**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**
| **x**  | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                          |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                            |
|   | **For the quarterly period ended September 30,  2006**                                                                                                          |
|   | ** **                                                                                                                                                      |
| **OR** |
|   |                                                                                                                                                            |
| **o**  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                         |
|   |                                                                                                                                                            |
|   | **For the transition period from            to           ** |

 

**CommissionFile Number 000-51846**

 

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**CLAYTONHOLDINGS, INC.**

(Exact name of registrant as specified in its charter)

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

 

Registrant’s telephone number, including area code: **(203) 926-5600**

 

(Former Name, Former Address and Former Fiscal year,if changed since last report)

Indicate by check mark whether the registrant:(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.   Yes  x    No  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):

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

 

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

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

20,611,372 shares of Common Stock, par value $0.01 pershare, outstanding as of November 6, 2006.

 

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**INDEX**
|                                    | ** **                                                                                                                          | **Page** |
|------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------|----------|
| Part I. Financial Information |                                                                                                                                |
|                               |                                                                                                                                |
| Item 1.  Financial Statements      |                                                                                                                                |
|                               |                                                                                                                                |     |
|                               | Condensed Consolidated  Balance Sheets as of September 30, 2006 (unaudited) and  December 31, 2005                   | 1        |
|                               |                                                                                                                                |     |   |
|                               | Condensed Consolidated  Statements of Income (unaudited) for the three and nine months ended  September 30, 2006 and 2005      | 2        |
|                               |                                                                                                                                |     |   |
|                               | Condensed Consolidated  Statement of Changes in Stockholders’ Equity (unaudited) for the nine months  ended September 30, 2006 | 3        |
|                               |                                                                                                                                |     |   |
|                               | Condensed Consolidated  Statements of Cash Flows (unaudited) for the nine months ended September 30,  2006 and 2005                 | 4        |
|                               |                                                                                                                                |     |   |
|                               | Notes to Condensed  Consolidated Financial Statements (unaudited)                                                                   | 6        |
|                               |                                                                                                                                |     |   |
| Item 2.                            | Management’s Discussion and Analysis of Financial Condition and  Results of Operations                                         | 20       |
|                               |                                                                                                                                |     |
| Item 3.                            | Quantitative and Qualitative Disclosures About Market Risk                                                                          | 32       |
|                               |                                                                                                                                |     |
| Item 4.                            | Controls and Procedures                                                                                                             | 32       |
|                               |                                                                                                                                |
| Part II. Other Information    |                                                                                                                                |
|                               |                                                                                                                                |
| Item 1.                            | Legal Proceedings                                                                                                                   | 34       |
|                               |                                                                                                                                |     |
| Item 1A.                           | Risk Factors                                                                                                                        | 34       |
|                               |                                                                                                                                |     |
| Item 2.                            | Unregistered Sales of Equity Securities and Use of Proceeds                                                                         | 34       |
|                               |                                                                                                                                |     |
| Item 3.                            | Defaults Upon Senior Securities                                                                                                     | 34       |
|                               |                                                                                                                                |     |
| Item 4.                            | Submission of Matters to a Vote of Security Holders                                                                                 | 34       |
|                               |                                                                                                                                |     |
| Item 5.                            | Other Information                                                                                                                   | 34       |
|                               |                                                                                                                                |     |
| Item 6.                            | Exhibits                                                                                                                            | 34       |
|                               |                                                                                                                                |
| Signatures                         | 35                                                                                                                                  |
|                               |                                                                                                                                |
| Exhibit Index                 |                                                                                                                                |

 

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**PART I. FINANCIAL INFORMATION**

**Item 1.   FinancialStatements**

**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                              | ** ** | **September 30, 2006** | ** **  | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                                                              | ** ** | **(unaudited)**                  | ** **  | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                                                              |       |                             |        |                            |       |
| Current assets:                                                                                                                                                                                                         |       |                             |        |                            |       |
| Cash and cash  equivalents                                                                                                                                                                                              |       | $                                | 23,407,841  |                            | $          | 7,208,875 |   |
| Cash held in  escrow                                                                                                                                                                                                    |       | 1,002,777                        |        | —                          |       |
| Restricted cash                                                                                                                                                                                                         |       | 25,378,170                       |        | 4,966,839                       |       |
| Accounts  receivable, net of allowance for doubtful accounts of $121,703 and $72,264 as  of September 30, 2006  and December 31,  2005, respectively                                                               |       | 39,940,992                       |        | 37,205,223                      |       |
| Unbilled  receivables                                                                                                                                                                                                   |       | 17,077,495                       |        | 14,925,988                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                              |       | 3,290,791                        |        | 3,942,676                       |       |
| Prepaid income  taxes                                                                                                                                                                                                   |       | 1,811,026                        |        | 3,730,970                       |       |
| Deferred tax  assets                                                                                                                                                                                                    |       | 350,805                          |        | 165,566                         |       |
| Due from  affiliated entities                                                                                                                                                                                           |       | —                           |        | 23,434                          |       |
| Total current  assets                                                                                                                                                                                                   |       | 112,259,897                      |        | 72,169,571                      |       |
|                                                                                                                                                                                                                    |       |                             |        |                            |       |
| Property and equipment,  net                                                                                                                                                                                            |       | 20,340,742                       |        | 18,175,717                      |       |
| Goodwill                                                                                                                                                                                                                |       | 73,958,797                       |        | 69,843,468                      |       |
| Intangible assets, net                                                                                                                                                                                                  |       | 77,864,475                       |        | 84,739,774                      |       |
| Other assets, net                                                                                                                                                                                                       |       | 1,841,197                        |        | 2,576,827                       |       |
|                                                                                                                                                                                                                    |       |                             |        |                            |       |
| Total assets                                                                                                                                                                                                            |       | $                                | 286,265,108 |                            | $          | 247,505,357 |   |
|                                                                                                                                                                                                                    |       |                             |        |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                          | ** ** | ** **                       | ** **  | ** **                      | ** ** |
| Current liabilities:                                                                                                                                                                                                    |       |                             |        |                            |       |
| Long-term debt  and capital lease obligations, current portion                                                                                                                                                          |       | $                                | 1,097,368   |                            | $          | 1,639,411 |   |
| Accounts payable  and accrued expenses                                                                                                                                                                                  |       | 23,042,095                       |        | 18,842,078                      |       |
| Servicer escrow  liability                                                                                                                                                                                              |       | 25,378,170                       |        | 4,966,839                       |       |
| Total current  liabilities                                                                                                                                                                                              |       | 49,517,633                       |        | 25,448,328                      |       |
|                                                                                                                                                                                                                    |       |                             |        |                            |       |
| Long-term debt and  capital lease obligations, net of current portion                                                                                                                                                   |       | 79,527,023                       |        | 148,777,172                     |       |
| Deferred tax  liabilities                                                                                                                                                                                               |       | 2,961,220                        |        | 3,381,001                       |       |
| Deferred revenue                                                                                                                                                                                                        |       | 68,534                           |        | 217,888                         |       |
| Deferred rent                                                                                                                                                                                                           |       | 1,008,204                        |        | 1,013,687                       |       |
|                                                                                                                                                                                                                    |       |                             |        |                            |       |
| Total  liabilities                                                                                                                                                                                                      |       | 133,082,614                      |        | 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 September 30, 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 September 30, 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  20,564,926 and 3,281,607 shares issued and outstanding as of September 30,  2006 and December 31, 2005, respectively        |       | 205,649                          |        | 32,816                          |       |
| Class B common  stock, par value $0.01 per share, no shares authorized, issued and  outstanding as of September 30, 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 September 30, 2006                                                                                   |       | —                           |        | —                          |       |
| Additional  paid-in capital                                                                                                                                                                                             |       | 140,252,582                      |        | 4,115,827                       |       |
| Retained  earnings                                                                                                                                                                                                      |       | 12,724,263                       |        | 8,390,066                       |       |
| Total  stockholders’ equity                                                                                                                                                                                        |       | 153,182,494                      |        | 12,542,279                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                        |       | $                                | 286,265,108 |                            | $          | 247,505,357 |   |

 

The accompanying notes are an integral part of thesestatements.

1

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFINCOME**

**(unaudited)**
| ** **                                         | ** ** | **For the three months ended September 30,** | ** ** | **For the nine months ended September 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                                   | ** ** | **2005**                                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Revenue                                            |       | $                                                                          | 60,969,255 |                                                                      | $          | 54,031,051 |   | $ | 178,000,902 |   | $ | 151,201,610 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Cost of  services:                                 |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Compensation expense                               |       | 29,707,045                                                                 |       | 24,923,443                                                                |       | 90,439,495 |   | 71,764,024 |   |
| Travel and related expenses                        |       | 6,302,644                                                                  |       | 7,455,077                                                                 |       | 20,182,431 |   | 21,924,136 |   |
| Other direct costs                                 |       | 2,164,172                                                                  |       | 1,672,184                                                                 |       | 7,548,790 |   | 4,037,539 |   |
| Total cost of services                             |       | 38,173,861                                                                 |       | 34,050,704                                                                |       | 118,170,716 |   | 97,725,699 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Gross profit                                       |       | 22,795,394                                                                 |       | 19,980,347                                                                |       | 59,830,186 |   | 53,475,911 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Operating  expenses:                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Salaries and benefits                              |       | 5,960,658                                                                  |       | 4,718,809                                                                 |       | 16,990,876 |   | 14,000,953 |   |
| Other selling, general and administrative expenses |       | 5,064,044                                                                  |       | 4,014,497                                                                 |       | 14,948,766 |   | 12,400,510 |   |
| Depreciation and amortization                      |       | 2,184,949                                                                  |       | 1,187,304                                                                 |       | 5,684,205 |   | 3,137,926 |   |
| Amortization of intangibles                        |       | 2,577,696                                                                  |       | 2,540,172                                                                 |       | 7,721,125 |   | 7,633,833 |   |
| Total operating expenses                           |       | 15,787,347                                                                 |       | 12,460,782                                                                |       | 45,344,972 |   | 37,173,222 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Income from operations                             |       | 7,008,047                                                                  |       | 7,519,565                                                                 |       | 14,485,214 |   | 16,302,689 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Interest  expense, net                             |       | 1,760,016                                                                  |       | 1,999,319                                                                 |       | 6,505,625 |   | 5,825,451 |   |
| Loss from  extinguishment of debt                  |       | —                                                                     |       | —                                                                    |       | 746,002 |   | — |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Income before  provision for income taxes          |       | 5,248,031                                                                  |       | 5,520,246                                                                 |       | 7,233,587 |   | 10,477,238 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Income tax  expense                                |       | 2,188,133                                                                  |       | 2,184,517                                                                 |       | 2,899,390 |   | 4,162,461 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Net income                                         |       | $                                                                          | 3,059,898  |                                                                      | $          | 3,335,729 |   | $ | 4,334,197 |   | $ | 6,314,777 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Earnings per  share:                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Basic                                              |       | $                                                                          | 0.15       |                                                                      | $          | 0.28 |   | $ | 0.24 |   | $ | 0.53 |   |
| Diluted                                            |       | $                                                                          | 0.14       |                                                                      | $          | 0.27 |   | $ | 0.23 |   | $ | 0.51 |   |
|                                               |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Weighted average  shares outstanding:              |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Basic                                              |       | 20,536,709                                                                 |       | 11,889,201                                                                |       | 17,776,603 |   | 11,887,779 |   |
| Diluted                                            |       | 21,312,210                                                                 |       | 12,378,509                                                                |       | 18,578,126 |   | 12,288,909 |   |

 

The accompanying notes are an integral part of thesestatements.

2

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENT OFCHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**
| ** **                                                                                                                  | ** ** | **Number of shares** | ** ** | **Value**                       | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                  | ** ** | **Common  Stock**              | ** ** | **Class B  Common  Stock** | ** ** | **Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Additional paid-  in capital** | ** ** | **Retained  Earnings** | ** ** | **Total** | ** ** |
| ** **                                                                                                                  | ** ** | ** **                     | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 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 |   | — |   | 131,753,767 |   | — |   | 131,840,017 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Conversion of  convertible preferred stock to redeemable preferred 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                                                                                                    |       | —                         |       | —                          |       | — |   | — |   | 1,023,759 |   | — |   | 1,023,759 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Exercise of stock  options                                                                                                  |       | 48,620                         |       | —                          |       | 486 |   | — |   | 81,706 |   | — |   | 82,192 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Net income for  the nine months ended September 30, 2006                                                                    |       | —                         |       | —                          |       | — |   | — |   | — |   | 4,334,197 |   | 4,334,197 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Balance, September 30,  2006                                                                                                |       | 20,564,926                     |       | —                          |       | $ | 205,649 |   | — |   | $ | 140,252,582 |   | $ | 12,724,263 |   | $ | 153,182,494 |   |
|                                                                                                                             |            |                                |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanyingnotes are an integral part of this statement.

3

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(unaudited)**

 
| ** **                                                                         | ** ** | **For the nine months ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
|                                                                               |       |                                                                      |       |   |   |
| Cash flows from  operating activities:                                             |       |                                                                      |       |   |   |
| Net income                                                                         |       | $                                                                         | 4,334,197  |   | $ | 6,314,777 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                                                      |       |   |   |
| Depreciation and amortization                                                      |       | 5,684,205                                                                 |       | 3,137,926 |   |
| Amortization of intangibles                                                        |       | 7,721,125                                                                 |       | 7,633,833 |   |
| Amortization of debt issuance cost                                                 |       | 267,693                                                                   |       | 450,838 |   |
| Accretion of note                                                                  |       | —                                                                    |       | 69,512 |   |
| Loss from extinguishment of debt                                                   |       | 746,002                                                                   |       | — |   |
| Stock based compensation                                                           |       | 1,023,759                                                                 |       | 148,356 |   |
| Deferred income taxes                                                              |       | (605,026                                                                  | )          | (1,170,122 | ) |
| Loss on sale of fixed assets                                                       |       | 5,648                                                                     |       | 120,239 |   |
| Provision for doubtful accounts                                                    |       | 178,743                                                                   |       | 226,690 |   |
| Changes in operating assets and liabilities, net of  business combinations:        |       |                                                                      |       |   |   |
| Accounts receivable                                                                |       | (2,125,487                                                                | )          | (14,476,737 | ) |
| Unbilled receivables                                                               |       | (2,151,507                                                                | )          | 878,459 |   |
| Prepaid expenses and other current assets                                          |       | 667,301                                                                   |       | (1,389,279 | ) |
| Prepaid income taxes                                                               |       | 1,919,945                                                                 |       | (1,250,894 | ) |
| Due to an affiliated entity                                                        |       | 23,434                                                                    |       | (267,990 | ) |
| Other assets, net                                                                  |       | (90,921                                                                   | )          | (13,490 | ) |
| Accounts payable and accrued expenses                                              |       | 4,236,695                                                                 |       | 1,097,780 |   |
| Deferred revenue                                                                   |       | (816,390                                                                  | )          | 581,618 |   |
| Deferred rent                                                                      |       | (5,483                                                                    | )          | 405,731 |   |
| Net cash provided by operating activities                                          |       | 21,013,933                                                                |       | 2,497,247 |   |
|                                                                               |       |                                                                      |       |   |   |
| Cash flows from  investing activities:                                             |       |                                                                      |       |   |   |
| Proceeds from sale of fixed assets                                                 |       | 35,000                                                                    |       | 20,055 |   |
| Capital expenditures                                                               |       | (6,698,654                                                                | )          | (8,026,002 | ) |
| Acquisition of businesses                                                          |       | (5,727,168                                                                | )          | (825,326 | ) |
| Cash held in escrow from acquisition of businesses inclusive  of interest earned   |       | (1,002,777                                                                | )          | — |   |
| Net cash used in investing activities                                              |       | (13,393,599                                                               | )          | (8,831,273 | ) |
|                                                                               |       |                                                                      |       |   |   |
| Cash flows from  financing activities:                                             |       |                                                                      |       |   |   |
| Proceeds from revolving credit facility                                            |       | 7,400,000                                                                 |       | 25,150,000 |   |
| Repayments of revolving credit facility                                            |       | (7,400,000                                                                | )          | (16,726,908 | ) |
| Repayments of loans payable                                                        |       | —                                                                    |       | (75,155 | ) |
| Repayments of capital lease obligations                                            |       | (216,966                                                                  | )          | (81,519 | ) |
| Repayment of term loan                                                             |       | (70,200,501                                                               | )          | (3,875,000 | ) |
| Deferred charges related to the issuance of debt                                   |       | (161,158                                                                  | )          | — |   |
| Proceeds from issuance of common stock upon initial public  offering          |       | 146,625,000                                                               |       | — |   |
| Underwriting commissions and offering expenses                                     |       | (14,784,499                                                               | )          | — |   |
| Redemption of convertible preferred stock                                          |       | (52,764,950                                                               | )          | — |   |
| Proceeds from the exercise of stock options                                        |       | 81,706                                                                    |       | 19,047 |   |
| Distributions to stockholders                                                      |       | —                                                                    |       | (4,000,000 | ) |
| Net cash provided by financing activities                                          |       | 8,578,632                                                                 |       | 410,465 |   |
|                                                                               |       |                                                                      |       |   |   |
| Net increase (decrease) in cash and cash equivalents                               |       | 16,198,966                                                                |       | (5,923,561 | ) |
|                                                                               |       |                                                                      |       |   |   |
| Cash and cash  equivalents at the beginning of the period                          |       | 7,208,875                                                                 |       | 12,450,147 |   |
|                                                                               |       |                                                                      |       |   |   |
| Cash and cash  equivalents at the end of the period                                |       | $                                                                         | 23,407,841 |   | $ | 6,526,586 |   |

 

The accompanying notes are an integral part ofthese statements.

4

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS (continued)**

**(unaudited)**

 

 
| ** **                                           | ** ** | **For the nine months ended September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
|                                                 |       |                                                                      |       |   |   |
| Supplementary  disclosures of cash flow information: |       |                                                                      |       |   |   |
| Cash paid during the period for:                     |       |                                                                      |       |   |   |
|                                                 |       |                                                                      |       |   |   |
| Income taxes                                         |       | $                                                                         | 1,577,965  |   | $ | 6,523,503 |   |
|                                                 |       |                                                                      |       |   |   |
| Interest                                             |       | $                                                                         | 5,979,195  |   | $ | 5,397,013 |   |
|                                                 |       |                                                                      |       |   |   |
| Other noncash  investing and financing activities:   |       |                                                                      |       |   |   |
| Assets acquired under capital lease                  |       | $                                                                         | 600,503    |   | $ | 187,050 |   |
| Liabilities  assumed from acquisitions               |       | $                                                                         | 1,013,143  |   | $ | 401,664 |   |

 

The accompanyingnotes are an integral part of these statements.

5

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIESNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

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

Clayton Holdings, Inc. (collectively with itswholly owned subsidiaries, the “Company”) was formed on March 31, 2005 asa Delaware corporation. The Company was formed to combine two companies whichwere under common control, GRP Holdings, Inc. (“GRP”), a Delawarecorporation, and TMHC Holdings, Inc. (“TMHC”), a Delaware corporation. GRPwas formed to acquire Clayton Services, Inc. (“CSI”) and First MadisonServices, Inc. (“FMS”) from unrelated parties on August 2, 2004. TMHCwas formed to acquire Clayton Fixed Income Services Inc., formerly known as “TheMurrayhill 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 entities undercommon control are accounted for at historical cost similar to a pooling ofinterests, and the financial statements of previously separate companies forperiods they were under common control are restated on a combined basis. TheCompany’s consolidated financial statements 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 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 services, professional staffingservices, compliance products and services as well as credit risk managementand securities surveillance, and special servicing. The Company usesproprietary technology and processes to provide these services across thelifecycle of a loan, from loan origination, aggregation and securities issuanceto the surveillance and administration of loans and securities. The Companyprovides a majority of its services to participants in the non-agency segment ofthe mortgage-backed securities, or MBS, market and the non-conforming mortgageloan market.

***Basis of Presentation***

The accompanying condensed consolidated financialstatements are unaudited. In the opinion of management, all adjustments,consisting of only normal recurring adjustments considered necessary for a fairpresentation, have been included. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with US GAAPhave been condensed or omitted. It is suggested that these unaudited condensedconsolidated financial statements be read in conjunction with the consolidatedfinancial statements, accounting policies and notes included in the Company’sregistration statement on Form S-1 (File No. 333-129526) declaredeffective by the Securities and Exchange Commission on March 23, 2006,which includes audited financial statements for the year endedDecember 31, 2005. Results for the interim periods are not necessarilyindicative of results for the full year.

***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.

6

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Allshare information has been adjusted to reflect a 1-for-4 reverse stock split ofcommon stock and class B common stock, which was consummated onMarch 1, 2006.

**Note 2—Summary of Significant Accounting Policies**

Significant accounting policies followed by theCompany, as summarized below, are in conformity with US GAAP.

***Principles of Consolidation***

The consolidated financial statements include theaccounts of the Company. All significant intercompany transactions and balanceshave 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 otheravailable information, as appropriate. The most significant estimates reflectedin the financial statements include deferred tax assets and liabilities, incometax accruals, valuation allowance for accounts receivable, unbilledreceivables, asset impairments, the valuation of stock options and thevaluation of intangible assets and assessments of their useful lives, andrelated party transactions. Actual results could differ from estimated amounts.The Company also makes estimates in determining other ordinary accruals.

***Segment Reporting***

The Company’s activities are considered to be in asingle industry segment for financial reporting purposes. The Company providesservices that support the purchase and sale of, and investment in, mortgageloans and related securities across the mortgage loan lifecycle. Revenues fromthe Company’s various products and services are affected by the same factors,primarily the origination of non-conforming mortgage loans and the issuance ofnon-agency mortgage-backed securities.

***Deferred Financing Costs***

The Company amortizes the costs that it incurs toobtain debt financing over the terms of the underlying obligations using theeffective interest method for the portion of the costs associated with termloan debt and using the straight line method for the portion of the costsassociated with the revolving credit facility. The amortization of deferredfinancing costs is included in interest expense. Unamortized deferred financingcosts are included in “other assets, net” in the accompanying condensedconsolidated balance sheets. As a result of the Company’s IPO (see Note 1) onMarch 29, 2006, the Company repaid $70,000,000 of principal on its$150,000,000 term loan and wrote off a proportionate share of the unamortizeddeferred financing costs associated with the term loan. A loss onextinguishment of $746,002 reflecting this write off is reflected in thestatement of income for the nine months ended September 30, 2006. Unamortizeddeferred financing costs at September 30, 2006 and December 31, 2005 were$1,501,562 and $2,354,099, respectively, and are included on the accompanyingconsolidated balance sheets in “other assets, net.”

***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.

7

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The Company derives most of its revenues fromprofessional service activities.  Revenues consisting of billed fees andpass-through expenses are recorded as work is performed and expenses areincurred. 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 certain retroactivevolume discounts from several of its travel providers. Such amounts are accruedas earned, are netted against travel and related expenses and historically havenot been material.  For the three months ended September 30, 2006 and2005, pass-through expenses included in revenues were $6,302,644 and$7,455,077, respectively.  For the ninemonths ended September 30, 2006 and 2005, pass-through expenses included inrevenues were $20,182,431 and $21,924,136, respectively.

The Company records provisions for fee adjustments anddiscretionary pricing adjustments as a reduction of revenues. Revenuesrecognized, but not yet billed to clients, have been recorded as unbilledreceivables in the accompanying condensed consolidated balance sheets.

***Stock-based Compensation***

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 SFASNo. 123(R). SFAS No. 123(R) became effective for annual reportingperiods beginning on or after June 15, 2005. The Company previouslyadopted the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” for all awards granted to employees. OnJanuary 1, 2006, the Company adopted SFAS No. 123(R) and SFASNo. 123(R) does not have a material impact on its financial statements.

According to the provisions of the incentive stockoption agreements between the Company and its employees, the vesting term forcertain options outstanding as of the date of the IPO accelerated by either oneyear or twenty percent, varying in accordance with the terms of the employee’sspecific incentive stock option agreement. In addition, 130,208 of performancebased options became immediately vested. Therefore, on March 29, 2006, theCompany recognized $611,696 of additional compensation expense from thisaccelerated vesting.

***Concentration of Credit Risk andSignificant Customers***

At September 30, 2006, 23.9% and 31.6% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively. At December 31, 2005, 30.1% and 25.5% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively.

For the three months ended September 30, 2006 and2005, revenue from the Company’s largest three clients accounted for anaggregate of 30.2% and 33.3% of total revenue, respectively. Revenue from twoclients exceeded 10% of revenue for the three months ended September 30, 2006and revenue from three clients exceeded 10% of revenue for the three monthsended September 30, 2005.

For the nine months ended September 30, 2006 and 2005,revenue from the Company’s largest three clients accounted for an aggregate of32.0% and 35.5% of total revenue, respectively. Revenue from two clientsexceeded 10% of revenue for the nine months ended September 30, 2006 andrevenue from three clients exceeded 10% of revenue for the nine months endedSeptember 30, 2005.

8

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***Earnings Per Share***

Basic earnings per share is computed by dividing netincome by the weighted-average number of shares of common stock and commonstock equivalents outstanding during the period. The Company’s convertiblepreferred stock is deemed to be a common stock equivalent and included in thecomputation of basic earnings per share because it receives dividends at a ratethat results in a per share amount that is equivalent to the per share amountpaid on common stock. Diluted earnings per share gives effect to dilutiveoptions, warrants and other potential common stock outstanding during theperiod.  At September 30, 2006, outstanding options to purchase 210,000and 130,000 common shares had exercise prices in excess of the average marketprice of common shares for the three and nine month periods ended September 30,2006, respectively.  At September 30, 2005, outstanding options topurchase 254,580 and 887,094 common shares had exercise prices in excess of theaverage market price of common shares for the three and nine month periodsended September 30, 2005, respectively.  These options were notincluded in the computation of diluted earnings per share for the respectiveperiods because the effect would be antidilutive.

The following tablepresents a reconciliation of the numerators and denominators of basic anddiluted net income per share for the three and nine months ended September 30,2006 and 2005:

 
| ** **                                                  | ** ** | **For the three months ended** | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                  | ** ** | **September 30, 2006**                   | ** ** | **September 30, 2005**                   | ** ** |
| ** **                                                  | ** ** | **Basic**                                          | ** ** | **Diluted**                                        | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Net income                                                  |       | $                                                  | 3,059,898  |                                               | $          | 3,059,898 |   | $ | 3,335,729 |   | $ | 3,335,729 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 20,536,709                                         |       | 20,536,709                                         |       | 11,889,201 |   | 11,889,201 |   |
| Dilutive effect  of stock options                           |       | —                                             |       | 775,501                                            |       | — |   | 489,308 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Total weighted  average number of common shares outstanding |       | 20,536,709                                         |       | 21,312,210                                         |       | 11,889,201 |   | 12,378,509 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Earnings per  share                                         |       | $                                                  | 0.15       |                                               | $          | 0.14 |   | $ | 0.28 |   | $ | 0.27 |   |

 
| ** **                                                  | ** ** | **For the nine months ended** | ** ** | **For the nine months ended** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                                                  | ** ** | **September 30, 2006**        | ** ** | **September 30, 2005**        | ** ** |
| ** **                                                  | ** ** | **Basic**                     | ** ** | **Diluted**                   | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                          |       |                          |       |   |   |   |   |
| Net income                                                  |       | $                             | 4,334,197  |                          | $          | 4,334,197 |   | $ | 6,314,777 |   | $ | 6,314,777 |   |
|                                                        |       |                          |       |                          |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 17,776,603                    |       | 17,776,603                    |       | 11,887,779 |   | 11,887,779 |   |
| Dilutive effect  of stock options                           |       | —                        |       | 801,523                       |       | — |   | 401,130 |   |
|                                                        |       |                          |       |                          |       |   |   |   |   |
| Total weighted  average number of common shares outstanding |       | 17,776,603                    |       | 18,578,126                    |       | 11,887,779 |   | 12,288,909 |   |
|                                                        |       |                          |       |                          |       |   |   |   |   |
| Earnings per share                                          |       | $                             | 0.24       |                          | $          | 0.23 |   | $ | 0.53 |   | $ | 0.51 |   |

 

***Adoption of New Accounting Pronouncements***

In July 2006, the FASB issued FASB Interpretation (“FIN”)No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASBStatement 109.”  FIN 48 prescribes a comprehensive model for recognizing,measuring, presenting and disclosing in the financial statements tax positionstaken or expected to be taken on a tax return including a decision whether tofile or not to file in a particular jurisdiction.  FIN 48 is effective forfiscal years beginning after December 15, 2006.  If there are changes innet assets as a result of application of FIN 48 these will be accounted for asan adjustment to retained earnings.  The Company is currently assessingthe impact of FIN 48 on its consolidated financial position and results ofoperations.

9

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In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.”   SFAS No. 157establishes a common definition for fair value to be applied to US GAAPguidance requiring use of fair value, establishes a framework for measuringfair value, and expands disclosure about such fair value measurements. SFAS No.157 is effective for fiscal years beginning after November 15, 2007. TheCompany is currently assessing the impact of SFAS No. 157 on its consolidatedfinancial position and results of operations.

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 thequantitative effects of financial misstatements.  This dual approach includes both an incomestatement focused assessment and a balance sheet focused assessment.  The guidance in SAB 108 must be applied toannual financial statements for fiscal years ending after November 15, 2006.The Company is currently assessing the impact of adopting SAB 108 but does notexpect that it will have a material effect on its consolidated financialposition or results of operations.

**Note 3—Business Acquisitions**

***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 anestimated aggregate purchase price of $5,727,168, pending a final closingbalance sheet. The asset purchase agreement provided for a 60-day periodsubsequent to the closing date to provide a closing balance sheet which will beused to determine final fair market values. The agreement also established two escrow accounts aggregating $600,000which are reflected in the accompanying condensed consolidated balance sheet,including accumulated interest, at September 30, 2006 as cash held in escrow.This escrow is held against any claims the Company may have forindemnification or a working capital shortfall upon preparation of the finalclosing balance sheet. The 60-day period to reach agreement on the finalclosing balance sheet was extended so that the Company can better evaluate thefair value of assets acquired.

In July, 2006, an additional escrow account in theamount of $392,842 was established by the former principal owners of M RNetwork I, Ltd.  This amount will be retained by the Company if theCompany is not able to collect certain accounts receivable balances included inthe assets acquired by the Company.  As aresult, the purchase price and the amount allocated to goodwill were reduced bythe amount of the escrow account.  This acquisition has not been presentedon a pro forma basis because it is not deemed to be material.

The purchase price was allocated as follows:

| Accounts receivable                           |   | $          | 789,024   |   |
|-----------------------------------------------|--------|------------|-----------|--------|
| Prepaid expenses                              |   | 15,417     |      |
| Property and  equipment                       |   | 949,555    |      |
|                                          |   |       |      |
| Goodwill                                      |   | 4,115,329  |      |
| Intangible  assets - customer relationships   |   | 771,000    |      |
| Intangible  assets - noncompetition agreement |   | 74,000     |      |
| Deposit                                       |   | 25,986     |      |
| Liabilities  assumed                          |   | (1,013,143 | )         |
|                                          |   | $          | 5,727,168 |   |

 

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

At September 30, 2006 and December 31, 2005, theCompany maintained cash and cash equivalent balances in excess of $100,000 attwo separate financial institutions. Accounts at these institutions are insuredby the Federal Deposit Insurance Corporation up to $100,000. At September 30,2006 and December 31, 2005, the cash balances exceeded $100,000 by$46,831,575 and $13,447,318, respectively, including restricted cash.

At September 30, 2006 and December 31, 2005, theCompany maintained restricted cash balances of $25,378,170 and $4,966,839,respectively. This balance represented funds received in connection withcertain 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 condensed consolidated balance sheets.

**Note 5—Property and Equipment, net**

Property and equipment, net consists of the following:

|                                                 | ** ** | **September 30,  2006** | ** ** | **December 31,   2005** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|-----------------------------------|------------|
|                                            |       |                         |       |                              |       |
| Computer and  office equipment                  |       | $                            | 9,474,716  |                              | $          | 6,526,737 |   |
| Software                                        |       | 16,734,694                   |       | 8,100,020                         |       |
| Furniture and  fixtures                         |       | 3,272,443                    |       | 2,926,452                         |       |
| Leasehold  improvements                         |       | 1,839,604                    |       | 1,391,952                         |       |
| Website                                         |       | 280,317                      |       | 280,317                           |       |
| Automobiles                                     |       | 112,336                      |       | 171,395                           |       |
|                                            |       | 31,714,110                   |       | 19,396,873                        |       |
| Less accumulated  depreciation and amortization |       | 11,762,807                   |       | 6,117,862                         |       |
|                                            |       | 19,951,303                   |       | 13,279,011                        |       |
| Software under  development                     |       | 389,439                      |       | 4,896,706                         |       |
|                                            |       | $                            | 20,340,742 |                              | $          | 18,175,717 |   |

 

Included in software at September 30, 2006 andDecember 31, 2005, is $10,213,442 and $3,189,915, respectively, ofinternally developed software placed in service. Software under developmentrepresents other internally developed software that has not yet been placed inservice.

For the three months ended September 30, 2006 and 2005depreciation and amortization expense charged to operations was $2,184,949 and$1,187,304, respectively. For the nine months ended September 30, 2006 and 2005depreciation and amortization expense charged to operations was $5,684,205 and$3,137,926, respectively.

**Note 6—Goodwill and Other Intangible Assets**

As of September 30, 2006 and December 31, 2005,intangible assets not subject to amortization consist of goodwill of$73,958,797 and $69,843,468, respectively, and trade names and trademarks of$15,504,917 and $15,504,338, respectively.

11

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At September 30, 2006,the Company’s intangible assets with identifiable useful lives, which continueto be amortized, consist of the following:

 
|                                     | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 36,400,000 |                          | $          | 4,381,482  |       | $ | 32,018,518 |   |
| Staffing services                   |       | 4,300,000                       |       | 931,667                       |       | 3,368,333  |       |
| Portfolio management                |       | 11,485,600                      |       | 2,761,009                     |       | 8,724,591  |       |
| Client backlog                      |       | 2,146,200                       |       | 1,010,791                     |       | 1,135,409  |       |
| Technology                          |       | 26,842,900                      |       | 11,746,441                    |       | 15,096,459 |       |
| Noncompetition  agreements          |       | 3,568,950                       |       | 1,566,598                     |       | 2,002,352  |       |
| Patent                              |       | 20,451                          |       | 6,555                         |       | 13,896     |       |
|                                |       | $                               | 84,764,101 |                          | $          | 22,404,543 |       | $ | 62,359,558 |   |

 

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 three months endedSeptember 30, 2006 and 2005 was $2,577,696 and $2,540,172, respectively. Amortization expense for the nine months ended September 30, 2006 and 2005 was$7,721,125 and $7,633,833, respectively.

**Note 7—Revolving Credit Facility, Long-Term Debt and CapitalLease Obligations**

Long-term debt andcapital lease obligations consist of the following: 

 

|                                         | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Term loans                              |       | $                            | 79,799,499 |                        | $          | 150,000,000 |   |
|                                    |       |                         |       |                        |       |
| Capital lease  obligations              |       | 824,892                      |       | 416,583                     |       |
|                                    |       |                         |       |                        |       |
| Total long-term debt                    |       | 80,624,391                   |       | 150,416,583                 |       |
| Less current  portion                   |       | 1,097,368                    |       | 1,639,411                   |       |
|                                    |       |                         |       |                        |       |
| Long-term debt,  net of current portion |       | $                            | 79,527,023 |                        | $          | 148,777,172 |   |

 

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***Credit Agreement***

On December 8, 2005 the Company entered into acredit agreement (the “Credit Agreement”) with a financial institution. TheCredit Agreement, provided 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 had 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 andApril 28, 2006, the Company exercised its option and amended the CreditAgreement to increase the revolving credit facility by $5,000,000 on each date,such that the Company had an aggregate revolving credit facility of $50,000,000as of, and subsequent to, April 28, 2006. The Credit Agreement expires onDecember 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 balance.  Therefore, scheduledquarterly payments of the term loan through December 31, 2010 were reducedfrom $375,000 to $200,501 with the remaining balance of $76,190,476 payable infour quarterly installments of $19,047,619 in 2011. As a result of therepayment of the term loan the Company wrote off a proportionate share ofdeferred financing costs associated with the term loan (see Note 2, DeferredFinancing Costs) and reflected a loss on extinguishment of $746,002 in thecondensed consolidated statement of income for the nine months ended September30, 2006.

The 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 commenced effectiveness on March 31, 2006. The Company isin compliance with these covenants. In addition, the Credit Agreement placeslimitations on total annual capital expenditures, indebtedness, liens,dividends and distributions, asset sales, transactions with affiliates,acquisitions and conduct of business, all as defined in the agreement. The CreditAgreement also contains provisions for an increased rate of interest duringperiods of default.

Loans under the Credit Agreement bear interest at theapplicable 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.

At September 30, 2006 and December 31, 2005, therevolving credit facility had no outstanding balance and there was anoutstanding balance of $79,799,499 and $150,000,000, respectively, under theterm loan with an interest rate of 8.33% and 9.25%, respectively.

***Interest Rate Cap***

In September 2004, CSI purchased an interest ratecap agreement to reduce the potential impact that interest rate increases couldhave on its floating-rate debt interest expense. The terms of the interest ratecap provide that the Company would receive quarterly payments equal to thenotional amount multiplied by the difference by which LIBOR exceeds 5%.  During the third quarter of 2006 the Companyreceived approximately $19,300 which was recorded as a reduction of interestexpense.  The initial notional amount was$20,000,000 and declines during the term of the agreement, which expired onSeptember 30, 2006. As of December 31, 2005, the notional amount was$16,937,500. The interest rate cap does not qualify for hedge accounting underSFAS No. 133, as amended. The initial premium of $29,900 was recorded asan asset on the date of purchase. Subsequent declines in the fair value of thisderivative were recorded as interest expense in the accompanying condensedconsolidated statements of income. For the three and nine months endedSeptember 30, 2005, the Company recorded $0 and $7,860, respectively, ofinterest expense to reflect a decline in the fair value of this asset duringthe respective periods.  In January 2006, the Company recorded interestexpense of $1,915 to reduce the book value of this asset to zero.

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***Capitalized Lease Obligations***

At September 30, 2006, the Company leased $1,068,087of equipment under agreements accounted for as capital leases with accumulateddepreciation of $240,219. The obligations for the equipment required theCompany to make monthly payments through March 2011, with implicitinterest 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%.

**Note 8—Preferred Stock**

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 asSeries A Convertible Preferred Stock, par value $0.01 per share, and24,185,493 shares designated as Series B Convertible Preferred Stock, parvalue $0.01 per share, all of which were outstanding. As of December 31,2005, the Series A and Series B convertible preferred stock werecarried on the consolidated balance sheet at their liquidation preference of$12,258,319 and $43,866,683, respectively.

On March 29, 2006, the Company completed itsinitial public offering of common stock, resulting in the conversion of theSeries A Convertible Preferred Stock into 2,206,308 shares of commonstock, 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 andSeries B Redeemable Preferred Stock for $52,764,950, and all of theSeries A and Series B Redeemable Preferred Stock were immediatelyretired. The difference between the liquidation preference amount of theconvertible preferred stock and the redemption amount of the redeemablepreferred stock was allocated to the common stock resulting from the conversionand credited to additional paid-in capital.

**Note 9—Commitments and Contingencies**

***Operating Leases***

The Company leases its office facilities and certainequipment under noncancelable operating lease arrangements expiring on variousdates through 2013. 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.

For the three months ended September 30, 2006 and2005, rent expense was approximately $895,651 and $696,621, respectively. Forthe nine months ended September 30, 2006 and 2005, rent expense wasapproximately $2,790,855 and $2,090,008, respectively.

***Litigation***

In the normal course of business, the Company issubject to various legal proceedings and claims, the resolution of which, inmanagement’s opinion, will not have a material adverse effect on the financialposition or the results of operations of the Company.

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**Note 10—Common Stock**

At December 31, 2005, the Company had 60,000,000 sharesof common stock authorized, of which 3,281,607 were issued and outstanding.

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 ofClass B common stock, par value $0.01 per share; (iii) 8,825,241shares of Series A Convertible Preferred Stock, par value $0.01 per share;and (iv) 24,185,493 shares 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 ofSeries A Convertible Preferred Stock were converted into 2,206,308 sharesof common stock and 8,825,241 shares of Series A Redeemable PreferredStock, and 24,185,493 shares of Series B Convertible Preferred Stock wereconverted into 6,046,371 shares of common stock and 24,185,493 shares ofSeries B Redeemable Preferred Stock.

Upon the consummation of the initial public offering,all outstanding shares of Class B common stock were converted into 357,020shares of common stock, par value $0.01 per share, and each share ofClass B Common Stock was retired.

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.

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) 69,673,021 shares of preferred stock, par value $0.01 per share,consisting of Series A Convertible Preferred Stock, Series BConvertible Preferred Stock, Series A Redeemable Preferred Stock andSeries B Redeemable Preferred Stock, (b) 80,326,979 shares of commonstock, consisting of common stock and Class B common stock, and(c) 10,000,000 shares of undesignated preferred stock to a total of160,000,000 shares of capital stock consisting of (i) 150,000,000 sharesof common stock, par value $0.01 per share, and (ii) 10,000,000 shares ofundesignated preferred stock, par value $0.01 per share.

All share information has been adjusted to reflect a1-for-4 reverse stock split of common stock and class B common stock,which was consummated on March 1, 2006.

At September 30, 2006, the Company had 150,000,000shares of common stock authorized, of which 20,564,926 were issued andoutstanding.

**Note 11- Related Party 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 ChiefExecutive Officer, who was appointed in April 2005, has served on theBoard of Directors of another public company since 1995 and is currently thechairman of this entity’s audit committee. This unrelated entity acquires andoriginates non-conforming residential and commercial loans.

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TheCompany has provided due diligence and professional staffing services to thisentity and revenues aggregated $27,375 for the three and nine month periodsended September 30, 2006, and $64,042 and $643,809 for the three and nine monthperiods ended September 30, 2005, respectively.

CFIS has contracts to perform Credit RiskManagement services for portfolios managed by a stockholder. Revenues generatedfrom the contracts for the nine months ended September 30, 2006 and 2005 wereapproximately $476,421 and $507,748, respectively, and for the three monthsended September 30, 2006 and 2005 were approximately $162,698 and $215,349,respectively, and were included in service fee revenue in the condensedconsolidated statements of income. Accounts receivable from this party atSeptember 30, 2006 and December 31, 2005, were $90,077 and $74,555,respectively.

Until December 8, 2005, the Company hadsubordinated note and subordinated convertible note purchase agreements withcertain stockholders of the Company. For the nine months ended September 30,2005 interest expense on these notes was $2,706,667. There was no interestexpense on these notes in the nine months ended September 30, 2006.

**Note 12—Stock Options**

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.  Theoptions generally vest over a period of four years, with 25% of each grantvesting after one year and the remaining shares vesting monthly over thefollowing three years.  As of September 30, 2006, 210,000 awards had beengranted under the 2006 Option Plan.  The Company issues new shares upon theexercise of stock options.

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Changes in options outstanding during the nine monthsended September 30, 2006 are as follows:

|                                                                                              | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Options  outstanding, December 31, 2005                                                 |       | 1,460,656                  |       | $                                          | 4.52       |   |
|                                                                                         |       |                       |       |                                       |       |
| Granted                                                                                      |       | 210,000                    |       | 14.14                                      |       |
| Exercised                                                                                    |       | 48,620                     |       | 1.68                                       |       |
| Forfeited                                                                                    |       | 41,295                     |       | 4.17                                       |       |
|                                                                                         |       |                       |       |                                       |       |
| Options  outstanding, September 30, 2006                                                     |       | 1,580,741                  |       | $                                          | 5.89       |   |
|                                                                                         |       |                       |       |                                       |       |
| Weighted average  fair value of options granted for the nine months ended September 30, 2006 |       |                       |       | $                                          | 5.63       |   |
| Options available for  future grant at September 30, 2006                                    |       |                       |       | 1,604,130                                  |       |

 

The intrinsic value of options exercised in the ninemonths ended September 30, 2006 was approximately $530,000.

Changes in unvestedoptions outstanding during the nine months ended September 30, 2006 are asfollows:

 
| ** **                                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Exercise  Price** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
|                                              |       |                       |       |                                       |       |
| Unvested options  outstanding, December 31, 2005  |       | 1,209,592                  |       | $                                          | 4.77       |   |
|                                              |       |                       |       |                                       |       |
| Granted                                           |       | 209,001                    |       | 14.13                                      |       |
| Vested                                            |       | 719,598                    |       | 4.73                                       |       |
| Cancelled or forfeited                            |       | 36,922                     |       | 3.85                                       |       |
|                                              |       |                       |       |                                       |       |
| Unvested options  outstanding, September 30, 2006 |       | 662,073                    |       | $                                          | 7.83       |   |

 

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The following tablesummarizes information about stock options outstanding at September 30, 2006:

 
| September 30, 2006 | ** ** |
|------------------------------|------------|
| ** **                   | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |   |
| **Exercise Price**      | ** ** | **Number  Outstanding** | ** ** | **Remaining  Contractual  Life (yrs)** | ** ** | **Intrinsic  Value as of  September 30,  2006** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Intrinsic  Value as of  September 30,  2006** | ** ** |   |
|                              | $          | 0.98 |   |   | 361,132 |   | 8.17 |   | $ | 4,187,123 |   | 252,762 |   | $ | 0.98 |   | $ | 2,930,634 |   |   |
|                         | 4.00       |   |   | 62,500 |   | 7.65 |   | 535,625 |   | 57,291 |   | 4.00 |   | 490,984 |   |   |
|                              | 4.13       |   |   | 86,817 |   | 8.24 |   | 732,909 |   | 65,936 |   | 4.13 |   | 556,632 |   |   |
|                         | 6.00       |   |   | 520,833 |   | 8.57 |   | 3,421,873 |   | 366,210 |   | 6.00 |   | 2,406,000 |   |   |
|                              | 6.36       |   |   | 109,869 |   | 8.82 |   | 682,286 |   | 58,678 |   | 6.36 |   | 364,390 |   |   |
|                         | 6.80       |   |   | 229,590 |   | 9.00 |   | 1,324,734 |   | 116,356 |   | 6.80 |   | 671,374 |   |   |
|                              | 12.34      |   |   | 30,000 |   | 9.92 |   | 6,900 |   | — |   | 12.34 |   | — |   |   |
|                         | 12.57      |   |   | 25,000 |   | 10.00 |   | — |   | — |   | 12.57 |   | — |   |   |
|                              | 13.05      |   |   | 25,000 |   | 9.80 |   | — |   | — |   | 13.05 |   | — |   |   |
|                         | 14.05      |   |   | 102,000 |   | 9.67 |   | — |   | — |   | 14.05 |   | — |   |   |
|                              | 17.00      |   |   | 15,500 |   | 9.48 |   | — |   | 1,435 |   | 17.00 |   | — |   |   |
|                         | 20.40      |   |   | 5,000 |   | 9.49 |   | — |   | — |   | 20.40 |   | — |   |   |
|                              | 21.38      |   |   | 7,500 |   | 9.51 |   | — |   | — |   | 21.38 |   | — |   |   |
|                         |       |   |   | 1,580,741 |   | 8.66 |   | $ | 10,891,450 |   | $ | 918,668 |   | $ | 4.50 |   | $ | 7,420,01 |   |   |
|                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

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 SFASNo. 123(R). SFAS No. 123(R) became effective for annual reportingperiods beginning on or after June 15, 2005. The Company previouslyadopted the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” for all awards granted to employees. OnJanuary 1, 2006 the Company adopted SFAS No. 123(R) and SFASNo. 123(R) does not have a material impact on its financial statements.

The Company completed its initial public offering onMarch 29, 2006. 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 theCompany recognized $611,696 of additional compensation expense from thisaccelerated vesting.

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The ongoing effect on consolidated results ofoperations of financial condition will be dependent upon future stock basedcompensation awards granted.  The Company utilizes the Black-Scholesoption valuation method to calculate the fair market value of the options usingassumptions in effect on the date of the grant, as follows:
| ** **                | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **September 30,  2006**    | ** ** | **September 30,  2005** | ** ** |
| Expected life  (in years) |       | 6.5–7.5                    |       | 6.25 |   |
| Risk-free  interest rate  |       | 4.6–5.1                    | %          | 3.9–4.2 | % |
| Volatility                |       | 25–28                      | %          | 25 | % |
| Dividend                  |       | 0                               | %          | 0 | % |

 

For the three months ended September 30, 2006 and 2005the Company recognized expenses related to the stock option grants summarizedabove over the vesting period of such options of approximately $170,000 and$70,000, respectively. For the nine months ended September 30, 2006 and 2005the Company recognized expenses related to the stock option grants summarizedabove over the vesting period of such options of approximately $1,024,000 and$148,000, respectively.  In addition, the Company will recognizeapproximately $1,755,000 of expense related to these grants over the remainingvesting period of such options.  This expense is expected to be recognizedover a weighted-average period of 2.92 years.

**Note 13—Subsequent Events**

On October 18, 2006, the Company accepted theresignation of its Chief Information Officer. In connection with this resignation, which shall be effective onFebruary 28, 2007, the Company and the employee entered into a separationagreement, filed as Exhibit 10.1 to the Form 8-K filed by the Company onOctober 18, 2006.

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**Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations **

**Forward Looking Statements and Projections**

*This Quarterly Report onForm 10-Q contains forward looking statements. Forward looking statementsrelate to future events or our future financial performance. We generallyidentify forward looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,”“believes,” “estimates,” “predicts,” “potential” or “continue” or the negativeof these terms or other similar words. These statements are only predictions.We have based these forward looking statements largely on our currentexpectations and projections about future events and financial trends that webelieve may affect our business, results of operations and financial condition.The outcome of the events described in these forward looking statements issubject to risks, uncertainties and other factors described in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” elsewhere in this Quarterly Report on Form 10-Q and in our QuarterlyReport on Form 10-Q for the three month period ended March 31, 2006.Accordingly, you should not rely upon forward looking statements as predictionsof future events. We cannot assure you that the events and circumstancesreflected in the forward looking statements will be achieved or occur, andactual results could differ materially from those projected in the forwardlooking statements. The forward looking statements made in this QuarterlyReport on Form 10-Q relate only to events as of the date on which thestatements are made. We undertake no obligation to update any forward lookingstatement to reflect events or circumstances after the date on which thestatement is made or to reflect the occurrence of unanticipated events.*

**Overview**

We provide a full suite of outsourced services,mortgage-related analytics and specialized consulting services for buyers andsellers of, and investors in, mortgage-related loans and securities and otherdebt instruments. Our services include transaction management, which consistsof due diligence, mortgage processing services for buyers of mortgage loans(conduit support services), professional staffing services, and complianceproducts and services, as well as monitoring of mortgage-backed securities(credit risk management and surveillance), and specialized loan servicingservices (special servicing). We provide a majority of our services toparticipants in the non-agency mortgage-backed securities, or MBS, market andthe non-conforming mortgage loan market. We believe that several trends supportthe demand for our services, including:

·                  thegrowth in outsourced services by capital markets firms and other major mortgageloan market participants;

·                  theincreased complexities and requirements of federal, state and local regulationsapplicable to the mortgage loan industry;

·                  investors’growing demand for loan performance data; and

·                  buyerspurchasing smaller pools of loans from a larger number of sellers, increasingthe need for our conduit 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.

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We believe the volume of non-agency MBSsecuritizations and non-conforming mortgage loan originations may be lower in2006 than in 2005. We expect the non-agency MBS securitization andnon-conforming mortgage loan origination markets to continue growing over thelong term, although the rate of growth may be slower than in recent years.We believe there is an increasing demand for and the availability of new loanproducts, increased home ownership driven in part by first-timehomeowners, minorities and immigrants, and increased liquidity in thenon-agency MBS market. We face a number of risks in our industry and the marketfor our services is highly competitive. Our business is driven in part bythe MBS market, the mortgage lending industry and the housing market, eachof which is highly sensitive to trends in the general economy, includinginterest rates, perceived and actual economic conditions, taxation policies,availability of credit, employment levels and wage and salary levels. Adversechanges in any of these trends, or a decline in the sale of both new andexisting homes or in home values, could lessen the demand for mortgage loans,which could result over time in a reduced demand for our services and diminishour revenue. A material reduction in the number of loans available forsecuritization may cause our clients to engage us for fewer services,which could have an adverse effect on our business and results of operations.Moreover, the majority of our business is generated through our largest 20 clients.The loss of one or more of these clients could adversely affect our businessand results of operations. Lastly, we are dependent on our independent loanreview specialists to perform our services. Our business could suffer ifwe are unable to recruit and retain additional qualified independent loanreview specialists.

**Basis of Presentation**

We were formed as a Delaware corporation inMarch 2005, following the combination of the holding companies of each ofClayton Services and its subsidiaries, including First Madison, and CFIS,formerly The Murrayhill Company, or Murrayhill. Prior to the combination, eachholding company was controlled by investment funds affiliated with TAAssociates. In accordance with US GAAP relating to companies under common controlprior to their combination, the financial statements of the previously separatecompanies under common control are restated on a combined basis from the datesof their respective acquisitions by the controlling entity. Accordingly, foraccounting purposes, the date of our inception was May 24, 2004, the datethat investment funds affiliated with TA Associates acquired CFIS, the first ofthe combined entities that were brought under common control.

**Critical Accounting Policies**

*Basis of Presentation*

Our condensed consolidated financial statements areunaudited. In our opinion, all adjustments, consisting of only normal recurringadjustments considered necessary for a fair presentation, have been included.Certain information and footnote disclosures normally included in financialstatements prepared in accordance with US GAAP have been condensed or omitted.It is suggested that these unaudited condensed consolidated financialstatements be read in conjunction with the consolidated financial statements, accountingpolicies and notes included in our registration statement on Form S-1(File No. 333-129526) declared effective by the Securities and ExchangeCommission on March 23, 2006, which includes audited financial statementsfor the year ended December 31, 2005. Results for the interim periods arenot necessarily indicative of results for the full year.

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 management in the selection ofappropriate assumptions for determining these estimates. By their nature, thesejudgments are subject to an inherent degree of uncertainty; therefore, wecannot assure you that actual results will not differ significantly from estimatedresults. We base these judgments on our historical experience, management’sforecasts and other available information, as appropriate.

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Our most critical accounting policies, which reflectsignificant management estimates and judgment in determining reported amountsin the condensed consolidated financial statements 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 also includesexpenses billed to clients, which include travel and other out-of-pocketexpenses, and other reimbursable expenses.

We record provisions for fee adjustments anddiscretionary pricing adjustments as a reduction of revenue. Revenuerecognized, but not yet billed to clients, has been recorded as unbilledreceivables in the Company’s condensed consolidated balance sheets.

*Stock-Based Compensation*

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 SFASNo. 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 does 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 purchase 210,000 shares were granted in thenine months ended September 30, 2006 with an average exercise price of $14.14per share.

*Earnings Per Share*

Basic earnings per share is computed by dividing netincome by the weighted-average number of shares of common stock and commonstock equivalents outstanding during the period. Our convertible preferredstock is deemed to be a common stock equivalent and included in the computationof basic earnings per share because it receives dividends at a rate thatresults in a per share amount that is equivalent to the per share amount paidon common stock. Diluted earnings per share gives effect to dilutive options,warrants and other potential common stock outstanding during theperiod.   At September 30, 2006, outstanding options to purchase210,000 and 130,000 common shares had exercise prices in excess of the averagemarket price of common shares for the three and nine month periods endedSeptember 30, 2006, respectively.   At September 30, 2005,outstanding options to purchase 254,580 and 887,094 common shares had exerciseprices in excess of the average market price of common shares for the

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threeand nine month periods ended September 30, 2005, respectively. These optionswere not included in the computation of diluted earnings per share for therespective periods because the effect would be antidilutive.

*Valuation of Long-lived AssetsExcluding Goodwill*

We evaluate all of our long-lived assets, includingintangible assets other than goodwill and fixed assets, periodically forimpairment in accordance with SFAS No. 144, Accounting for the Impairment orDisposal of Long-lived Assets (SFAS No. 144). SFAS No. 144 requires thatlong-lived assets be evaluated for impairment when events or changes in factsand circumstances indicate that their carrying value may not be recoverable. Ifevents or circumstances indicate that the carrying value of an asset may not berecoverable, we assess the recoverability of identified intangible assets bycomparing the projected undiscounted net cash flows associated with the relatedasset or group of assets over their remaining lives against their respectivecarrying amounts. The amount of impairment will be measured as the differencebetween the carrying value and the fair value of the impaired asset. Animpairment will be recorded as an operating expense in the period of theimpairment and as a reduction in the carrying value of that asset.

*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 thatwould arise 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 and OtherIntangible Assets” (“SFAS No. 142”), which provides, among other things, thatgoodwill and intangibles with indefinite lives are no longer amortized but arereviewed for impairment at least annually (beginning with the first anniversaryof the acquisition date). Annual impairment tests were conducted for ClaytonServices and CFIS in 2006 and there was no impairment to goodwill orintangibles with indefinite lives of either entity.

**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 condensedconsolidated balance sheets.  For thethree and nine months ended September 30, 2006, transaction management revenueaccounted for 79.4% of total revenue.

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

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loansin the MBS issuance. These fees are recognized each month as services arerendered. Our special servicing activities are conducted under annual ormulti-year contracts for which we typically receive revenue on a per loan permonth basis. For the three and nine months ended September 30, 2006,surveillance and special servicing services revenue accounted for 20.6% oftotal revenue.

For the three months ended September 30, 2006 and2005, revenue from our largest three clients accounted for an aggregate of30.2% and 33.3% of total revenue, respectively. Revenue from two clientsexceeded 10% of revenue for the three months ended September 30, 2006 andrevenue from three clients exceeded 10% of revenue for the three months endedSeptember 30, 2005.

For the nine months ended September 30, 2006 and 2005,revenue from our largest three clients accounted for an aggregate of 32.0% and35.5% of total revenue, respectively. Revenue from two clients exceeded 10% ofrevenue for the nine months ended September 30, 2006 and revenue from threeclients exceeded 10% of revenue for the nine months ended September 30, 2005.

**Cost of Services**

*Compensation Expense*

Compensation expense consists primarily ofcompensation for independent loan review specialists and employees directlyinvolved in the delivery of our services, which include our client servicemanagers who manage our engagements. Compensation expense also includes payrollrelated benefits for our direct employees. The professionals we retain from aprofessional employment organization, including our independent loan reviewspecialists, do not receive any employee benefits from us and are onlycompensated for actual hours worked. Our direct cost of operations does notinclude an allocation of overhead costs.

*Travel and Related Expenses*

Travel and related expenses consist of expensesincurred in enabling employees and independent loan review specialists totravel to clients’ sites and are comprised of airfare, hotel and car rentalexpenses. A majority of these expenses is either directly billed to clients orincluded in the per file rates charged. As such, these expenses are directly orindirectly included in our revenue.

*Other Direct Costs*

Other direct costs include the cost of third partymortgage loan services (primarily collateral appraisal fees), outside supportfor our compliance services used in connection with our loan reviews,independent loan review specialist training and miscellaneous non-billabletransaction 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 with becoming a public company, we haveincurred significant additional operating expenses such as increased auditfees, professional fees, directors and officers’ insurance costs, compensationfor our board of directors, and expenses related to hiring additional personneland expanding our administrative functions. Many of these expenses either werenot incurred or were incurred at a lower level by us as a private company.

*Salaries and Benefits*

Salaries and benefits consist of employee compensationfor those employees who are not directly billable to a particular assignmentincluding costs of administrative, finance, human resources, technology andexecutive personnel.

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*Other Selling, General and Administrative Expenses*

Other selling, general and administrative expensesconsist of costs such as rent and utilities, marketing, advertising andpromotion expenses, non-reimbursable travel and entertainment, informationtechnology, insurance, education, training and hiring expenses other than forindependent loan review specialists and 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.

*Depreciation and Amortization*

We incur depreciation and amortization expenses forcosts related to the capitalization of property and equipment and softwaredeveloped for internal use on a straight-line basis over the estimated usefullives of the assets, which range from three to seven years. Leaseholdimprovements and assets under capital lease are amortized over the shorter ofthe estimated useful life of the asset or the lease term.

*Treatment of Goodwill 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 beingallocated to goodwill. The allocation of the purchase price to these intangibleassets is based on a number of significant assumptions as determined by us andin the case of material acquisitions our independent appraisal expert,including evaluations of the future income producing capabilities of theseassets and related future expected cash flows. We also make estimates about theuseful lives of the acquired intangible assets. Should different conditionsresult in the determination that the value of the goodwill and acquiredintangible assets has been impaired, we could incur write-downs of goodwill orintangible assets, or changes in the estimation of useful lives of thoseintangible assets. In accordance with SFAS No. 142, *Goodwill and Other Intangible Assets* (SFASNo. 142), goodwill is not amortized, but is subject to annual impairmenttesting which is discussed in greater 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.  Thefirst step 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.

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**Net Interest Expense**

Net interest expense consists of interest paid on ourdebt net of interest received on our cash balances. Interest expense for thenine months ended September 30, 2006 primarily consisted of interest on our$150,000,000 term loan, amortization of debt issuance costs related to the termloan and interest on our revolving line of credit. Interest expense for thenine months ended September 30, 2005 primarily consisted of interest on ourprior term loan, which had a balance of $37,750,000 at the start of the period,and interest on 12% senior subordinated and 12% subordinated notes issued to TAAssociates and our other noteholders in connection with the acquisitions ofClayton Services and CFIS, respectively, by investment funds affiliated with TAAssociates. The combined balance of the 12% senior subordinated and 12%subordinated notes at the start of the period was $29,486,478. The remainingbalances of the prior term loan, the 12% senior subordinated notes and the 12% subordinatednotes were repaid with the proceeds from our $150,000,000 term loan onDecember 8, 2005.

**Loss from Extinguishment of Debt**

On March 29, 2006, following our initial publicoffering, we repaid $70,000,000 of the outstanding balance on our $150,000,000 termloan and the entire $7,400,000 outstanding balance on our revolving line ofcredit. Due to the prepayment of $70,000,000 on our term loan, we wrote-off aportion of the debt issuance costs on the term loan and recognized a loss fromextinguishment of debt of $746,002.

**Results of Operations**

***Comparison of Three Month Periods EndedSeptember 30, 2006 and 2005***

**Revenue**

Our revenue was $61.0 million for the three monthsended September 30, 2006, an increase of $7.0 million or 12.8%, compared to revenueof $54.0 million for the three months ended September 30, 2005*.*The increase was primarily due to anincrease in volume in our conduit support services and special servicingbusinesses, as well as growth in our surveillance services due in part toan increased joint sales effort following the combination of CFIS and Clayton.Revenue for the three months ended September 30, 2006 included $1.8 millionfrom Clayton Lender Solutions, Inc., (formerly d/b/a as Mortgage ResourceNetwork), following the Company’s acquisition of substantially all of theassets of that business in February 2006. Our total revenues per loan increased 0.4%, as growth in our non-loanrelated services offset reduced revenues per loan in our core due diligencebusiness.  Revenues per loan in our coredue diligence business decreased during the period due to an increase in thepercentage of loans serviced in our central underwriting facility and anincrease in the prevalence of other file reviews, in which we verify a limitednumber of data points in a loan file.  Thetotal number of loans serviced increased by 12.4%.

**Cost of Services**

Our cost of services was $38.2 million for the threemonths ended September 30, 2006, an increase of $4.1 million or 12.1%, comparedto cost of services of $34.1 million for the three months ended September 30,2005. This increase was attributable to the specific factors discussed below.

*Compensation Expense.*Compensationexpense was $29.7 million for the three months ended September 30, 2006,an increase of $4.8 million or 19.2%, compared to compensation expense of$24.9 million for the three months ended September 30, 2005***.*** The increase was primarily dueto the growth in our conduit support services, special servicing, consultingand surveillance businesses, as well as the acquisition of Clayton LenderSolutions, Inc.  Compensation expense in our due diligence business alsoincreased, as increased fixed expenses due to investments in productdevelopment and management infrastructure offset reduced variable expenses perloan.

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*Travel and Related Expenses.*Traveland related expenses were $6.3 million for the three months ended September 30,2006, a decrease of $1.2 million or 15.5%, compared to travel and relatedexpenses of $7.5 million for the three months ended September 30,2005.  Travel expenses per loan decreased by 24.8% due to reduced travelexpenses per loan in our core due diligence business and a decrease in travelexpenses in our non-loan related professional staffing services business.  Travel expenses per loan in our core due diligence business decreased due toreduced expenses per loan in our field business and an increase in thepercentage of loans serviced in our central underwriting facility.

*Other Direct Costs.*Otherdirect costs were $2.2 million for the three months ended September 30,2006, an increase of $0.5 million or 29.4%, compared to other direct costs of$1.7 million for the three months ended September 30, 2005. The increasewas primarily due to an increase in third-party appraisal fees due to anincrease in appraisal revenue in our due diligence business.

**Operating Expenses**

Operating expenses were $15.8 million for the threemonths ended September 30, 2006, an increase of $3.3 million or 26.7%, comparedto operating expenses of $12.5 million for the three months endedSeptember 30, 2005. This increase was attributable to the specific factorsdiscussed below.

*Salaries and Benefits.*Salariesand benefits were $6.0 million for the three months ended September 30, 2006,an increase of $1.3 million or 26.3%, compared to salaries and benefits of$4.7 million for the three months ended September 30, 2005.  Thisincrease was primarily due to the costs of additional administrative, finance,human resources, technology and executive personnel which were added inpreparation for becoming a public company and following the acquisition ofClayton Lender Solutions, Inc*.*

*Other Selling, General andAdministrative Expenses.*Other selling, general andadministrative expenses were $5.1 million for the three months ended September30, 2006, an increase of $1.1 million or 26.1%, as compared to selling, generaland administrative expenses of $4.0 million for the three months endedSeptember 30, 2005*. ** ***This increase was due togeneral increases in occupancy, corporate governance, insurance, relocation andnon-reimbursable travel costs relating to growth in our business, theacquisition of Clayton Lender Solutions, Inc. and becoming a publiccompany.  These increases were partially offset by reduced consultingexpenses and professional fees.

*Depreciation and Amortization.*Depreciationand amortization was $2.2 million for the three months ended September 30,2006, an increase of $1.0 million or 84.0%, compared to depreciation andamortization of $1.2 million for the three months ended September 30, 2005*.*This increase was primarily due todepreciation recorded on additional property and equipment and softwaredeveloped for internal use. These additions were made to enhance our corporateinfrastructure and technology platform in support of the growth inbusiness operations and in preparation for becoming a public company.

*Amortization of Intangibles.*Amortizationof intangibles was $2.6 million for the three months ended September 30, 2006,an increase of $0.1 million or 1.5%, compared to amortization of intangibles of$2.5 million for the three months ended September 30, 2005.

**Interest Expense, net**

Interest expense, net was $1.8 million for the threemonths ended September 30, 2006, a decrease of $0.2 million or 12.0%, comparedto interest expense, net of $2.0 million for the three months endedSeptember 30, 2005*.*This decreasewas due to decreased borrowings under our credit facilities due to the prepaymentof $70.0 million owed under our senior term loan following our initial publicoffering in March 2006 and higher interest income. *See “—Liquidity and Capital Resources.”*

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***Comparison of Nine Month Periods EndedSeptember 30, 2006 and 2005***

**Revenue**

Our revenue was $178.0 million for the ninemonths ended September 30, 2006, an increase of $26.8 million or 17.7%,compared to revenue of $151.2 million for the nine months ended September30, 2005*.*The increase wasprimarily due to an increase in volume in our conduit support services, specialservicing and professional staffing services businesses as well as growth inour surveillance services due in part to an increased joint sales effortfollowing the combination of CFIS and Clayton. Revenue for the nine monthsended September 30, 2006 included $5.0 million from Clayton Lender Solutions,Inc., following the Company’s acquisition of substantially all of the assets ofthat business in February 2006. Due to growth in our non-loan relatedservices, our total revenues per loan increased 18.4%. This increase offset a0.5% decrease in the number of loans serviced during the nine months endedSeptember 30, 2006 as compared to the nine months ended September 30,2005.  Revenues per loan in our core duediligence business decreased during the period due to an increase in thepercentage of loans serviced in our central underwriting facility and anincrease in the prevalence of other file reviews, in which we verify a limitednumber of data points in a loan file.

**Cost of Services**

Our cost of services was $118.2 million for the ninemonths ended September 30, 2006, an increase of $20.5 million or 20.9%,compared to cost of services of $97.7 million for the nine months endedSeptember 30, 2005. This increase was attributable to the specific factorsdiscussed below.

*Compensation Expense.*Compensationexpense was $90.4 million for the nine months ended September 30, 2006, anincrease of $18.6 million or 26.0%, compared to compensation expense of$71.8 million for the nine months ended September 30, 2005*.*The increase was primarily due to thegrowth in our conduit support services, professional staffing services, specialservicing and consulting businesses, as well as the acquisition of ClaytonLender Solutions, Inc.  Compensation expense in our core due diligencebusiness also increased, as a result of increased fixed expenses due toinvestments in product development and management infrastructure.

*Travel and Related Expenses.*Traveland related expenses were $20.2 million for the nine months ended September 30,2006, a decrease of $1.7 million or 7.9%, compared to travel and relatedexpenses of $21.9 million for the nine months ended September 30, 2005.Travel expenses per loan decreased by 7.5%, as reduced travel expenses per loanin our core due diligence business offset increased travel expense in ournon-loan related professional staffing services 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.*Otherdirect costs were $7.5 million for the nine months ended September 30, 2006, anincrease of $3.5 million or 87.0%, compared to other direct costs of$4.0 million for the nine months ended September 30, 2005. The increasewas primarily due to an increase in third-party appraisal fees due to anincrease in appraisal revenue in our due diligence business.

**Operating Expenses**

Operating expenses were $45.3 million for the ninemonths ended September 30, 2006, an increase of $8.1 million or 22.0%, comparedto operating expenses of $37.2 million for the nine months ended September30, 2005. This increase was attributable to the specific factors discussedbelow.

*Salaries and Benefits.*Salariesand benefits were $17.0 million for the nine months ended September 30, 2006,an increase of $3.0 million or 21.4%, compared to salaries and benefits of$14.0 million for the nine months ended September 30, 2005. Salaries andbenefits expense for the nine months ended September 30, 2006 included $0.6million of expense related to the acceleration of vesting of certain stock

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optionsas a result of the Company’s initial public offering in March 2006. Theremaining increase was primarily due to the costs of additional administrative,finance, human resources, technology and executive personnel which were addedin preparation for becoming a public company and following the acquisition ofClayton Lender Solutions, Inc.

*Other Selling, General andAdministrative Expenses.*Other selling, general andadministrative expenses were $15.0 million for the nine months ended September30, 2006, an increase of $2.6 million or 20.5%, compared to selling, generaland administrative expenses of $12.4 million for the nine months endedSeptember 30, 2005*.**** ** ***Thisincrease was due to general increases in occupancy, corporate governance,insurance, recruiting, relocation, non-reimbursable travel andtelecommunications costs relating to growth in our business, the acquisition ofClayton Lender Solutions, Inc. and becoming a public company.  Theseincreases were partially offset by reduced consulting expenses and professionalfees.

*Depreciation and Amortization.*Depreciationand amortization was $5.7 million for the nine months ended September 30, 2006,an increase of $2.6 million or 81.1%, compared to depreciation and amortizationof $3.1 million for the nine months ended September 30, 2005*.*This increase was primarily due todepreciation recorded on additional property and equipment and softwaredeveloped for internal use. These additions were made to enhance our corporateinfrastructure and technology platform in support of the growth inbusiness operations and in preparation for becoming a public company.

*Amortization of Intangibles.*Amortizationof intangibles was $7.7 million for the nine months ended September 30, 2006,an increase of $0.1 million or 1.1%, compared to amortization of intangibles of$7.6 million for the nine months ended September 30, 2005.

**Interest Expense, net**

Interest expense, net was $6.5 million for the ninemonths ended September 30, 2006, an increase of $0.7 million or 11.7%, comparedto interest expense, net of $5.8 million for the nine months endedSeptember 30, 2005*.*This increasewas due to increased borrowings outstanding under our credit facilities duringthe first three months of the year prior to our initial public offering. *See “—Liquidity and Capital Resources.”*

**Loss from Extinguishment of Debt**

For the nine months ended September 30, 2006, werecognized a loss from extinguishment of debt of $0.7 million due to thewrite-off of debt issuance costs as a result of a $70.0 million prepayment onour term loan following our initial public offering. *See “—Liquidity and Capital Resources.”*

**Liquidity and Capital 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,including 1,125,000 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 March 1, 2006, we consummated a 1-for-4reverse stock split of our common stock and class B common stock.

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Immediately prior to the completion of the offering,the following transactions occurred:

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

·                  our series A convertiblepreferred stock converted into 2,206,308 shares of common stock and 8,825,241shares of series A redeemable preferred stock.

·                  ourseries B convertible preferred stock converted into 6,046,371 shares ofcommon stock and 24,185,493 shares of series B redeemable preferred stock.

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

·                  redeem $52.8 million of redeemablepreferred 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 owed under thesenior term loan portion of our credit facility.

·                  repay $7.4 million owed under therevolving credit portion of our credit facility.

·                  fund$1.6 million of working capital.

On February 3, 2006, we acquired substantiallyall of the assets and assumed certain liabilities of Clayton LenderSolutions, Inc. (formerly known as Mortgage Resource Network) for anaggregate purchase price and fees aggregating approximately $5.7 million. Working capital was used to fund the acquisition of such assets and assumedliabilities. Clayton Lender Solutions, Inc. 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 $21.0million and $2.5 million in the nine months ended September 30, 2006 and 2005,respectively. Cash provided from operations is generated primarily from netincome and the timing of accounts receivable collections and disbursements ofaccounts payable. Cash provided by operations for the nine months endedSeptember 30, 2006 was generated from net income of $4.3 million plus $15.4million of non cash charges plus $1.3 million from a net decrease in currentassets, primarily due to an increase in accrued expenses and a decrease inprepaid taxes partially offset by an increase in accounts receivable andunbilled receivables and a decrease in deferred revenue. Cash provided byoperations for the nine months ended September 30, 2005 resulted from $6.3million of net income plus $11.4 million of non cash charges and was negativelyimpacted by a net increase in operating assets of $15.3 million primarily froman increase in the balance of accounts receivable****as a result of an increase in the amount of time receivablesremained outstanding. We believe cash flow from operations will be sufficientto finance our current operations for the next twelve months.

Our investing activities used cash of $13.4 millionand $8.8 million in the nine months ended September 30, 2006 and 2005,respectively. Cash used in investing activities in the nine months endedSeptember 30, 2006 primarily consisted of the Clayton Lender Solutions, Inc. acquisition and capital expenditures. Cash used in investing activities inthe nine months ended September 30, 2005 primarily consisted of capitalexpenditures and the acquisition of NYSIS, Inc.

Our financing activities provided cash of $8.6 millionand $0.4 million in the nine months ended September 30, 2006 and 2005,respectively. The principal sources of cash from financing activities in thenine months ended September 30, 2006 were the proceeds from the initial publicoffering described above and, to a lesser extent, borrowings under our revolvingcredit agreement. This was partially offset by the redemption of preferredstock and repayments of outstanding debt under our credit facility describedabove. The principal sources of cash from financing activities in the ninemonths ended September 30, 2005 were borrowings under our prior revolvingcredit agreement, partially offset by loan repayments and distributions toshareholders.

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Cash paid for interest expense was $6.0 million and$5.4 million in each of the nine months ended September 30, 2006 and 2005,respectively. In the nine months ended September 30, 2006, the majority ofinterest expense was paid on borrowings outstanding under our term loan. In thenine months ended September 30, 2005, the majority of interest expense was paidon borrowings outstanding under our subordinated notes, senior subordinatednotes, prior revolving line of credit and prior term loan.

***Credit Agreement***

On December 8, 2005, we entered into a$190.0 million senior credit facility. The credit facility provided for a $150.0 millionterm loan, and a revolving credit facility of $40.0 million. The creditfacility also provided us with an option, subject to the consent of thelenders, to increase the revolving credit facility by $10.0 million to anaggregate of $50.0 million. We exercised the option to increase our revolvingcredit facility on January 11, 2006 and April 28, 2006, and amendedour credit facility to increase the revolving loan facility by$5.0 million on each date, for an aggregate revolving credit facility of$50.0 million as of April 28, 2006. Following our initial publicoffering in March 2006, we repaid $70.0 million outstanding under the termloan and repaid $7.4 million outstanding under the revolving credit facility.

The credit agreement terminates on December 8,2011. Principal repayments on the term loan of $200,500 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, fixed charge ratio and total leverage ratio. As of September 30,2006, we were in compliance with all debt covenants. In addition, the creditagreement 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 credit agreement also contains provisions for an increasedinterest rate during periods of default. We do not believe that these covenantswill affect our ability to operate our business.

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.

At September 30, 2006, there was an outstandingbalance of $79.8 million under the term loan and no outstanding balance underthe revolving credit facility.

***Interest Rate Cap***

In September 2004, we purchased an interest ratecap agreement to reduce the potential impact that interest rate increases couldhave on our floating-rate debt interest expense. In January 2006, the Companyrecorded interest expense of $1,915 to reduce the book value of this asset tozero.  The terms of the interest rate capagreement, which expired on September 30, 2006, provide that we wouldreceive quarterly payments equal to the notional amount multiplied by thedifference by which LIBOR exceeds 5%. During the third quarter of 2006 the Company received approximately$19,300 which was recorded as a reduction of interest expense.  The initial premium of $29,900 was recordedas an asset on the date of purchase. Subsequent declines in the fair value ofthis derivative were recorded as interest expense.

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***Contractual Obligations***

The following table describes our cash commitments, inthousands, to settle contractual obligations as of September 30, 2006.
| ** **                    | ** ** | **Total** | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More than  5 years** | ** ** |
|-------------------------------|------------|-----------|------------|-----------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
| Term loans and  loans payable |       | $         | 79,799     |                        | $          | 200                |       | $                  | 2,406      |                             | $          | 77,193 |   | $ | — |   |
| Capital lease  obligations    |       | 959       |       | 92                          |       | 751                |       | 116                |       | —                           |       |
| Operating lease  obligations  |       | 9,067     |       | 707                         |       | 6,772              |       | 1,113              |       | 475                              |       |
|                          |       |      |       |                        |       |               |       |               |       |                             |       |
| Total                         |       | $         | 89,825     |                        | $          | 999                |       | $                  | 9,929      |                             | $          | 78,422 |   | $ | 475 |   |

 

**Off-Balance-Sheet Arrangements**

As of September 30, 2006, we did not have anysignificant off-balance-sheet arrangements, as defined in Item303(a)(4)(ii) of Regulation S-K of the SEC.

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

During the nine months ended September 30, 2006, therewere no material changes in our market risk exposure. For a discussion of ourmarket risk associated with interest rate risk and equity price risk as ofDecember 31, 2005, see Risk Factors and Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained inour registration statement on Form S-1 (File No. 333-129526),declared effective by the Securities and Exchange Commission on March 23,2006, which includes audited financial statements for the year endedDecember 31, 2005.

**Item 4.  Controls andProcedures**

***Evaluation of Disclosure Controls andProcedures***

Our management,with the participation of our chief executive officer and chief financialofficer, evaluated the effectiveness of our disclosure controls and proceduresas of September 30, 2006.  The term “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms. Disclosure controls and procedures include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’s management,including its principal executive and principal financial officers, asappropriate to allow timely decisions regarding required disclosure. Managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving their objectivesand management necessarily applies its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.  Based on the evaluation of our disclosurecontrols and procedures as of September 30, 2006, our chief executive officerand chief financial officer concluded that, as of such date, the Company’sdisclosure controls and procedures were effective at the reasonable assurancelevel.

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***Changes in Internal Control Over FinancialReporting***

During the quarterended September 30, 2006, we added and integrated professionals possessingsignificant accounting and control expertise to our finance and accountingstaff, drafted and implemented critical accounting policies and procedures, andtrained certain key personnel with responsibilities for financial and taxreporting to address the material weakness in our internal control overfinancial reporting identified as existing on March 31, 2006 and June 30, 2006.Other than these actions, no change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)occurred during the three months ended September 30, 2006 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

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**Part II— OTHER INFORMATION**

**Item 1.  LegalProceedings**

Not applicable.

**Item 1A. Risk Factors**

Not applicable.

**Item 2.  Unregistered Sales of Equity Securitiesand Use of Proceeds**

Not applicable.

**Item 3.  Defaults UponSenior Securities**

Not applicable.

**Item 4.  Submission ofMatters to a Vote of Security Holders**

On July 26, 2006, we held our Annual Meeting of Stockholders.  At the meeting, the stockholders re-electedFrank P. Filipps, Stephen M. Lamando and Margaret Sue Ellis to the Board ofDirectors, each to serve for a three-year term as a Class I Director.  19,323,905 votes were cast forMr. Filipps’ election; 136,454 votes were cast to withhold authority forMr. Filipps.  19,144,818 votes werecast for Mr. Lamando’s election; 315,541 votes were cast to withholdauthority for Mr. Lamando. 19,148,007 votes were cast for Ms. Ellis’ election; 312,352 votes werecast to withhold authority for Ms. Ellis. Also at the meeting, the stockholders ratified the appointment of GrantThornton LLP as our independent registered public accounting firm for thecurrent year.  The votes cast to ratifyGrant Thornton LLP’s appointment were as follows: 19,454,580 shares voted for,1,670 voted against and 4,109 shares abstained from voting.

**Item 5.  OtherInformation**

Not applicable.

**Item 6.  Exhibits**

The exhibits listed in the Exhibit Indeximmediately preceding the exhibits are filed as part of this QuarterlyReport on Form 10-Q and such Exhibit Index is incorporated herein byreference.

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                               | **CLAYTON HOLDINGS, INC.** |
|-------------------------------|---------------------------------|
|                          |                            |   |
| Date:  November 10, 2006 | By:                             | /s/ Frederick C. Herbst |   |
|                          |                            | Frederick C. Herbst |
|                          | * *                        | *Chief Financial Officer* |
|                          |                            | (Duly Authorized Officer and Principal  Financial Officer) |

 

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**EXHIBIT INDEX**

Listed and indexed below are all Exhibits filed aspart of this report.
| Exhibit No. | ** ** | **Description**                                                                                                                                                                             |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1             |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002, Rule 13a-14(a)/15d-14(a), by Chief Executive  Officer.                                                  |
|             |       |                                                                                                                                                                                        |
| 31.2             |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002, Rule 13a-14(a)/15d-14(a), by Chief Financial  Officer.                                                  |
|             |       |                                                                                                                                                                                        |
| 32.1             |       | Certification pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002, by Chief Executive Officer and Chief Financial Officer. |

 

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