allocation ofoverhead costs.

***Advertising***

The Company has incurredminimal advertising costs each period and all costs related to advertising andother promotional expenditures are expensed as incurred. Aggregate advertisingand other promotional expenditures of the Successor for the years ended December 31,2006 and 2005 and from the date of inception through December 31, 2004were $1,261,397, $1,277,737 and $520,570, respectively. For the period January 1,2004 through August 1, 2004, aggregate advertising and other promotionalexpenditures of the Predecessor were $549,119.

***Income Taxes***

The Company recognizes deferred income tax liabilitiesand assets for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns. Deferred income taxliabilities and assets are determined based on the difference between thefinancial statement and the tax basis of assets and liabilities using enactedtax rates in effect for the year in which the differences are expected toreverse. The Company recognizes deferred tax assets if it is more likely thannot that the assets will be realized in future years and a valuation allowanceon the deferred tax assets if they are deemed to be impaired.

Income taxes on netearnings of the Predecessor were obligations of the stockholders pursuant toits election of “S” corporation status under Section 1372 of the InternalRevenue Code effective August 1, 1994. Accordingly, no Federal and certainstate income taxes have been provided for in the accompanying financialstatements for the period January 1, 2004 through August 1, 2004. Forstate tax purposes, the S Corporation was required to pay State corporateincome tax applicable to Subchapter S corporations and recorded such paymentsas expenses in the period such taxes were incurred.

***Stock-based Compensation***

The Company adopted thefair value measurement provisions of SFAS No. 123(R), “Share-BasedPayment,” using the prospective method under which the Company recognizes thecompensation expense 

F-10

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

of a stock-basedaward to an employee over the vesting period based on the fair value of theaward on the grant date consistent with the method described in Note 15.

***Concentration of Credit Risk and Significant Customers***

Financial instruments, which potentially subject theCompany to concentration of credit risk, consist principally of cash and cashequivalents, accounts receivable and unbilled receivables. The Company’s cashis deposited with two financial institutions and, at times, may exceedfederally insured limits. The Company had not experienced any losses on thesedeposits.

At December 31, 2006, 23.1% and 29.2% of theCompany’s billed and unbilled receivables, respectively, were related to itstwo largest clients. At December 31, 2005, 30.1% and 25.5% of the Company’sbilled and unbilled receivables, respectively, were related to its two largestclients.

For the year ended December 31,2006, the two largest clients accounted for 13.2% and 10.6% of revenue of theSuccessor, respectively. For the year ended December 31, 2005, the twolargest clients accounted for 12.9% and 11.2% of revenue of the Successor,respectively. For the period from inception through December 31, 2004, thetwo largest clients accounted for 17.9% and 12.2% of revenue of the Successor,respectively. For the period January 1, 2004 through August 1, 2004the two largest clients accounted for 22.7% and 27.0% of revenue of thePredecessor, respectively.

***Earnings Per Share***

Basic earnings per shareis computed by dividing net income by the weighted-average number of shares ofcommon stock and common stock equivalents outstanding during the period. Priorto our IPO on March 29, 2006, the Company’s convertible preferred stockwas deemed to be a common stock equivalent and included in the computation ofbasic earnings per share because it received dividends at a rate that resultedin a per share amount that was equivalent to the per share amount paid oncommon stock. Diluted earnings per share gives effect to dilutive options,warrants and other potential common stock outstanding during the period.

***Offering Costs and Other Assets***

Costs directly associatedwith the Company’s initial public offering of securities were capitalized andrecorded in prepaid expenses and other current assets in the accompanyingconsolidated balance sheet. Upon completion of the initial public offering on March 29,2006, approximately $4,500,000 of offering expenses were recorded as areduction of the proceeds received in arriving at the amount to be recorded instockholders’ equity. Deferred offering costs as of December 31, 2005 wereapproximately $2,340,000.

***Cash and Cash Equivalents***

The Company considers allhighly liquid investments with an original maturity date of 90 days orless from the date of acquisition to be cash and cash equivalents.

***Property and Equipment***

Property and equipment are stated at cost. Maintenanceand repairs are charged to expense as incurred; costs of additions andimprovements are capitalized.

F-11

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Depreciation is provided on a straight-line basis overthe estimated useful lives of the assets, which range from 30 months to sevenyears. Leasehold improvements and assets under capital leases are amortizedover the shorter of the estimated useful life of the asset or the lease term.

In accordance with Statementof Position 98-1, “Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use,” the costs of computer softwaredeveloped or acquired for internal use incurred during the preliminary projectstage are expensed as incurred. Costs incurred during the applicationdevelopment stage are capitalized. Costs incurred during the post-implementation or operation stage are expensed as incurred. Capitalizedsoftware is classified within property and equipment and is amortized over theestimated useful life of the software, which is generally from three to fiveyears.

***Intangible Assets***

Intangible assets consist of customer relationships,client backlog, technology, trade name and trademarks, non-competitionagreements and excess of cost over fair value of net assets acquired (“goodwill”).Customer relationships are the value of the specifically acquired customerrelationships. Client backlog is the estimated present value of fees to beearned for services performed on loans currently under surveillance. Technologyis the value of recreating the completed technology infrastructure. Trade nameand trademarks are the value inherent in the recognition of the “Clayton” name.The value of the noncompetition agreements are an appraisal of potential lostrevenues that would arise from an individual initiating a competing enterprise.

Exceptfor goodwill, trade name and trademarks, all intangible assets are stated atcost less accumulated amortization. The costs attributable to the identifiedintangibles were based on a number of significant assumptions as determined bythe Company and its independent appraisal expert. Identifiable intangibleassets with finite lives are amortized under the straight-line method overtheir applicable estimated useful lives, estimated by the Company to be between4 to 18 years, as follows:

| Customer relationships              |   |      |   |
|-------------------------------------|--------|-----------|--------|
| Transaction management and advisory |   | 18 years  |   |
| Staffing services                   |   | 10 years  |   |
| Portfolio management                |   | 4 years   |   |
| Client backlog                      |   | 5 years   |   |
| Technology                          |   | 5 years   |   |
| Noncompetition agreement            |   | 4-5 years |   |

 

The weighted average amortization period forintangible assets finite lives is 12 years.

The Company adopted Statement of Financial AccountingStandards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets” (“SFAS No. 142”),which provides, among other things, that goodwill and intangibles withindefinite lives are no longer amortized but are reviewed for impairment atleast annually (beginning with the first anniversary of the acquisition date).Impairment tests were conducted for CSI and CFIS in 2006 and there was noimpairment to goodwill of either entity.

In December 2006, the Company recorded animpairment charge of $279,458 to reflect the write-off of certain customerrelationships associated with portfolio management.

F-12

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

In October 2005, theCompany’s Board of Directors approved the discontinuance of the use of thetrade name “Murrayhill” and the Company recorded an impairment charge of$1,631,700.

***Valuation of Long-lived Assets Excluding Goodwill***

The Company evaluates all of its long-lived assets,including intangible assets other than goodwill and fixed assets, periodicallyfor impairment in accordance with SFAS No. 144, Accounting for theImpairment or Disposal of Long-lived Assets (SFAS No. 144). SFAS No. 144requires that long-lived assets be evaluated for impairment when events orchanges in facts and circumstances indicate that their carrying value may notbe recoverable. If events or circumstances indicate that the carrying value ofan asset may not be recoverable, the amount of impairment will be measured asthe difference between the carrying value and the fair value of the impairedasset. An impairment will be recorded as an operating expense in the period ofthe impairment and as a reduction in the carrying value of that asset.

Assets to be disposed ofare reported at the lower of carrying values or fair values, less estimatedcosts of disposal.

***Derivative Financial Instruments***

The Company accounts forderivative financial instruments in accordance with SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities,” as amended. SFAS No. 133requires certain gains and losses for those instruments which qualify ashedging activities, defined as transactions involving offsetting changes infair value or cash flows for the risk being hedged, to be reported as acomponent of other comprehensive income. For all other derivative instruments,the related gains or losses are recorded in the income statement. The Companyhad an interest rate cap agreement which it executed in conjunction with itsformer credit agreement to lock in a maximum interest rate should variablerates rise. The interest rate cap agreement expired on September 30, 2006(See Note 9).

***Reclassifications***

Certain reclassificationshave been made to the prior periods’ financial statements to conform to thecurrent year presentation. These reclassifications had no effect on previouslyreported results of operations or retained earnings.

***Adoption of New Accounting Pronouncements***

In March 2004, the Financial Accounting StandardsBoard (“FASB”) Emerging Issues Task Force (“EITF”) released Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” EITF 03-1 provides guidance for determining whetherimpairment for certain debt and equity investments is other-than-temporary andthe measurement of an impaired loss. The recognition and measurementrequirements of EITF 03-1 were initially effective for reporting periodsbeginning after June 15, 2004. In September 2004, the FASB Staffissued FASB Staff Position (“FSP”) EITF 03-1-1 that delayed theeffective date for certain measurement and recognition guidance contained inEITF 03-1. The FSP requires that entities continue to apply previouslyexisting “other-than-temporary” guidance until a final consensus is reached.Management does not anticipate that issuance of a final consensus willmaterially impact the Company’s financial condition or results of operations.

In December 2004, the FASB issued SFAS No. 123(R),“Accounting for Stock Based Compensation” which establishes standards fortransactions in which an entity exchanges its equity instruments for goods 

F-13

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

or services. This standardrequires an issuer to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award. This eliminates the exception to account for such awards usingthe intrinsic method previously allowable under Accounting Principles Board (“APB”)Opinion No. 25. In March 2005, the SEC released Staff AccountingBulletin (“SAB”) 107, “Share-Based Payment,” which expresses views of the SECStaff about the application of SFAS No. 123(R). In April 2005, theSEC issued a rule that SFAS No. 123(R) became effective forannual reporting periods beginning on or after June 15, 2005. Wepreviously adopted the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” for all awards granted to employees. On January 1,2006, the Company adopted SFAS No. 123(R) and SFAS 123(R) didnot have a material impact on our financial statements.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3.” SFAS No. 154 replaces APB Opinion No. 20,“Accounting Changes,” and FASB Statement No. 3, “Reporting AccountingChanges in Interim Financial Statements,” and changes the requirements for theaccounting for and reporting of a change in accounting principle. This Statementapplies to all voluntary changes in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions. SFAS No. 154is effective for fiscal years beginning after December 15, 2005. TheCompany adopted SFAS No. 154 as of January 1, 2006. It did not have amaterial impact on the Company’s financial condition or results of operations.

In June 2005, the FASB ratified the EmergingIssues Task Force Issue No. 05-06,*Determining the Amortization Period for Leasehold Improvements* (“EITF 05-06”).EITF 05-06 provides that the amortization period used for leaseholdimprovements acquired in a business combination or purchased after theinception of a lease be the shorter of (1) the useful life of the assetsor (2) a term that includes required lease periods and renewals that arereasonably assured upon the acquisition or the purchase. The Company adoptedEITF 05-06 as of June 29, 2005. It did not have a materialimpact on its consolidated financial position or results of operations.

In July 2006, the FASB issued FASB Interpretation(“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement 109.” FIN 48, which clarifies Statement109, “Accounting for Income Taxes,” establishes the criterion that anindividual tax position has to meet for some or all of the benefits of thatposition to be recognized in the Company’s financial statements. On initialapplication, FIN 48 will be applied to all tax positions for which the statuteof limitations remains open. Only tax positions that meet themore-likely-than-not recognition threshold at the adoption date will berecognized or continue to be recognized. The cumulative effect of applying FIN48 will be reported as an adjustment to retained earnings at the beginning ofthe period in which it is adopted. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. The Company is currently assessing theimpact of FIN 48 on its consolidated financial position and results ofoperations.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.” SFAS No. 157 establishes a common definitionfor fair value to be applied to US GAAP guidance requiring use of fair value,establishes a framework for measuring fair value, and expands disclosure aboutsuch fair value measurements. SFAS No. 157 is effective for fiscal yearsbeginning after November 15, 2007. The Company is currently assessing theimpact of SFAS No. 157 on its consolidated financial position and resultsof operations.

F-14

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

In September 2006, the Securities and ExchangeCommission (“SEC”) staff issued Staff Accounting Bulletin (“SAB”) 108 “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements.” SAB 108 requires that public companiesutilize a “dual-approach” to assessing the quantitative effects of financialmisstatements. This dual approach includes both an income statement focusedassessment and a balance sheet focused assessment. The guidance in SAB 108 mustbe applied to annual financial statements for fiscal years ending after November 15,2006. The Company adopted SAB 108 effective December 31, 2006. Theapplication of the guidance contained in SAB 108 did not have a material impacton the Company’s consolidated financial position or results of operations.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities.” SFAS No. 159 permits entities to choose to measuremany financial assets and financial liabilities at fair value. Unrealized gainsand losses on items for which the fair value option has been elected arereported in earnings. SFAS No. 159 is effective for fiscal years beginningafter November 15, 2007. The Company is currently assessing the impact ofSFAS No. 159 on its consolidated financial position and results ofoperations.

**Note 3—BusinessAcquisitions**

***Asset Purchase fromM R Network I, Ltd.***

On February 3, 2006, the Company entered into anasset purchase agreement through a subsidiary pursuant to which the subsidiaryacquired substantially all of the assets and assumed certain liabilities ofM R Network I, Ltd. (formerly d/b/a Mortgage ResourceNetwork and currently d/b/a Clayton Lender Solutions, Inc.) for anaggregate purchase price of $5,344,970. This acquisition has not been presentedon a pro forma basis because it is not deemed to be material.

Thepurchase price was allocated as follows:

| Accounts  receivable                             |   | $          | 952,943   |   |
|--------------------------------------------------|--------|------------|-----------|--------|
| Prepaid expenses                                 |   | 19,030     |      |
| Property and  equipment                          |   | 957,792    |      |
| Goodwill                                         |   | 3,558,177  |      |
| Intangible assets—customer  relationships   |   | 771,000    |      |
| Intangible assets—noncompetition  agreement |   | 74,000     |      |
| Deposit                                          |   | 25,986     |      |
| Liabilities  assumed                             |   | (1,013,958 | )         |
|                                             |   | $          | 5,344,970 |   |

 

***GRP and TMHC***

In March 2005, GRP and TMHC were combined to formthe Company. In connection with this combination, the existing stockholders ofeach of GRP and TMHC entered into a share exchange agreement with the Company,whereby shares of common stock and convertible preferred stock of each of GRPand TMHC were exchanged for the Company’s common stock, class B commonstock, Series A convertible preferred stock and Series B convertiblepreferred stock (see Note 10).

F-15

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The outstanding shares of the convertible preferredstock are convertible into shares of the Company’s common stock and redeemablepreferred stock. The convertible preferred stock automatically convertspursuant to the formula described in Note 10 below upon the closing of theCompany’s first qualified underwritten public offering. As of December 31,2004, the Series A and Series B convertible preferred stock werecarried on the balance sheet at their liquidation preference of $27,189,514 and$74,512,615, respectively. In the event the convertible preferred stock isconverted to redeemable preferred stock, the liquidation preference of theredeemable preferred stock would be 94.1% of the liquidation preference of theconvertible preferred stock. In connection with a recapitalization andrefinancing of its credit facilities in December 2005 (see Note 9),the Company paid a dividend on the Series A and Series B convertiblepreferred stock in the amounts of $14,931,195 and $40,918,805, respectively,and the liquidation preference was reduced by these amounts. As of December 31,2005, the Series A and Series B convertible preferred stock arecarried on the balance sheet at the liquidation preference of $12,258,319 and$43,866,683, respectively.

During 2005, the Company incurred costs totalingapproximately $1,200,000 in connection with the March 2005 businesscombination, primarily for employee severance costs, legal and otherprofessional fees. As this transaction is considered a merger of entities undercommon control, in accordance with FASB Statement of Financial AccountingStandards (“SFAS”) No. 141, “Business Combinations” (“SFAS No. 141”),these costs have been expensed as incurred.

Thefollowing pro forma information represents the results of operations of theCompany for the year ended December 31, 2004, as if the combination notedabove was effected on January 1, 2004:

| Revenue             |   | $         | 164,897,000 |   |
|---------------------|--------|-----------|-------------|--------|
| Net income          |   | 7,480,000 |        |
| Earnings per share: |   |      |        |
| Basic               |   | $         | .63         |   |
| Diluted             |   | $         | .63         |   |

 

***Clayton Fixed Income Services Inc.***

On May 24, 2004, TA acquired a majority interestin CFIS and concurrently formed TMHC. The total consideration paid by TA for77% of CFIS’s outstanding common shares was $41,702,128 comprised of$27,702,128 in cash paid directly to founding shareholders, $4,000,000 in cashpaid to CFIS in exchange for 247 shares of CFIS common stock, and $10,000,000in cash paid to CFIS in connection with TMHC’s issuance of convertible seniorsubordinated notes to TA, the proceeds of which were used to redeem shares fromthe CFIS founders (see Note 9). Each of the then outstanding sharesof CFIS common stock was exchanged for common stock or convertible preferredstock of TMHC. After the share exchange the founding shareholders of CFIS held2,150,000 shares of TMHC common stock and investment funds affiliated withTA Associates held 7,060,193 shares of TMHC convertible preferred stockaggregating $31,702,128. TMHC also incurred acquisition costs of $1,030,701.Including the dilutive effect of options available for issuance from the TMHC 2004Stock Option and Grant Plan executed concurrently with the equity sale (seeNote 9), TA held an approximate 73.5% interest in TMHC on a fully dilutedbasis.

Subsequent to the formation of the Company, the2,150,000 shares of TMHC common stock held by founding shareholders of CFISwere exchanged at a conversion rate of .3125 per TMHC share for 671,874 sharesof the Company’s common stock and the 7,060,193 shares of TMHC convertiblepreferred stock 

F-16

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

were exchanged at aconversion rate of 1.25 per TMHC share for 8,825,241 shares of the Company’s Series Aconvertible preferred stock.

In accounting for the partial acquisition of CFIS byTA, TMHC applied purchase accounting as prescribed by SFAS No. 141 andEITF Issue No. 88-16, Basis in Leveraged Buyout Transactions. Underthis accounting method, the purchase price for the portion of TMHC acquired byTA has been reflected at fair value with the difference between the purchaseprice and the sum of the fair value of tangible and identifiable intangibleassets acquired less liabilities assumed resulting in the recording ofidentified intangible assets of $14,707,350 and goodwill of $30,796,352.Included in goodwill is $5,540,544 that resulted from the recognition of adeferred tax liability related to intangible assets that are not deductible fortax purposes. The allocation of the purchase price to these intangible assetsis based on a number of significant assumptions as determined by the Companyand its independent appraisal expert, including evaluation of the future incomeproducing capabilities of these assets and related future expected cash flows.

Prior to the exchange ofequity on May 24, 2004, CFIS issued 247 shares of common stock for$4,000,000 in cash. As of December 31, 2004, this contribution was beingheld by the Company as an accrued distribution to founding shareholders inaccordance with the terms of the share purchase agreement. The $4,000,000 waspaid in April 2005.

***Clayton Services, Inc. and First Madison Services, Inc.***

On August 2, 2004, TA, through its newly formedentity GRP, acquired substantially all of the assets and certain liabilities ofCSI and FMS, pursuant to a Contribution and Asset Transfer Agreement (the “Agreement”)with GRP. GRP paid $120,000,000 in cash and issued 3,000,000 shares of commonstock valued at $2,610,000. GRP also incurred acquisition costs ofapproximately $3,092,000. The acquisition was financed through borrowingspursuant to a term loan of $40,000,000, proceeds from the issuance of 6,780,000shares of convertible preferred stock of GRP aggregating $70,000,000, and theissuance of certain subordinated notes and 220,000 shares of common stock witha carrying value of $191,400 (see Note 9) for proceeds of $20,000,000.

Subsequent to the formation of the Company, the3,220,000 shares of GRP common stock were exchanged at an aggregate conversionrate of 0.8918 per GRP share for 2,514,556 shares of the Company’s common stockand 357,020 of the Company’s Class B common stock. The 6,780,000 shares ofGRP convertible preferred stock were exchanged at a conversion rate of 3.5672per GRP share for 24,185,493 shares of the Company’s Series B convertiblepreferred stock with a liquidation preference of $74,512,615. The differencebetween the increase in the carrying value of preferred stock of $4,512,615 andthe aggregate carrying value of $2,801,400 for all the common stock resulted ina decrease in stockholders’ equity of $1,711,215.

F-17

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Pursuant to the Agreement, GRP assumed certaincontractual arrangements whereby additional cash may be paid to the owners ofCSI upon the attainment of certain specified financial criteria over the periodfrom the date of the transaction through December 31, 2005. The totaladditional consideration aggregates to a maximum of $40,000,000. The first suchcontingent amount was measured and attained at December 31, 2004, amountedto $10,000,000 plus accrued interest, and is reflected as additional goodwillon the balance sheet and is included in restricted cash as of December 31,2004. This amount, plus interest, was paid to the owners of CSI inAugust 2005. In November, 2005, the Agreement was amended and$10,000,000 plus accrued interest was paid to the former owners of CSI. Suchamount was recorded as additional goodwill and increased the liquidationpreference amount of the Series B convertible preferred stock by$10,000,000 plus accrued interest. Additionally, the amendment provided thatthe former owners of CSI will receive $13,250,000 in satisfaction of theremaining contingent payments, upon the occurrence of certain events, but in noevent later than May 1, 2006. In connection with a recapitalization andrefinancing of its credit facilities in December 2005 (See Note 9),the Company paid $13,250,000 in satisfaction of the remaining contingentpayments. Such amount was recorded as additional goodwill.

Thefollowing table summarizes the fair values of the assets acquired and theliabilities assumed at the date of acquisition. Fair values are based uponthird party appraisals and internal studies.

| ** **              | ** ** | **GRP**     | ** **  | **TMHC**   | ** ** |
|-------------------------|------------|-------------|-------------|------------|------------|
| Current assets          |       | $           | 37,862,951  |       | $          | 1,648,970 |   |
| Property and  equipment |       | 5,286,932   |        | —     |       |
| Other assets            |       | 55,773      |        | —     |       |
| Intangible assets       |       | 86,323,000  |        | 14,707,350 |       |
| Goodwill                |       | 5,382,193   |        | 30,796,352 |       |
| Total assets acquired   |       | 134,910,849 |        | 47,152,672 |       |
| Liabilities  assumed    |       | (9,486,349  | )           | (5,450,544 | )          |
|                    |       | $           | 125,424,500 |       | $          | 41,702,128 |   |

 

The goodwill recorded inconnection with the GRP transaction is tax deductible except for approximately$2,610,000 that is related to the valuation of the common stock issued as partof the transaction. The goodwill recorded in connection with the TMHCtransaction is all non-tax deductible goodwill.

***Asset Purchase from NISYS, Inc.***

On March 18, 2005, the Company entered into anAsset Purchase Agreement through a subsidiary pursuant to which the subsidiaryacquired substantially all of the assets and assumed liabilities of NISYS, Inc.,including the assumption of an outstanding note, were purchased for anaggregate of $825,326 comprised of $764,642 of cash paid to the seller and$60,684 of transaction costs.

Thepurchase price was allocated as follows:

| Property and  equipment |   | $         | 353,713 |   |
|-------------------------|--------|-----------|---------|--------|
| Technology              |   | 1,060,327 |    |
| Liabilities  assumed    |   | (588,714  | )       |
|                    |   | $         | 825,326 |   |

 

F-18

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The NISYS businessprovides imaged document management, automated decisioning and collaborativeprocess management software that enables third parties to streamline manual,paper-based loan processes. The NISYS platform integrates third partycomponents for workflow/document management, optical characterrecognition/imaging and a rules engine. This acquisition has not beenpresented on a pro forma basis because it is not deemed to be material.

**Note 4—Cash,Cash Equivalents and Restricted Cash**

At December 31, 2006 and 2005, the Companymaintained cash and cash equivalent balances in excess of $100,000 at twoseparate financial institutions. Accounts at these institutions are insured bythe Federal Deposit Insurance Corporation up to $100,000. At December 31,2006 and 2005, the cash balances exceeded $100,000 by $31,862,444 and$13,447,318, respectively, including restricted cash.

At December 31, 2006and 2005, the Company maintained restricted cash balances of $11,738,871 and$4,966,839, respectively. This balance represented funds received in connectionwith certain loan servicing functions the Company performs for a customer. Suchfunds are received throughout the month and remitted to the customer on amonthly basis. The balance on hand is included in servicer escrow liability inthe accompanying consolidated balance sheets.

**Note 5—Property andEquipment, net**

Propertyand equipment consists of the following:

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer and  office equipment                  |       | $                     | 10,338,249 |   | $ | 6,526,737 |   |
| Software                                        |       | 17,864,010            |       | 8,100,020 |   |
| Furniture and  fixtures                         |       | 3,296,009             |       | 2,926,452 |   |
| Leasehold  improvements                         |       | 1,851,453             |       | 1,391,952 |   |
| Website                                         |       | 280,317               |       | 280,317 |   |
| Automobiles                                     |       | 112,336               |       | 171,395 |   |
|                                            |       | 33,742,374            |       | 19,396,873 |   |
| Less accumulated  depreciation and amortization |       | 13,959,975            |       | 6,117,862 |   |
|                                            |       | 19,782,399            |       | 13,279,011 |   |
| Software under  development                     |       | 582,467               |       | 4,896,706 |   |
|                                            |       | $                     | 20,364,866 |   | $ | 18,175,717 |   |

 

Included in software at December 31, 2006 and2005, is $10,383,256 and $3,189,915, respectively, of internally developedsoftware placed in service. Software under development represents otherinternally developed software that has not yet been placed in service. It isthe Company’s policy not to capitalize interest on internally developedsoftware because the amount is immaterial.

For the years ended December 31,2006 and 2005, depreciation and amortization expense charged to operations ofthe Successor was $7,916,666 and $4,693,611, respectively. For the period frominception through December 31, 2004 depreciation and amortization expensecharged to operations of the Successor was $1,115,511. For the period January 1,2004 through August 1, 2004, the depreciation and amortization expensecharged to operations of the Predecessor was $792,511.

F-19

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Note 6—Goodwill andOther Intangible Assets**

As of December 31, 2006 and 2005, intangibleassets not subject to amortization consist of goodwill of $73,401,645 and$69,843,468, respectively, and trade names and trademarks of $15,504,917 and$15,504,338, respectively. In October 2005, the Company’s Board ofDirectors approved the discontinuance of the use of the trade name “Murrayhill”and the Company recorded an impairment charge of $1,631,700.

At December 31,2006, the Company’s intangible assets with identifiable useful lives, whichcontinue to be amortized, consist of the following:

| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer relationships              |       |                            |       |                          |       |       |       |   |   |
| Transaction management and advisory |       |                            | $          | 36,400,000                    |       |       | $          | 4,887,037 |   | $ | 31,512,963 |   |
| Staffing services                   |       |                            | 4,300,000  |                          |       | 1,039,167  |       | 3,260,833 |   |
| Portfolio management                |       |                            | 10,779,600 |                          |       | 2,666,101  |       | 8,113,499 |   |
| Client backlog                      |       |                            | 2,146,200  |                          |       | 1,118,101  |       | 1,028,099 |   |
| Technology                          |       |                            | 26,842,900 |                          |       | 13,088,586 |       | 13,754,314 |   |
| Noncompetition  agreements          |       |                            | 3,568,950  |                          |       | 1,748,446  |       | 1,820,504 |   |
| Patent                              |       |                            | 20,452     |                          |       | 8,259      |       | 12,193 |   |
|                                |       |                            | $          | 84,058,102                    |       |       | $          | 24,555,697 |   | $ | 59,502,405 |   |

 

In December 2006, the Company recorded animpairment charge of $279,458 to reflect the write-off of certain customerrelationships associated with portfolio management.

At December 31,2005, the Company’s intangible assets with identifiable useful lives, whichcontinue to be amortized, consist of the following:

| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**   | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|-----------|------------|
| Customer relationships              |       |                            |       |                          |       |      |       |   |   |
| Transaction management and advisory |       |                            | $          | 36,400,000                    |       |      | $          | 2,864,815 |   | $ | 33,535,185 |   |
| Staffing services                   |       |                            | 4,300,000  |                          |       | 609,167   |       | 3,690,833 |   |
| Portfolio management                |       |                            | 10,714,600 |                          |       | 1,776,817 |       | 8,937,783 |   |
| Client backlog                      |       |                            | 2,146,200  |                          |       | 688,861   |       | 1,457,339 |   |
| Technology                          |       |                            | 26,842,900 |                          |       | 7,720,006 |       | 19,122,894 |   |
| Noncompetition  agreements          |       |                            | 3,494,950  |                          |       | 1,022,292 |       | 2,472,658 |   |
| Patent                              |       |                            | 20,204     |                          |       | 1,460     |       | 18,744 |   |
|                                |       |                            | $          | 83,918,854                    |       |      | $          | 14,683,418 |   | $ | 69,235,436 |   |

 

Amortization expense for the years ended December 31,2006, 2005 and for the period from inception to December 31, 2004 was$10,298,820, $10,175,444 and $4,508,693, respectively.

F-20

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Estimatedfuture amortization expense associated with these intangible assets during thenext five fiscal years is as follows:

| 2007 |   | $         | 10,134,280 |   |
|------|--------|-----------|------------|--------|
| 2008 |   | 9,842,343 |       |
| 2009 |   | 6,581,345 |       |
| 2010 |   | 3,018,556 |       |
| 2011 |   | 3,004,989 |       |

 

**Note 7—Fair Valueof Financial Instruments**

The Company has determinedthe estimated fair values of financial instruments using available marketinformation and appropriate valuation methodologies. However, considerablejudgment is required in interpreting market data to develop fair valueestimates. As a result, the estimates presented below are not necessarilyindicative of the amounts that the Company could realize or be required to payin a current market exchange.

***Cash and CashEquivalents, Restricted Cash, Accounts Receivable, Unbilled Receivables,Accounts Payable and Accrued Expenses***

The carrying amounts ofthese items are reasonable estimates of their fair values due to the short-termnature of these assets.

***Debt***

The fair value oflong-term debt approximates its carrying value at December 31, 2006 and2005, based on an assessment of currently available terms for similararrangements.

***Interest Rate Cap Agreement***

The carrying amount of the Company’s interest rate capagreement in effect as of December 31, 2005 is fair value. The fair valueof the interest rate cap agreement is based on estimates obtained from bankersto settle the agreement. The interest cap agreement expired on September 30,2006.

F-21

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Note 8—AccountsPayable and Accrued Expenses**

Accountspayable and accrued expenses consist of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Trade accounts payable:            |       |                  |       |   |   |
| Vendor payables (primarily travel) |       | $                     | 261,939    |   | $ | 2,487,351 |   |
| Other accounts payable             |       | 4,965,034             |       | 1,658,524 |   |
| Accrued expenses:                  |       |                  |       |   |   |
| Bonuses                            |       | 9,510,253             |       | 7,842,254 |   |
| Payroll                            |       | 2,443,192             |       | 1,276,543 |   |
| Compensation expense               |       | 1,105,591             |       | 508,226 |   |
| Travel expense                     |       | 30,660                |       | 728,756 |   |
| Accrued professional fees          |       | 491,594               |       | 1,140,272 |   |
| Other accrued expenses             |       | 4,023,619             |       | 3,200,152 |   |
|                               |       | $                     | 22,831,882 |   | $ | 18,842,078 |   |

 

**Note 9—RevolvingCredit Facility, Long-Term Debt and Capital Lease Obligations**

Long-termdebt and capital lease obligations consist of the following:

| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Term loans                              |       | $                     | 64,598,998 |   | $ | 150,000,000 |   |
| Capital lease  obligations              |       | 753,201               |       | 416,583 |   |
| Total long-term debt                    |       | 65,352,199            |       | 150,416,583 |   |
| Less current  portion                   |       | 928,633               |       | 1,639,411 |   |
| Long-term debt,  net of current portion |       | $                     | 64,423,566 |   | $ | 148,777,172 |   |

 

***New Credit Agreement***

On December 8, 2005 the Company entered into acredit agreement (the “New Credit Agreement”) with a financial institution. TheNew Credit Agreement provides the Company with a $150,000,000 term loan, all ofwhich was funded at closing, and a $40,000,000 revolving credit facility, noneof which was funded at closing. Subject to the agreement of the lenders toincrease their commitments, the Company has the option to borrow up to anadditional $10,000,000 under the revolving credit facility, for an aggregaterevolving credit facility of $50,000,000. On January 11, 2006 and April 28,2006, the Company exercised its option and amended the New Credit Agreement toincrease the revolving credit facility by $5,000,000 on each date, such thatthe Company had an aggregate revolving credit facility of $50,000,000 as of,and subsequent to, April 28, 2006. The New Credit Agreement expires on December 8,2011.

After the Company’s initial public offering wascompleted on March 29, 2006 the Company repaid $70,000,000 of the$150,000,000 outstanding term loan balance without incurring any prepaymentpenalty. In addition, $7,400,000 which was outstanding under the revolvingcredit facility was repaid. The first $375,000 of the $70,000,000 term loanpayment was applied against the principal payment due on March 31, 2006and future principal repayments were recalculated pro rata based on theremaining 

F-22

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

balance. In December 2006,the Company repaid $15,000,000 of its outstanding term loan balance. Therefore,scheduled quarterly payments of the term loan through December 31, 2010were reduced from $375,000 to $162,718 with the remaining balance of$61,995,510 payable in four equal quarterly installments in 2011. As a resultof the repayments of the term loan in 2006 the Company wrote off aproportionate share of deferred financing costs associated with the term loan(see Note 2, Deferred Financing Costs) and reflected a loss on extinguishmentof $885,945 in the consolidated statement of income for the year ended December 31,2006.

The New Credit Agreement is collateralized bysubstantially all of the assets of the Company. The agreement containscovenants which, among other matters, require the Company to maintain certainlevels of interest coverage ratio, fixed charge ratio and total leverage ratio.Such covenants commence effectiveness on March 31, 2006. In addition, theNew Credit Agreement places limitations on total annual capital expenditures,indebtedness, liens, dividends and distributions, asset sales, transactions withaffiliates, acquisitions and conduct of business, all as defined in theagreement. The New Credit Agreement also contains provisions for an increasedrate of interest during periods of default.

Loans under the New Credit Agreement bear interest atthe applicable London interbank offered rate (“LIBOR”) plus 3.00% or Prime Rateplus 2.0%, at the Company’s option. In addition, the Company is required to paya commitment fee of 0.5% based on the calculation of the excess of therevolving credit loan commitment over the revolving outstanding balance asdefined. On March 15, 2007, the terms of the New Credit Agreement wereamended. The amendment lowered the interest rate on borrowings under the NewCredit Agreement from LIBOR plus 3.00% to LIBOR plus 1.75%, or Prime Rate plus0.75%, at the Company’s option.

The proceeds of this New Credit Agreement were used torepay all outstanding borrowings under the prior credit agreement, outstandingsubordinated and senior subordinated notes and $13,250,000 in satisfaction ofall remaining contingent payments related to TA’s acquisition of CSI. Inaddition, a dividend of $55,850,000 was paid to the holders of the Company’s Series Aand Series B convertible preferred stock. The amount of the liquidationpreference of the convertible preferred stock was reduced by the amount of thedividend.

At December 31, 2006and 2005, the revolving credit facility had no outstanding balance and therewas an outstanding balance of $64,598,998 and $150,000,000 under the term loanwith an interest rate of 8.35% and 9.25%, respectively.

***Credit Agreement—Prior***

On August 2, 2004, CSI entered into a creditagreement with a financial institution. The credit agreement provided CSI withborrowings of up to $60,000,000 under credit facilities consisting of a$40,000,000 term loan and a $20,000,000 revolving credit loan facility.

On December 8, 2005, in conjunction with the NewCredit Agreement, the Company repaid outstanding balances under the revolvingcredit facility and term loan of $11,450,000 and $33,875,000, respectively. Inaddition, outstanding interest including the unused line fee of $231,126 andprepayment penalties of $11,309 were remitted.

The credit agreement wascollateralized by substantially all of the assets of the CSI and FMS and containedseveral covenants including a limitation on total annual capital expenditures.Prior the refinancing of the facility, CSI had exceeded the total capitalexpenditure limitations and did not make a 

F-23

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

requiredpre-payment. The lenders subsequently waived compliance with these covenantswithout penalty and increased the annual capital expenditure limitations forfiscal years 2005 through 2009.

*Revolving CreditLoan Facility—Prior*

The prior revolving creditloan facility included a $2,000,000 letter of credit facility. Loans under therevolving credit loan facility bore interest for the initial period (asdefined) at the applicable LIBOR rate, plus 4.25% or Prime Rate plus 2.75% and,thereafter, all loans under the revolving credit loan facility bore interest atapplicable margins over the LIBOR and Prime Rate determined on the basis of theCompany’s ratio of total debt to twelve months trailing EBITDA. In addition,the Company was required to pay a commitment fee of 0.5% based on thecalculation of the excess of the revolving credit loan commitment over therevolving outstanding as defined. The revolving credit loan facility was toexpire on August 2, 2009.

*Term Loan—Prior*

The $40,000,000 Term Loanwas payable in twenty consecutive quarterly installments commencing on September 30,2004 consisting of (i) four quarterly installments of $1,125,000 through June 30,2005, (ii) four quarterly installments of $1,625,000 through June 30,2006, (iii) four quarterly installments of $2,000,000 through June 30,2007, (iv) four quarterly installments of $2,375,000 through June 30,2008 and (v) four quarterly installments of $2,875,000 through June 30,2009. This facility bore interest for the initial payment period at theapplicable LIBOR plus 4.25% or Prime Rate plus 2.75% and, thereafter, boreinterest at applicable margins based upon a total debt to EBITDA ratio. Theweighted average interest rate as of December 31, 2004 was 6.44%. On August 2,2004, the Company paid $1,712,500 to execute the term loan. This cost was recordedas deferred financing cost and was amortized over the expected life of the termloan using the effective interest method, or as repayments were made. From August 2,2004 through December 31, 2004 and January 1, 2005 through December 8,2005 the amortization of the deferred financing cost aggregated $142,709 and$524,403, respectively and is reflected as interest expense in the accompanyingconsolidated statement of income. In connection with the New Credit Agreement,the unamortized deferred financing cost of $1,045,338 was written-off and isincluded in the loss from extinguishment of debt in the accompanying statementof income.

***Interest Rate Cap***

In September 2004,CSI purchased an interest rate cap agreement to reduce the potential impactthat interest rate increases could have on its floating-rate debt interestexpense. The terms of the interest rate cap provided that the Company wouldreceive quarterly payments equal to the notional amount multiplied by thedifference by which LIBOR exceeds 5%. The initial notional amount was$20,000,000 and declined during the term of the agreement, which expired on September 30,2006. As of December 31, 2005, the notional amount was $16,937,500. Theinterest rate cap did not qualify for hedge accounting under SFAS No. 133,as amended. The initial premium of $29,900 was recorded as an asset on the dateof purchase. Subsequent declines in the fair value of this derivative wererecorded as interest expense in the accompanying consolidated statements ofincome. During the third quarter of 2006, the Company received approximately$19,300 which was recorded as a reduction of interest expense. During theperiod May 24, 2004 to December 31, 2004 and for the year ended December 31,2005, the Company recorded $20,125 and $7,860, respectively, of interestexpense based on a decline in the fair value of this derivative during 

F-24

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

theperiods. In January 2006, the Company recorded interest expense of $1,915to reduce the book value of this asset to zero.

***Subordinated Note Agreements***

*CSI SubordinatedNote Purchase Agreement*

On August 2, 2004, CSI entered into a $20,000,000subordinated note purchase agreement with certain stockholders of the Companyand a lender to finance the acquisition of the Predecessor. The subordinatednote was to mature on August 2, 2010 with an interest rate of 12% perannum.

As part of the subordinated note purchase agreement,CSI issued 220,000 shares of common stock to the stockholders which was valuedat $191,400 for $0.01 per share or $2,200. The difference of $189,200 betweenthe purchase price of the common stock and the share value was recorded as areduction of the initial value of the subordinated notes. This discount wasamortized over the expected life of the subordinated notes using the effective interestmethod, or as payments were made. For the period May 24, 2004 through December 31,2004 and for the year ended December 31, 2005, $13,319 and $29,945,respectively was recorded as additional interest expense.

As of December 31, 2004 CSI was in compliancewith covenants related to the prior credit agreement and as contained in thesubordinated note purchase agreement except for the cross-default provisionsrelated to the covenants in the credit agreement. Compliance with this covenantin the credit agreement was subsequently waived by the senior lenders. Thesubordinated noteholders subsequently waived this non-compliance withoutpenalty and increased the capital expenditure limitations for fiscal years 2005through 2009.

On December 8, 2005,in conjunction with the New Credit Agreement, the Company repaid the entire$20,000,000 subordinated note, related interest of $153,000 and prepaymentpenalties of $800,000. The aggregate prepayment penalty and the unamortizeddebt discount of $146,718 were included in the loss from the extinguishment ofdebt in the accompanying statement of operations.

*TMHC SubordinatedConvertible Note Purchase Agreement*

On May 24, 2004, TMHC issued senior subordinatedconvertible notes due May 24, 2010, in the amount of $10,000,000 to TA.The notes contained an annual interest rate of 12% payable quarterly. On August 31,2004, the notes were converted into senior subordinated notes in the amount of$9,990,000 bearing the same repayment terms and 72,451 common stock purchasewarrants at an exercise price of $.01 per share. On August 31, 2004, thewarrants were exercised.

At the time the notes were converted, the TMHCassessed the related fair value of potential shares to be issued in connectionwith the warrants. The fair value of TMHC’s warrants was estimated based uponthe excess of the fair value per share of the Company, as determined by anindependent valuation expert, over the exercise price of $.01 per share; and asa result, the warrants’ fair value of $357,685 was recorded in equity, reducingthe initial value of the senior subordinated notes. This discount was beingaccreted over the expected life of the senior subordinated notes using theeffective interest method, or as repayments are made. During the period May 24,2004 (date of inception) through December 31, 2004 and for the year ended December 31,2005, $20,233 and $55,523, respectively was recorded as additional interestexpense.

On December 8, 2005,in conjunction with the New Credit Agreement, the Company repaid the entire$9,990,000 subordinated convertible note, related interest of $23,310 andprepayment penalties of 

F-25

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

$499,500.The aggregate prepayment penalty, the unamortized debt discount of $270,707 andthe unamortized debt issuance costs of $184,578 were included in the loss fromthe extinguishment of debt in the accompanying statement of operations.

***Capitalized Lease Obligations***

At December 31, 2006, the Company leased$1,068,087 of equipment under agreements accounted for as capital leases withaccumulated depreciation of $311,169. The obligations for the equipmentrequired the Company to make monthly payments through March 2011, withimplicit interest rates from 7.06% to 19.06%.

At December 31, 2005, the Company leased $467,584of equipment under agreements accounted for as capital leases with accumulateddepreciation of $51,597. The obligations for the equipment required the Companyto make monthly payments through August 2010, with implicit interest ratesfrom 7.06% to 19.06%.

Futureminimum lease payments under noncancelable capital lease obligations as of December 31,2006 are as follows:

| ** **                              | ** ** | **Amount** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2007                                    |       | $          | 338,119    |   |
| 2008                                    |       | 240,952    |       |
| 2009                                    |       | 172,198    |       |
| 2010                                    |       | 102,207    |       |
| 2011                                    |       | 13,267     |       |
| Total minimum lease payments            |       | 866,743    |       |
| Less amount  representing interest      |       | 113,542    |       |
| Present value of minimum lease payments |       | 753,201    |       |
| Less current  maturities                |       | 277,761    |       |
| Long-term capital  lease obligations    |       | $          | 475,440    |   |

 

***Future maturities of Long-Term Debt and Capital LeaseObligations***

Foryears subsequent to December 31, 2006, scheduled annual maturities oflong-term debt and capital lease obligations outstanding as ofDecember 31, 2006 are as follows:

| ** ** | ** ** | **Long-term  debt** | ** ** | **Capital lease  obligation** | ** ** | **Total** | ** ** |
|------------|------------|---------------------|------------|------------------------------------|------------|-----------|------------|
| 2007       |       | $                   | 650,872    |                               |       | $         | 277,761    |   |   | $ | 928,633 |   |
| 2008       |       | 650,872             |       |                               | 206,718    |      |       | 857,590 |   |
| 2009       |       | 650,872             |       |                               | 157,201    |      |       | 808,073 |   |
| 2010       |       | 650,872             |       |                               | 98,419     |      |       | 749,291 |   |
| 2011       |       | 61,995,510          |       |                               | 13,102     |      |       | 62,008,612 |   |
|       |       | $                   | 64,598,998 |                               |       | $         | 753,201    |   |   | $ | 65,352,199 |   |

 

F-26

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Note 10—PreferredStock**

As of December 31, 2005 the Company had 8,825,241shares designated as Series A Redeemable Preferred Stock, par value $0.01per share, and 27,837,046 shares designated as Series B RedeemablePreferred Stock, par value $0.01 per share, none of which were outstanding. Asof December 31, 2005, the Company had 8,825,241 shares designated as Series AConvertible Preferred Stock, par value $0.01 per share, and 24,185,493 sharesdesignated as Series B Convertible Preferred Stock, par value $0.01 pershare, all of which were outstanding. As of December 31, 2005, the Series Aand Series B convertible preferred stock were carried on the consolidatedbalance sheet at their liquidation preference of $12,258,319 and $43,866,683,respectively.

On March 29, 2006,the Company completed its initial public offering of common stock, resulting inthe conversion of the Series A Convertible Preferred Stock into 2,206,308shares of common stock, par value $0.01 per share, and 8,825,241 shares of Series ARedeemable Preferred Stock, and the conversion of 24,185,493 shares of Series BConvertible Preferred Stock into 6,046,371 shares of common stock, par value$0.01 per share, and 24,185,493 shares of Series B Redeemable PreferredStock. A portion of the proceeds from the initial public offering was used toredeem all shares of the Series A Redeemable Preferred Stock and Series BRedeemable Preferred Stockfor $52,764,950, and all of the Series A and Series B RedeemablePreferred Stock were immediately retired. The difference between theliquidation preference amount of the convertible preferred stock and theredemption amount of the redeemable preferred stock was allocated to the commonstock resulting from the conversion and credited to additional paid-in capital.

**Note 11—Commitmentsand Contingencies**

***Operating Leases***

The Company leases its office facilities and certainequipment under noncancelable operating lease arrangements expiring on variousdates through 2017. Such leases include fixed or minimum payments plus, in somecases, scheduled base rent increases over the term of the lease and additionalrents based on the Consumer Price Index. Certain leases provide for monthlypayments of real estate taxes, insurance and other operating expensesapplicable to the property.

As of December 31,2006, future minimum annual lease payments are as follows:

| 2007       |   | $         | 3,367,436  |   |
|------------|--------|-----------|------------|--------|
| 2008       |   | 3,213,322 |       |
| 2009       |   | 2,229,364 |       |
| 2010       |   | 1,441,313 |       |
| 2011       |   | 1,252,439 |       |
| Thereafter |   | 5,339,319 |       |
|       |   | $         | 16,843,193 |   |

 

For the years ended December 31,2006 and 2005 and for the period from inception through December 31, 2004rent expense was $3,924,044, $3,021,458 and $706,836, respectively. For theperiod January 1, 2004 through August 1, 2004 rent expense wasapproximately $812,242.

F-27

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

***Employment Contracts***

Various members of senior management have entered intoemployment agreements which are terminable upon thirty days notice by eitherthe Company or the employee and provide for certain specified benefitsincluding performance bonuses, travel allowances and severance payments upontermination, resignation or a change in control.

On October 18, 2006, in connection with theresignation (effective February 28, 2007) of its Chief InformationOfficer, the Company entered into a Separation Agreement. This agreementprovides for salary continuation in the aggregate amount of $260,000, andhealth insurance premium continuation in the aggregate amount of approximately$3,604, each through February 29, 2008. In addition, the agreement providesfor 2006 incentive compensation, subject to certain conditions, in theaggregate amount of $166,000. Such amounts were recorded as a liability onOctober 31, 2006.

On August 31, 2005,the Company entered into a Separation Agreement and Mutual Release with its formerChief Financial Officer. This agreement provided for salary continuation in theaggregate amount of $168,372, and health insurance premium continuation in theaggregate amount of approximately $10,612, each through August 31, 2006.Such amounts were recorded as a liability on August 31, 2005.

***Litigation***

In the normal course ofbusiness, the Company is subject to various legal proceedings and claims, theresolution of which, in management’s opinion, will not have a material adverseeffect on the financial position or the results of operations of the Company.

**Note 12—IncomeTaxes**

The Predecessor elected “S” corporation status undersection 1372 of the Internal Revenue Code effective August 1, 1994. Underthis section, the net income of the Company was taxed directly to the Company’sstockholders and not to the Company. The Company was directly liable forcertain state and local income taxes as an S-corporation.

Thestate and local income tax benefits of the Predecessor for continuingoperations were as follows:

| ** **         | ** ** | **For the period  January 1, 2004  through  August 1, 2004** | ** ** |
|--------------------|------------|--------------------------------------------------------------------------------------------|------------|
| Current            |       |                                                                                       | $          | (165,586 | ) |   |
| Deferred           |       |                                                                                       | (93,850    | ) |   |
| Income tax benefit |       |                                                                                       | $          | (259,436 | ) |   |

 

F-28

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Thecomponents of deferred tax assets and liabilities are as follows:

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax assets:                      |       |                  |       |   |   |
| Allowance for doubtful accounts           |       | $                     | 89,311     |   | $ | 28,109 |   |
| Accrued compensation                      |       | 357,497               |       | 137,457 |   |
| Deferred revenue                          |       | 170,626               |       | 17,504 |   |
| Deferred compensation                     |       | 249,416               |       | — |   |
| Deferred rent                             |       | 362,673               |       | 383,072 |   |
| State tax net operating loss carryforward |       | 685,247               |       | 327,714 |   |
| Total gross deferred tax assets           |       | 1,914,770             |       | 893,856 |   |
| Valuation allowance                       |       | (685,247              | )          | (327,714 | ) |
| Net deferred tax assets                   |       | 1,229,523             |       | 566,142 |   |
| Deferred tax  liabilities:                |       |                  |       |   |   |
| Property and equipment                    |       | (2,473,521            | )          | (972,411 | ) |
| Amortization of intangibles               |       | (2,272,983            | )          | (2,809,166 | ) |
| Total gross deferred tax liabilities      |       | (4,746,504            | )          | (3,781,577 | ) |
| Net deferred tax  liability               |       | $                     | (3,516,981 | ) | $ | (3,215,435 | ) |

 

Our state net operating loss carryforwards begin toexpire in 2025.

Thecomponents of the provision for income taxes from the date of inception for theSuccessor are as follows:

| ** **                  | ** ** | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** | **For the period  from inception through  December 31, 2004** | ** ** |
|-----------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| Current                     |       |                                             |       |                                             |       |                                                                                        |       |   |   |   |   |   |   |
| Federal                     |       |                                             | $          | 4,594,841                                        |       |                                                                                        |       | $ | 4,815,754 |   |   |   | $ | 1,899,748 |   |   |
| State                       |       |                                             | 624,101    |                                             |       |                                                                                        | 771,312    |   |   |   | 462,315 |   |   |
| Foreign                     |       |                                             | 147,299    |                                             |       |                                                                                        | —     |   |   |   | — |   |   |
|                        |       |                                             | 5,366,241  |                                             |       |                                                                                        | 5,587,066  |   |   |   | $ | 2,362,063 |   |   |
| Deferred                    |       |                                             |       |                                             |       |                                                                                        |       |   |   |   |   |   |   |
| Federal                     |       |                                             | 278,246    |                                             |       |                                                                                        | (1,977,994 | ) |   |   | 4,361 |   |   |
| State                       |       |                                             | 23,300     |                                             |       |                                                                                        | (455,418   | ) |   |   | (12,325 | ) |   |
|                        |       |                                             | 301,546    |                                             |       |                                                                                        | (2,433,412 | ) |   |   | (7,964 | ) |   |
| Provision for income  taxes |       |                                             | $          | 5,667,787                                        |       |                                                                                        |       | $ | 3,153,654 |   |   |   | $ | 2,354,099 |   |   |

 

F-29

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Forthe period from the date of inception through December 31, 2004, theSuccessor’s income tax provision resulted in effective tax rates that variedfrom the statutory Federal income tax rate. The components of the income taxexpense are as follows:

| Pre-tax book  income at statutory rate of 34% |   | $       | 1,936,855 |   | 34.00 | % |
|-----------------------------------------------|--------|---------|-----------|--------|-------|---|
| State taxes                                   |   | 287,644 |      | 5.05   | %     |
| Permanent items                               |   | 129,600 |      | 2.27   | %     |
| Provision for  income taxes                   |   | $       | 2,354,099 |   | 41.32 | % |

 

TheSuccessor’s income taxes resulted in effective tax rates that varied from thestatutory Federal income tax rate. The components of the income tax expense areas follows:

| ** **                             | ** ** | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Pre-tax book  income at statutory rate |       | $                                                | 4,740,488  |                                             | 35.00      | % | $ | 2,788,403 |   | 34.00 | % |
| State taxes                            |       | 454,632                                          |       | 3.36                                             | %          | 295,685 |   | 3.60 | % |
| Permanent items                        |       | 345,868                                          |       | 2.55                                             | %          | 231,195 |   | 2.82 | % |
| State rate change                      |       | (29,048                                          | )          | (0.21                                            | )%         | (161,629 | ) | (1.97 | )% |
| Use of Federal  graduated rate         |       | (96,990                                          | )          | (0.72                                            | )%         | — |   | — | % |
| Other                                  |       | 252,837                                          |       | 1.87                                             | %          | — |   | — | % |
| Provision for  income taxes            |       | $                                                | 5,667,787  |                                             | 41.85      | % | $ | 3,153,654 |   | 38.45 | % |

 

**Note 13—RelatedParty Transactions**

On March 29, 2006, the Company paid $52,764,950from proceeds from its IPO to redeem from investment funds affiliated with TAAssociates and other preferred stockholders, including Brian L. Libman, adirector of the Company, all of the shares of redeemable preferred stockoutstanding immediately following the conversion of Series A ConvertiblePreferred Stock and Series B Convertible Preferred Stock.

The Company’s Chief Executive Officer, who wasappointed in April 2005, has served on the Board of Directors of anotherpublic company since 1995 and is currently the chairman of this entity’s auditcommittee. This unrelated entity acquires and originates non-conformingresidential and commercial loans. The Company has provided due diligence andstaffing services to this entity and revenues aggregated approximately $27,000,$644,000, $533,000 and $98,000 for the years ended December 31, 2006 and2005, for the period from inception through December 31, 2004, and January 1,2004 through August 1, 2004, respectively.

CFIS had contracts to perform Credit Risk Managementservices for portfolios managed by a stockholder. Revenues generated from thecontracts for the years ended December 31, 2006 and 2005 and from the dateof inception through December 31, 2004 of approximately $661,257, $567,800and $404,400, respectively were included in service fee revenue in theconsolidated statements of income and $141,056 and $118,432 were included inaccounts receivable at December 31, 2006 and 2005, respectively. Thesecontracts were cancelled effective December 31, 2006.

As described in Note 3, the Company hadsubordinated note and subordinated convertible note purchase agreements withcertain stockholders of the Company. There was no interest expense on these 

F-30

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

notes for the year ended December 31,2006. For the years ended December 31, 2005 and 2004 interest expense onthese notes was approximately $3,360,000 and $1,680,000, respectively. Inconnection with a refinancing of its credit facility in December 2005 (seeNote 9), these notes were repaid.

TMHC accrued distributionsto owners totaling $1,759,370 in the period from January 1, 2004 through May 23,2004, prior to the formation of TMHC. $840,000 was paid to owners in the periodJanuary 1, 2004 through May 23, 2004 and $919,370 was paid to ownersin the period May 24, 2004 through December 31, 2004.

**Note 14—EmployeeSavings Plan**

The Company sponsors anemployee savings plan that provides for optional employer participation inaccordance with the provisions of Section 401(k) of the InternalRevenue Code. The plans allow participants to make pretax contributions. To beeligible to participate in the plan, employees not covered under collectivebargaining agreements must meet certain age and service requirements. Inaddition to employee contributions, the Board of Directors may approveadditional Company contributions. For the years ended December 31, 2006and 2005 and during the period from the date of inception through December 31,2004, the Company made contributions to the plan of approximately $390,000,$380,000 and $174,000, respectively. For the period January 1, 2004through August 1, 2004, the Predecessor made contributions to the plan ofapproximately $31,000.

**Note 15—StockOptions**

The Company’s 2005 Stock Option and Grant Plan (“2005Option Plan”) permitted the Company to make grants of incentive stock options,non-qualified stock options, restricted stock awards and unrestricted stockawards to officers, employees, directors, consultants and other key persons.Stock options granted under the 2005 Option Plan have a maximum term of tenyears from the date of grant and incentive stock options have an exercise priceof no less than the fair market value of the common stock on the date of grant.In connection with the adoption of the Company’s 2006 Option Plan, which isdiscussed below, the board of directors determined not to grant any furtherawards under the 2005 Option Plan.

On January 26, 2006, the Company’s Board ofDirectors approved the adoption of the Company’s 2006 Stock Option andIncentive Plan (“2006 Option Plan”), and the 2006 Option Plan was subsequentlyapproved by stockholders on March 8, 2006. The 2006 Option Plan permitsgrants of incentive stock options, non-qualified stock options, stockappreciation rights, deferred stock awards, restricted stock awards,unrestricted stock awards and dividend equivalent rights. The Company reserved1,814,130 shares of common stock for issuance of awards under the 2006 OptionPlan, subject to adjustment for any stock split, dividend or other change inthe Company’s capitalization. Generally, shares that are forfeited or cancelledfrom awards under the 2006 Option Plan will be available for future grants.Stock options granted under the 2006 Option Plan have a maximum term of tenyears from the date of grant and incentive stock option awards have an exerciseprice of no less than the fair market value of the common stock on the date ofgrant, which will be on the last day of the month of the award. The optionsgenerally vest over a period of four years, with 25% of each grant vestingafter one year and the remaining shares vesting monthly over the followingthree years. The Company issues new shares upon the exercise of stock options. Cashreceived upon the exercise of options for the years ended December 31,2006, 2005 and for the period from inception through December 31, 2004 was$413,135, $19,047 and $0, respectively.

F-31

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

On March 31, 2005, the holders of all of theoutstanding shares of common and convertible preferred stock of each of GRP andTMHC contributed their respective shares in exchange for like securities of theCompany. In connection with this transaction, all outstanding stock optionsgranted under each of the TMHC 2004 Stock Option and Grant Plan and the GRP2004 Stock Option and Grant Plan were assumed by the Company and became optionsunder the Company’s 2005 Option Plan. The exercise price of each originaloption and the number of options were appropriately adjusted to reflect theexchange ratio of the respective common shares and full credit was given forall vesting under the old plans. Upon conversion, the term of the options underthe TMHC 2004 Stock Option and Grant Plan was changed from seven to ten years.Subsequent to this transaction, the original TMHC and GRP plans wereterminated.

The March 31, 2005 cancellation and replacementhad no accounting consequence since the aggregate intrinsic value of theoptions immediately after the cancellation and replacement was not greater thanthe aggregate intrinsic value immediately before the cancellation andreplacement, and the ratio of the exercise price per share to the fair valueper share was not reduced.

Changes in optionsoutstanding are as follows:

| ** **                                                                                | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Options outstanding,  date of inception                                                   |       | —                     |       |                                       | $          | — |   |   |
| Granted                                                                                   |       | 967,500                    |       |                                       | 1.09       |   |   |
| Exercised                                                                                 |       | —                     |       |                                       | —     |   |   |
| Forfeited                                                                                 |       | —                     |       |                                       | —     |   |   |
| Options outstanding, January 1, 2005                                                 |       | 967,500                    |       |                                       | 1.09       |   |   |
| Impact of option conversion; including the effect of  the reverse stock split             |       | (411,713                   | )          |                                       | 0.81       |   |   |
| Options outstanding, as adjusted                                                          |       | 555,787                    |       |                                       | 1.90       |   |   |
| Granted                                                                                   |       | 963,978                    |       |                                       | 5.91       |   |   |
| Exercised                                                                                 |       | (4,613                     | )          |                                       | 4.13       |   |   |
| Forfeited                                                                                 |       | (54,496                    | )          |                                       | 2.52       |   |   |
| Options outstanding, December 31, 2005                                               |       | 1,460,656                  |       |                                       | 4.52       |   |   |
| Granted                                                                                   |       | 230,000                    |       |                                       | 14.54      |   |   |
| Exercised                                                                                 |       | (172,303                   | )          |                                       | 2.44       |   |   |
| Forfeited                                                                                 |       | (40,563                    | )          |                                       | 4.26       |   |   |
| Expired                                                                                   |       | (7,016                     | )          |                                       | 6.80       |   |   |
| Options outstanding, December 31, 2006                                               |       | 1,470,774                  |       |                                       | 6.33       |   |   |
| Weighted average fair value of options granted for  the year ended December 31, 2006 |       |                       |       |                                       | $          | 5.83 |   |   |
| Options available for  future grant at December 31, 2006                             |       |                       |       |                                       | 1,584,130  |   |   |

 

The total intrinsic value of options exercised duringthe years ended December 31, 2006, 2005 and 2004 was approximately$1,992,000, $11,000 and $0, respectively.

F-32

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Thefollowing table summarizes information about stock options outstanding at December 31,2006:

| ** **              | ** ** | **December 31, 2006** | ** ** |
|-------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Options Outstanding**    | ** ** | **Options Exercisable** | ** ** |
| **Exercise Price** | ** ** | ** **                      | ** ** | **Number Outstanding** | ** ** | **Remaining  Contractual  Life (yrs.)** | ** ** | **Aggregate Intrinsic  Value as of  December 31, 2006** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Aggregate Intrinsic  Value as of  December 31, 2006** | ** ** |
| $0.98 - 0.98            |       |                            | 285,520    |   |   |   | 7.88 |   |   |   | $ | 5,063,538 |   |   |   | 213,891 |   |   |   | $ | 0.98 |   |   |   | $ | 3,793,237 |   |   |
| 4.00 - 6.00             |       |                            | 647,003    |   |   |   | 8.21 |   |   |   | 8,466,213 |   |   |   | 497,423 |   |   |   | 5.59 |   |   |   | 6,528,372 |   |   |
| 6.36 - 6.80             |       |                            | 308,251    |   |   |   | 8.69 |   |   |   | 3,718,069 |   |   |   | 169,345 |   |   |   | 6.64 |   |   |   | 2,044,488 |   |   |
| 12.34 - 17.00           |       |                            | 197,500    |   |   |   | 9.50 |   |   |   | 987,925 |   |   |   | 1,624 |   |   |   | 17.00 |   |   |   | 2,777 |   |   |
| 18.71 - 21.38           |       |                            | 32,500     |   |   |   | 9.72 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
|                    |       |                            | 1,470,774  |   |   |   | 8.45 |   |   |   | $ | 18,235,745 |   |   |   | 882,283 |   |   |   | 4.69 |   |   |   | $ | 12,368,874 |   |   |
|                         |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted average contractual life of optionsexercisable at December 31, 2006 was 8.21 years.

The number of options exercisable at December 31,2005 and 2004 were 209,029 and 197,083, respectively. The weighted average fairvalue of options granted during 2005 and for the period from inception through December 31,2004 was $1.58 and $0.53, respectively. The aggregate intrinsic value ofoptions outstanding and exercisable at December 31, 2005 was approximately$3,300,000 and $513,000, respectively.

In December 2004, the FASB issued SFAS No. 123(R),which establishes standards for transactions in which an entity exchanges itsequity instruments for goods or services. This standard requires an issuer tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award. Thiseliminates the exception to account for such awards using the intrinsic methodpreviously allowable under Accounting Principles Board (“APB”) Opinion No. 25.In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-BasedPayment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R).SFAS No. 123(R) became effective for annual reporting periodsbeginning on or after June 15, 2005. The Company previously adopted thefair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” for all awards granted to employees. On January 1,2006 the Company adopted SFAS No. 123(R) and SFAS No. 123(R) didnot have a material impact on our financial statements.

The Company completed its initial public offering on March 29,2006. According to the provisions of incentive stock option agreements betweenthe Company and its employees, the vesting term for certain options outstandingas of the date of the IPO accelerated by either one year or twenty percent,varying in accordance with the terms of the employee’s specific incentive stockoption agreement. In addition, 130,208 of performance based options becameimmediately vested. Therefore, on March 29, 2006 the Company recognized$611,696 of additional compensation expense from this accelerated vesting.

F-33

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The ongoing effect onconsolidated results of operations or financial condition will be dependentupon future stock based compensation awards granted. The Company utilizes theBlack-Scholes option valuation method to calculate the fair market value of theoptions using assumptions in effect on the date of the grant, as follows:

| ** **               | ** ** | **2006**    | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|--------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Expected life (in years) |       | 6.5 - 7.5   |       | 6.25        |       | 6.5         |       |
| Risk-free interest rate  |       | 4.6% - 5.1% |       | 3.9% - 4.2% |       | 3.7% - 3.9% |       |
| Volatility               |       | 25% - 28%   |       | 25%         |       | 57%         |       |
| Dividend                 |       | 0%          |       | 0%          |       | 0%          |       |

 

For the years ended December 31,2006 and 2005 and from the date of inception through December 31, 2004 theCompany recognized expenses related to the stock option grants summarized aboveover the vesting period of such options of approximately $1,202,000, $252,000and $125,000, respectively. In addition, the Company will recognizeapproximately $1,632,000 of expense related to these grants over the remainingvesting period of such options. This expense is expected to be recognized overa weighted-average period of approximately 3 years.

**Note 16—Stockholders’Equity**

*Common Stock*

At December 31, 2006, the Company has150,000,000 shares of Common Stock authorized, of which 20,688,556 areissued and outstanding. During 2006, the Company issued 172,302 shares ofCommon Stock upon the exercise of stock options.

At December 31, 2005, the Company has60,000,000 shares of Common Stock authorized, of which 3,281,607 areissued and outstanding. During 2005, the Company issued 4,613 shares ofCommon Stock upon the exercise of stock options.

Prior to the initial public offering, the Company’soutstanding capital stock consisted of: (i) 3,281,607 shares ofcommon stock, par value $0.01 per share; (ii) 357,020 shares of Class Bcommon stock, par value $0.01 per share; (iii) 8,825,241 shares of Series AConvertible Preferred Stock, par value $0.01 per share; and (iv) 24,185,493shares of Series B Convertible Preferred Stock, par value $0.01 per share.

In connection with, and upon the completion of, theinitial public offering on March 29, 2006, 8,825,241 shares of Series AConvertible Preferred Stock were converted into 2,206,308 shares of commonstock and 8,825,241 shares of Series A Redeemable Preferred Stock, and24,185,493 shares of Series B Convertible Preferred Stock were convertedinto 6,046,371 shares of common stock and 24,185,493 shares of Series BRedeemable Preferred Stock.

Inclusive of an over-allotment option of 1,125,000shares of its common stock, the Company sold 8,625,000 shares of common stockin its initial public offering at a price to the public of $17.00 pershare, for net proceeds of approximately $131,800,000 after deductingthe underwriting discount and approximately $4,500,000 of offeringexpenses. After giving effect to this offering and the conversion transactionsdescribed above, the Company had 20,516,306 shares of common stockoutstanding as of March 29, 2006.

F-34

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

On March 29, 2006, in connection with the Company’sinitial public offering, the Fourth Amended and Restated Certificate ofIncorporation, which was adopted by the stockholders prior to the initialpublic offering, was filed with the State of Delaware. The Company’sCertificate of Incorporation was amended to change the authorized capital stockof the Company from an aggregate of 160,000,000 shares, consisting of (a) 69,673,021shares of preferred stock, par value $0.01 per share, consisting of Series AConvertible Preferred Stock, Series B Convertible Preferred Stock, Series ARedeemable Preferred Stock and Series B Redeemable Preferred Stock, (b) 80,326,979shares of common stock, consisting of common stock and Class B commonstock, and (c) 10,000,000 shares of undesignated preferred stock to atotal of 160,000,000 shares of capital stock consisting of (i) 150,000,000shares of common stock, par value $0.01 per share, and (ii) 10,000,000shares of undesignated preferred stock, par value $0.01 per share.

On February 28, 2006, the Company’s Board ofDirectors approved a 1-for-4 reverse stock split. All share and pershare amounts in the accompanying consolidated financial statements have beenretroactively adjusted for all periods of the Successor presented, to giveeffect to the reverse stock split.

The Company also hadauthorized 1,428,092 shares of Class B Common Stock, 357,020 of whichwere issued and outstanding at December 31, 2005. The provisions of theCompany’s common stock and Class B common stock are the same with theexception of the Class B common stock having no voting rights. Upon theconsummation of the initial public offering, all outstanding shares of Class Bcommon stock were converted into 357,020 shares of common stock, par value$0.01 per share, and each share of Class B Common Stock was retired.

**Note 17—EarningsPer Share**

Thefollowing is a reconciliation of the numerator and denominator of the basic anddiluted earnings per share computations for the periods indicated:

| ** **                                                  | ** ** | **Successor**                                    | ** ** | **Predecessor**                                  | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                  | ** ** | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** | **For the period  from inception  through  December 31, 2004** | ** ** | **For the period  January 1, 2004  through  August 1, 2004** | ** ** |
| ** **                                                  | ** ** | **Basic**                                        | ** ** | **Diluted**                                      | ** ** | **Basic** | ** ** | **Diluted** | ** ** | **Basic** | ** ** | **Diluted** | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
| Net income                                                  |       | $                                                | 7,876,465  |                                             | $          | 7,876,465 |   | $ | 5,047,534 |   | $ | 5,047,534 |   | $ | 3,342,532 |   | $ | 3,342,532 |   | $ | 13,386,017 |   | $ | 13,386,017 |   |
| Weighted average number of common shares outstanding        |       | 18,497,195                                       |       | 18,497,195                                       |       | 11,888,671 |   | 11,888,671 |   | 9,034,350 |   | 9,034,350 |   | 10,162,309 |   | 10,162,309 |   |
| Dilutive effect of stock options                            |       | —                                           |       | 784,357                                          |       | — |   | 415,956 |   | — |   | 61,187 |   | — |   | — |   |
| Total weighted average number of common shares  outstanding |       | 18,497,195                                       |       | 19,281,552                                       |       | 11,888,671 |   | 12,304,627 |   | 9,034,350 |   | 9,095,537 |   | 10,162,309 |   | 10,162,309 |   |
| Earnings per share                                          |       | $                                                | 0.43       |                                             | $          | 0.41 |   | $ | 0.42 |   | $ | 0.41 |   | $ | 0.37 |   | $ | 0.37 |   | $ | 1.32 |   | $ | 1.32 |   |

 

At December 31, 2006and 2005 and for the period from inception through December 31, 2004,outstanding options to purchase 150,000, 366,886 and 165,625 common shares,respectively, had exercise prices in excess of the average market price forthose periods. These options were not included in the computation of dilutedearnings per share for the respective periods because the effect would beantidilutive.

F-35

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Note 18—SegmentInformation**

**Reportable Segments**

We have organized ourbusiness portfolio into three reportable segments to reflect our businessstrategy. We measure and evaluate our reportable segments based on segmentoperating income. We generally account for intersegment transactions at cost. Segmentoperating income is equal to gross profit less direct selling, general andadministrative (“SG&A”) expenses. Our segments and their principal activitiesconsist of the following:

***Transaction Management***

The transactionmanagement segment provides a full range of outsourced transaction managementservices to our clients, including:

·       duediligence services—assisting loan buyers and sellers make better decisions onhow they price portfolios and manage risk;

·       conduitsupport services—providing the technology and systems required to manage keyaspects of a buyer’s loan acquisition pipeline, including overall processmanagement, due diligence, fulfillment, funding and integration with third-partyservice providers;

·       complianceproducts and services—providing our proprietary compliance testing enginethrough the High Cost Analyzer suite to market participants including loanoriginators;

·       professionalstaffing services—access to qualified independent mortgage loan professionalsis provided to our clients to augment their staffs on both a long- andshort-term basis; and

·       consulting services—providing advice to clients on issues relatedto business process improvement, risk management, regulatory compliance, andtechnology enablement.

***Special Servicing***

The special servicingsegment provides comprehensive loan management for defaulted and delinquentloans and reverse mortgages, collection management, oversight and reporting,foreclosure and bankruptcy administration, eviction and real estate owneddisposition oversight.

***Surveillance***

The surveillance segment provides credit riskmanagement and surveillance services consisting of the oversight and monitoringof predominantly residential non-agency MBS to MBS underwriters, issuers andinvestors.

F-36

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Thefollowing table provides operating financial information for the Successor forour three reportable segments:

| ** **                     | ** ** | **For the Year Ended December 31, 2006** | ** **  |
|--------------------------------|------------|------------------------------------------------------------------------|-------------|
| ** **                     | ** ** | **Transaction  Management**                                            | ** **  | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
| Revenue                        |       | $                                                                      | 191,140,219 |   |   | $ | 13,062,999 |   |   | $ | 34,991,715 |   | $ | 239,194,933 |   |
| Depreciation and  amortization |       | 14,157,945                                                             |        |   | 1,332,445 |   |   | 2,725,096 |   | 18,215,486 |   |
| Impairment of  intangibles     |       | —                                                                 |        |   | 279,458 |   |   | — |   | 279,458 |   |
| Segment operating  income      |       | 43,524,255                                                             |        |   | 6,039,083 |   |   | 18,787,030 |   | 68,350,368 |   |
| Capital  expenditures          |       | 5,643,900                                                              |        |   | 352,864 |   |   | 161,800 |   | 6,158,564 |   |
| Goodwill                       |       | 34,358,505                                                             |        |   | 2,722,546 |   |   | 30,938,401 |   | 68,019,452 |   |
| Assets                         |       | 114,404,020                                                            |        |   | 21,035,477 |   |   | 45,015,815 |   | 180,455,312 |   |
|                                |            |                                                                        |             |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                     | ** ** | **For the Year Ended December 31, 2005** | ** **  |
|--------------------------------|------------|------------------------------------------------------------------------|-------------|
| ** **                     | ** ** | **Transaction  Management**                                            | ** **  | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
| Revenue                        |       | $                                                                      | 173,400,467 |   |   | $ | 8,776,084 |   |   | $ | 25,325,869 |   | $ | 207,502,420 |   |
| Depreciation and  amortization |       | 11,717,879                                                             |        |   | 1,026,014 |   |   | 2,125,162 |   | 14,869,055 |   |
| Impairment of  intangibles     |       | —                                                                 |        |   | — |   |   | 1,631,700 |   | 1,631,700 |   |
| Segment operating  income      |       | 44,748,063                                                             |        |   | 4,089,975 |   |   | 11,209,608 |   | 60,047,646 |   |
| Capital  expenditures          |       | 6,575,582                                                              |        |   | 326,946 |   |   | 353,738 |   | 7,256,266 |   |
| Goodwill                       |       | 30,800,328                                                             |        |   | 2,722,546 |   |   | 30,938,401 |   | 64,461,275 |   |
| Assets                         |       | 116,972,058                                                            |        |   | 14,180,168 |   |   | 44,155,877 |   | 175,308,103 |   |
|                                |            |                                                                        |             |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                     | ** ** | **For the Period from Inception through December 31, 2004** | ** ** |
|--------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Transaction  Management**                                                                         | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
| Revenue                        |       | $                                                                                                   | 63,884,106 |   |   | $ | 3,899,437 |   |   | $ | 12,020,988 |   | $ | 79,804,531 |   |
| Depreciation and  amortization |       | 3,876,075                                                                                           |       |   | 516,855 |   |   | 1,231,274 |   | 5,624,204 |   |
| Segment operating  income      |       | 15,466,559                                                                                          |       |   | 1,881,115 |   |   | 2,573,602 |   | 19,921,276 |   |
| Capital  expenditures          |       | 2,020,452                                                                                           |       |   | 156,212 |   |   | 556,302 |   | 2,732,966 |   |
| Goodwill                       |       | 9,274,709                                                                                           |       |   | 725,291 |   |   | 30,796,352 |   | 40,796,352 |   |
| Assets                         |       | 104,405,697                                                                                         |       |   | 9,275,930 |   |   | 47,346,822 |   | 161,028,449 |   |
|                                |            |                                                                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table provides operating financial information for the Predecessorfor our three reportable segments:

| ** **                       | ** ** | **For the Period January 1, 2004 through August 1, 2004** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Transaction  Management**                                                                            | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
| Revenue                          |       | $                                                                                                      | 74,180,502 |   |   | $ | 2,035,575 |   |   |   | $ | 122,456 |   |   |   | $ | 76,338,533 |   |   |
| Depreciation and  amortization   |       | 742,459                                                                                                |       |   | 1,869 |   |   |   | 48,183 |   |   |   | 792,511 |   |   |
| Segment operating  income (loss) |       | 20,838,032                                                                                             |       |   | 1,306,138 |   |   |   | (765,444 | ) |   |   | 21,378,726 |   |   |
| Capital  expenditures            |       | 1,292,398                                                                                              |       |   | — |   |   |   | 160,648 |   |   |   | 1,453,046 |   |   |
| Assets                           |       | 36,668,855                                                                                             |       |   | 134,872 |   |   |   | 387,699 |   |   |   | 37,191,426 |   |   |
|                                  |            |                                                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-37

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Thefollowing tables are reconciliations of certain segment items to the totalconsolidated amount.

| ** **                                           | ** ** | **Successor** | ** **        | **Predecessor**                                  | ** ** |
|------------------------------------------------------|------------|---------------|-------------------|--------------------------------------------------|------------|
| **Segment Operating Income:**              | ** ** | ** **    | ** **        | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** | **Inception through  December 31, 2004** | ** ** | **January 1, 2004 through  August 1, 2004** | ** ** |
| Total segment  operating  income                     |       |          | $ 68,350,368 |                                             |       |   | $ 60,047,646 |   |   |   | $ 19,921,276 |   |   |   | $ 21,378,726 |   |   |
| Direct selling,  general and administrative expenses |       |          | 15,977,562        |                                             |       |   | 11,926,347 |   |   |   | 7,435,624 |   |   |   | 1,295,947 |   |   |
| Consolidated  reported gross profit                  |       |          | $ 84,327,930 |                                             |       |   | $ 71,973,993 |   |   |   | $ 27,356,900 |   |   |   | $ 22,674,673 |   |   |
|                                                      |            |               |                   |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                  | ** ** | **Successor** | ** **       | **Predecessor**                                  | ** ** |
|---------------------------------------------|------------|---------------|------------------|--------------------------------------------------|------------|
| **Capital Expenditures:**              | ** ** | ** **    | ** **       | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** | **Inception through  December 31, 2004** | ** ** | **January 1, 2004 through  August 1, 2004** | ** ** |
| Total segment  capital expenditures         |       |          | $ 6,158,564 |                                             |       |   | $ 7,256,266 |   |   |   | $ 2,732,966 |   |   |   | $ 1,453,046 |   |   |
| General capital  expenditures               |       |          | 2,798,532        |                                             |       |   | 3,664,661 |   |   |   | 2,227,760 |   |   |   | 816,606 |   |   |
| Consolidated  reported capital expenditures |       |          | $ 8,957,096 |                                             |       |   | $ 10,920,927 |   |   |   | $ 4,960,726 |   |   |   | $ 2,269,652 |   |   |
|                                             |            |               |                  |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| **Assets:**                   | ** ** | ** ** | ** **         | **December 31, 2006** | ** ** | **December 31, 2005** | ** **         |
|-------------------------------|------------|------------|--------------------|---------------------------------|------------|---------------------------------|--------------------|
| Total segment  assets         |       |       | $ 180,455,312 |                            |       |                            | $ 175,308,103 |   |   |
| General assets                |       |       | 82,457,279         |                            |       |                            | 72,197,254         |   |   |
| Consolidated  reported assets |       |       | $ 262,912,591 |                            |       |                            | $ 247,505,357 |   |   |

 

| **Goodwill:**                   | ** ** | ** ** | ** **        | **December 31, 2006** | ** ** | **December 31, 2005** | ** **        |
|---------------------------------|------------|------------|-------------------|---------------------------------|------------|---------------------------------|-------------------|
| Total segment  goodwill         |       |       | $ 68,019,452 |                            |       |                            | $ 64,461,275 |   |   |
| Unallocated  goodwill           |       |       | 5,382,193         |                            |       |                            | 5,382,193         |   |   |
| Consolidated  reported goodwill |       |       | $ 73,401,645 |                            |       |                            | $ 69,843,468 |   |   |

 

Unallocated goodwill isassociated with the August 2004 GRP transaction in which the Companyacquired substantially all of the assets and certain liabilities of CSI and FMS.At the date of this transaction, the Company managed its activities as, andconsidered that its businesses operated in, a single industry segment;therefore, the goodwill associated with the GRP transaction was not allocated. AtDecember 31, 2006, although we are reporting segment information inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” it is impracticable to allocate a portion of thegoodwill recorded in connection with the GRP transaction. See note 3, BusinessAcquisitions, for additional information.

**Note 19—QuarterlyFinancial Information (unaudited)**

Thefollowing table presents our unaudited quarterly results of operations for eachof the quarters in 2006 and 2005. You should read the following table inconjunction with the consolidated financial statements and related notes containedelsewhere in this Annual Report on Form 10-K. We have prepared 

F-38

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**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

the unaudited information on the same basis as ouraudited consolidated financial statements. Results of operations for anyquarter are not necessarily indicative of results for any future quarters orfor a full year.

| ** **                                         | ** ** | **Quarter Ended**               | ** **    |
|----------------------------------------------------|------------|--------------------------------------|---------------|
| ** **                                         | ** ** | **March 31,  2006**             | ** **    | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** **    |
| **CONSOLIDATED STATEMENT OF  INCOME:**             |       |                                 |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                            |       |                                 | $ 55,228 |   |   |   | $ 61,804 |   |   |   | $ 60,969 |   |   |   | $ 61,194 |   |   |   | $ 47,896 |   |   |   | $ 49,275 |   |   |   | $ 54,031 |   |   |   | $ 56,300 |   |   |
| Cost  of services:                                 |       |                                 |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Compensation expense                               |       |                                 | 29,464        |   |   |   | 31,268 |   |   |   | 29,707 |   |   |   | 28,610 |   |   |   | 23,368 |   |   |   | 23,473 |   |   |   | 24,923 |   |   |   | 27,911 |   |   |
| Travel and related expenses                        |       |                                 | 7,127         |   |   |   | 6,753 |   |   |   | 6,303 |   |   |   | 5,928 |   |   |   | 7,354 |   |   |   | 7,115 |   |   |   | 7,455 |   |   |   | 7,863 |   |   |
| Other direct costs                                 |       |                                 | 2,344         |   |   |   | 3,041 |   |   |   | 2,164 |   |   |   | 2,158 |   |   |   | 1,312 |   |   |   | 1,053 |   |   |   | 1,673 |   |   |   | 2,028 |   |   |
| Total cost of services                             |       |                                 | 38,935        |   |   |   | 41,062 |   |   |   | 38,174 |   |   |   | 36,696 |   |   |   | 32,034 |   |   |   | 31,641 |   |   |   | 34,051 |   |   |   | 37,802 |   |   |
| Gross profit                                       |       |                                 | 16,293        |   |   |   | 20,742 |   |   |   | 22,795 |   |   |   | 24,498 |   |   |   | 15,862 |   |   |   | 17,634 |   |   |   | 19,980 |   |   |   | 18,498 |   |   |
| Operating expenses:                                |       |                                 |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Salaries and benefits                              |       |                                 | 5,372         |   |   |   | 5,659 |   |   |   | 5,960 |   |   |   | 6,175 |   |   |   | 4,055 |   |   |   | 5,227 |   |   |   | 4,719 |   |   |   | 4,910 |   |   |
| Other selling, general and administrative expenses |       |                                 | 4,883         |   |   |   | 5,002 |   |   |   | 5,064 |   |   |   | 5,257 |   |   |   | 3,439 |   |   |   | 4,947 |   |   |   | 4,014 |   |   |   | 4,781 |   |   |
| Depreciation and amortization                      |       |                                 | 1,538         |   |   |   | 1,961 |   |   |   | 2,185 |   |   |   | 2,233 |   |   |   | 870 |   |   |   | 1,081 |   |   |   | 1,187 |   |   |   | 1,556 |   |   |
| Amortization of intangibles                        |       |                                 | 2,542         |   |   |   | 2,601 |   |   |   | 2,578 |   |   |   | 2,578 |   |   |   | 2,547 |   |   |   | 2,547 |   |   |   | 2,540 |   |   |   | 2,541 |   |   |
| Impairment of intangibles                          |       |                                 | —        |   |   |   | — |   |   |   | — |   |   |   | 279 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,632 |   |   |
| Total operating expenses                           |       |                                 | 14,335        |   |   |   | 15,223 |   |   |   | 15,787 |   |   |   | 16,522 |   |   |   | 10,911 |   |   |   | 13,802 |   |   |   | 12,460 |   |   |   | 15,420 |   |   |
| Income from operations                             |       |                                 | 1,958         |   |   |   | 5,519 |   |   |   | 7,008 |   |   |   | 7,976 |   |   |   | 4,951 |   |   |   | 3,832 |   |   |   | 7,520 |   |   |   | 3,078 |   |   |
| Interest expense, net                              |       |                                 | 3,070         |   |   |   | 1,676 |   |   |   | 1,760 |   |   |   | 1,525 |   |   |   | 1,817 |   |   |   | 2,009 |   |   |   | 1,999 |   |   |   | 2,364 |   |   |
| Loss from extinguishment of debt                   |       |                                 | 746           |   |   |   | — |   |   |   | — |   |   |   | 140 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,991 |   |   |
| Income (loss) before provision for income taxes    |       |                                 | (1,858        | ) |   |   | 3,843 |   |   |   | 5,248 |   |   |   | 6,311 |   |   |   | 3,134 |   |   |   | 1,823 |   |   |   | 5,521 |   |   |   | (2,277 | ) |   |
| Income tax expense (benefit)                       |       |                                 | (781          | ) |   |   | 1,492 |   |   |   | 2,188 |   |   |   | 2,769 |   |   |   | 1,242 |   |   |   | 736 |   |   |   | 2,185 |   |   |   | (1,010 | ) |   |
| Net income (loss)                                  |       |                                 | $ (1,077 | ) |   |   | $ 2,351 |   |   |   | $ 3,060 |   |   |   | $ 3,542 |   |   |   | $ 1,892 |   |   |   | $ 1,087 |   |   |   | $ 3,336 |   |   |   | $ (1,267 | ) |   |

 

**Note 20—SubsequentEvents**

On January 3, 2007, Clayton Services, Inc.,a wholly-owned subsidiary of the Registrant, entered into a lease agreementwith FOA 6302 East Martin Luther King Boulevard LLC (the “Lease”) for 51,134-sq.ft. of office space located at 6302 East Dr. Martin Luther King, Jr.Boulevard, Tampa, Florida. The term of the Lease will expire on March 31,2017. The Lease provides for an initial rent of approximately $57,100 permonth, subject to adjustment as provided in the Lease.

On January 30, 2007, the Company’s CompensationCommittee granted 165,000 shares of restricted stock under the 2006 Option Planto certain key members of its management. The shares will vest in equal annualinstallments over 4 years.

On February 5, 2007, the Company repaid$5,000,000 of its outstanding term loan balance. There were no penaltiesassociated with this repayment.  At December 31,2006, the $5,000,000 used to make this payment was included in “cash and cashequivalents” in the accompanying consolidated balance sheet.

On March 15, 2007, the terms of the New CreditAgreement were amended. The amendment lowered the interest rate on borrowingsunder the New Credit Agreement from LIBOR plus 3.00% to LIBOR plus 1.75%, orPrime Rate plus 0.75%, at the Company’s option.

F-39

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of DirectorsClayton Fixed Income Services Inc.(formerly known as The Murrayhill Company)

We have audited the accompanying consolidatedstatements of income, shareholders’ equity and cash flows of Clayton FixedIncome Services Inc. (formerly known as The Murrayhill Company) and itssubsidiary (the Company) for the period from January 1, 2004 through May 23,2004. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides a reasonable basis for our opinion.

In ouropinion, the financial statements referred to above, present fairly, in all materialrespects, the results of operations and cash flows of Clayton Fixed IncomeServices Inc. for the period from January 1, 2004 through May 23,2004 in conformity with accounting principles generally accepted in the UnitedStates of America.
| /s/  GRANT THORNTON  LLP |   |
|------------------------------------|--------|
| New York, New  York                |
| October 14,  2005             |

 

F-40

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**CLAYTON FIXED INCOME SERVICES INC.(F/K/A THE MURRAYHILL COMPANY)CONSOLIDATED STATEMENT OF INCOME**

| ** **                                         | ** ** | **For the period January 1,  2004 through May 23,  2004** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| Revenue                                            |       |                                                                                         | $          | 6,097,018 |   |   |
| Cost of services                                   |       |                                                                                         |       |   |   |
| Compensation expense                               |       |                                                                                         | 1,493,351  |   |   |
| Travel and related expenses                        |       |                                                                                         | 30,937     |   |   |
| Total cost of services                             |       |                                                                                         | 1,524,288  |   |   |
| Gross profit                                       |       |                                                                                         | 4,572,730  |   |   |
| Operating  expenses                                |       |                                                                                         |       |   |   |
| Salaries and benefits                              |       |                                                                                         | 1,373,978  |   |   |
| Other selling, general and administrative expenses |       |                                                                                         | 1,029,600  |   |   |
| Depreciation and amortization                      |       |                                                                                         | 116,263    |   |   |
| Total operating expense                            |       |                                                                                         | 2,519,841  |   |   |
| Income from operations                             |       |                                                                                         | 2,052,889  |   |   |
| Interest  (income), net                            |       |                                                                                         | (5,852     | ) |   |
| Net income                                         |       |                                                                                         | $          | 2,058,741 |   |   |

 

The accompanying notes are an integral part of this statement.

F-41

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**CLAYTON FIXED INCOME SERVICES INC.(F/K/A THE MURRAYHILL COMPANY)CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY**

| ** **                                                           | ** ** | **Common Stock**      | ** ** | **Additional** | ** ** | ** **           | ** ** | ** **             | ** ** | ** **          | ** ** |
|----------------------------------------------------------------------|------------|----------------------------|------------|----------------|------------|----------------------|------------|------------------------|------------|---------------------|------------|
| ** **                                                           | ** ** | **Number of  Shares** | ** ** | **Amount**     | ** ** | **Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |
| Balance at January 1, 2004                                      |       |                       | 3,000      |           |       |                 | $          | 30                     |       |                | $          | 74,970 |   | $ | 2,652,666 |   | $ | — |   | $ | 2,727,666 |   |
| Net income from January 1, 2004 through  May 23, 2004 |       |                       | —     |           |       |                 | —     |                   |       | —              |       | 2,058,741 |   | — |   | 2,058,741 |   |
| Issuance of common stock                                             |       |                       | 247        |           |       |                 | 2          |                   |       | 3,999,998           |       | — |   | — |   | 4,000,000 |   |
| Repurchase of common stock                                           |       |                       | —     |           |       |                 | —     |                   |       | —              |       | — |   | (10,000,000 | ) | (10,000,000 | ) |
| Cost associated with the issuance of common  stock              |       |                       | —     |           |       |                 | —     |                   |       | (783,543            | )          | — |   | — |   | (783,543 | ) |
| Distributions                                                        |       |                       | —     |           |       |                 | —     |                   |       | (1,047,963          | )          | (4,711,407 | ) | — |   | (5,759,370 | ) |
| Balance at  May 23, 2004                                        |       |                       | 3,247      |           |       |                 | $          | 32                     |       |                | $          | 2,243,462 |   | $ | — |   | $ | (10,000,000 | ) | $ | (7,756,506 | ) |

 

The accompanying notes are an integral part of this statement.

F-42

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**CLAYTON FIXED INCOME SERVICES INC.(F/K/A THE MURRAYHILL COMPANY)CONSOLIDATED STATEMENT OF CASH FLOWS**

| ** **                                                                         | ** ** | **For the period January 1,  2004 through May 23, 2004** | ** **  |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|-------------|
| **Cash flows from operating  activities**                                          | ** ** |                                                                                             | ** **  | ** ** |   |
| Net income                                                                         |       |                                                                                             | $           | 2,058,741 |   |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                                                                             |        |   |   |
| Depreciation and  amortization                                                     |       |                                                                                             | 116,263     |   |   |
| Deferred rent                                                                      |       |                                                                                             | 127,073     |   |   |
| Changes in operating assets and liabilities:                                       |       |                                                                                             |        |   |   |
| Accounts  receivable, net                                                          |       |                                                                                             | (649,818    | ) |   |
| Due from related  parties                                                          |       |                                                                                             | (133,289    | ) |   |
| Prepaid expenses                                                                   |       |                                                                                             | (222,284    | ) |   |
| Accounts payable  and accrued liabilities                                          |       |                                                                                             | 123,639     |   |   |
| Net cash provided  by operating activities                                         |       |                                                                                             | 1,420,325   |   |   |
| **Cash  flows from investing activities**                                          | ** ** |                                                                                             | ** **  | ** ** |   |
| Purchase of  property and equipment                                                |       |                                                                                             | (121,328    | ) |   |
| Net cash used in  investing activities                                             |       |                                                                                             | (121,328    | ) |   |
| **Cash  flows from financing activities**                                          | ** ** |                                                                                             | ** **  | ** ** |   |
| Distributions                                                                      |       |                                                                                             | (840,000    | ) |   |
| Proceeds from  convertible note                                                    |       |                                                                                             | 9,752,841   |   |   |
| Purchase of  treasury stock                                                        |       |                                                                                             | (10,000,000 | ) |   |
| Net proceeds from  issuance of common stock                                        |       |                                                                                             | 3,216,457   |   |   |
| Net cash provided  by financing activities                                         |       |                                                                                             | 2,129,298   |   |   |
| Net increase in  cash and cash equivalents                                         |       |                                                                                             | 3,428,295   |   |   |
| Cash and cash  equivalents at the beginning of period                              |       |                                                                                             | 2,094,566   |   |   |
| Cash and cash  equivalents at the end of period                                    |       |                                                                                             | $           | 5,522,861 |   |   |

 

The accompanying notes are an integral part of this statement.

F-43

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**CLAYTON FIXED INCOME SERVICES INC. (F/K/A THE MURRAYHILL COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1—Organization and Summary of SignificantAccounting Policies**

***Organization andDescription of Business***

Clayton Fixed IncomeServices Inc. (formerly known as The Murrayhill Company) (the Company orCFIS) was formed as an S corporation on April 1, 1997. On January 22,2004, the Company formed IPS, a wholly-owned subsidiary, to develop and provideadditional service offerings to the fixed-income industry.

The Company monitors andreports on the performance of defaulted loans, loan servicers, master servicers,and trustees in securitized and wholly-owned mortgage and other credit pools.The Company is retained by the issuer of securitized loan pools to act as aparty to the securitized transaction. The Company is retained for the life ofthe transaction, with the responsibility of monitoring and reporting creditrisk issues affecting the security. The Company advises the servicer, masterservicer, trustee, and asset manager in a transaction of systemic weaknessesaffecting loan performance, as well as resolution tactics for individual loansin default. The Company additionally performs consulting and benchmarkinganalyses of the servicers and master servicers it monitors.

On May 24, 2004,investment funds affiliated with TA Associates, Inc. (TA) acquired a majorityinterest in CFIS and concurrently formed TMHC Holdings, Inc. (TMHC).TMHC was formed to acquire CFIS. The total consideration paid by TAfor 77% of CFIS’s outstanding common shares was $41,702,128 comprised of$27,702,128 in cash paid directly to founding shareholders, $4,000,000 in cashpaid to CFIS in exchange for 247 shares of CFIS common stock, and $10,000,000in cash paid to CFIS in connection with TMHC’s issuance of convertible seniorsubordinated notes to TA the proceeds of which were used to redeem shares fromthe CFIS Founders. Each of the then outstanding shares of CFIS common stock wasexchanged for common stock or convertible preferred stock of TMHC. After theshare exchange, the founding shareholders of CFIS held 2,150,000 shares of TMHCcommon stock and investment funds affiliated with TA held 7,060,193 shares ofTMHC convertible preferred stock aggregating $31,702,128. Including thedilutive effect of options available for issuance from TMHC’s 2004 Stock Optionand Grant Plan executed concurrently with the equity sale, TA held anapproximate 73.5% interest in TMHC on a fully diluted basis. Prior to theexchange of equity on May, 24, 2004, CFIS issued 247 shares of commonstock for $4,000,000 in cash.

***SignificantAccounting Policies***

Significant accountingpolicies followed by the Company, a summarized below, are in conformity withaccounting principles generally accepted in the United States of America (“USGAAP”).

*Allowance forUncollectible Receivables.**  *Provision for uncollectible accounts is made inamounts approximating anticipated losses. Individual accounts are written offagainst the allowance when collection of the accounts appears doubtful.

*Basis of Consolidation.**  *The consolidated financialstatements include the accounts of the Company and its wholly-owned subsidiary,after eliminations of intercompany transactions and balances.

*Revenue Recognition.**  *Revenue is recognized whenpersuasive evidence of an arrangement exists, the service has been performed,the fee is fixed and determinable, and collection of the resulting receivableis reasonably assured. As a party to the trust of mortgage-backed securities,the Company receives a monthly fee calculated as the product of a negotiatedrate by the underlying collateral principal balance.

F-44

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**CLAYTON FIXED INCOME SERVICES INC. (F/K/A THE MURRAYHILL COMPANY) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Likewise, when the Companyis not a party to the trust, the Company receives a monthly fee as calculatedabove, or calculated as the product of a negotiated rate by the number ofdefaulted loans in the monitored pool. These fees are recognized as revenue eachmonth for services rendered.

*Advertising Cost.**  *The Company expenses advertisingcosts as incurred. Advertising costs incurred during the period January 1,2004 through May 23, 2004 were minimal.

*Use of Estimates.**  *The preparation of financialstatements in conformity with US GAAP requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from thoseestimates.

***Concentration Risk***

The Company has threeclients that each make up more than 10% of total revenue. These three clientsrepresent 69% of the consolidated annual revenue of the Company for the periodended May 23, 2004.

***Income Taxes***

The Company is not subjectto income taxes, as the Company’s tax filing status is that of anS corporation. All tax consequences of the Company’s operations are passedthrough to and reported by the individual shareholders on their personal incometax returns.

**Note 2—Leases and Rent Expense**

The Company leases certainfacilities and equipment under noncancelable operating lease agreements. Rentexpense, which is being recognized on a straight-line basis over the relatedlease terms, was $242,318 for the period January 1, 2004 through May 23,2004.

**Note 3—Related Party Transactions**

The Company has contractsto perform credit risk management services for portfolios managed by astockholder. Revenues generated from the contracts for the period January 1,2004 through May 23, 2004 were $186,904, and are included in service feerevenue in the consolidated income statement.

During the period January 1,2004 through May 23, 2004 the Company paid expenses on behalf of itsshareholder aggregating $139,171. These amounts were subsequently repaid to theCompany by the stockholder.

The Company accrueddistributions to shareholders totaling $1,759,370 during the period January 1,2004 through May 23, 2004, of which $840,000 was paid to stockholdersprior to May 23, 2004 and $919,370 was paid subsequent to May 23,2004.

**Note 4—401(k) Salary Deferral Plan**

The Company sponsors a 401(k) ProfitSharing Plan and Trust (the Plan), pursuant to which eligible employees maydefer compensation for income tax purposes under section 401(k) ofthe Internal Revenue Code of 1986. Participation in the Plan is available toall employees who meet eligibility requirements. Eligible employees maycontribute up to the maximum allowed by law. Matching contributions may be madeas described in the Plan document. Matching contributions by the Company to thePlan on behalf of participating employees were $75,165 during the period January 1,2004 through May 23, 2004.

F-45

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**Schedule II**

**CLAYTON HOLDINGS, INC. AND SUBSIDIARIES**Valuation and Qualifying Accounts

| ** **                       | ** ** | ** ** | ** ** | **Additions**                                  | ** ** | ** **                                    | ** ** | ** **                               | ** ** |
|----------------------------------|------------|------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------|------------|
| **Accounts**                     | ** ** | ** ** | ** ** | **Balance at  beginning  of period** | ** ** | **Charged to  costs and  expenses** | ** ** | **Charged to other  accounts** | ** ** | **Deductions** | ** ** | **Balance at end  of period** | ** ** |
| Allowance for doubtful  accounts | ** ** |       | ** ** | ** **                                     |       |                                          | ** ** | ** **                               |       |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| 2004                             |       |       | $          | 4,100                                          | ** ** |                                          |       | $                                        | 85,437     | ** ** |   |   | $ | — | ** ** |   | $ | — |   |   | $ | 89,537 | ** ** |   |
| 2005                             |       |       | 89,537     | ** **                                     |       |                                          | 245,839    | ** **                               |       |   | — | ** ** |   | (263,112 | ) |   | 72,264 | ** ** |   |
| 2006                             |       |       | 72,264     | ** **                                     |       |                                          | 352,534    | ** **                               |       |   | — | ** ** |   | (233,229 | ) |   | 191,569 | ** ** |   |
|                                  |            |            |            |                                                |            |                                               |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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