**Table of Contents**

** **

** **

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

----

** **

**Form 10-Q**

 
| **(Mark  One)** |
|-----------------|
| **x**           | ** ** | **QUARTERLY REPORT UNDER  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE  QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008** |
|            |   |   |
| **o**           | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE  TRANSITION PERIOD FROM TO** |

 

**Commission File No. 000-52903**

 

**CMR Mortgage Fund II, LLC**

(Exact name of registrant as specified in itscharter)

 

| **California  (**State or other jurisdiction  of  incorporation or organization)                        | ** ** | **20-0671528**(I.R.S. Employer  Identification No.) |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|
|                                                                                                    |       |                                                |
| **62 First  Street, 4th Floor  San Francisco, California**(Address of principal executive offices) | ** ** | **94105**(Zip Code)                                 |

 

----

 

**Registrant’s telephone number,including area code:**

**(415) 974-1100**

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to the filing requirements for at least the past 90 days.  Yes oNo  x

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company.  See thedefinitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

 
| Large accelerated filer o                      |   | Accelerated filer o         |
|------------------------------------------------|--------|-----------------------------|
| Non-accelerated filer o                        |   | Smaller reporting company x |
| (Do not check if a smaller  reporting company) |   |                        |

 

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

 

There is no trading market for the registrant’smembership interests.

 

 

 

----

**Table of Contents**

 

**TABLE OF CONTENTS**

 
| ** **                          | **Page**                                                                                            |
|-------------------------------------|-----------------------------------------------------------------------------------------------------|
| PART I.  FINANCIAL INFORMATION | 2                                                                                                   |
|                                | Item 1.  Financial Statements                                                                       | 2 |
|                                | Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 22 |
|                                | Item 3. Quantitative and Qualitative Disclosures about  Market Risk                                 | 35 |
|                                | Item  4. Controls and Procedures                                                                    | 35 |
| PART II.  OTHER INFORMATION    | 35                                                                                                  |
|                                | Item  1. Legal Proceedings                                                                          | 35 |
|                                | Item  1A. Risk Factors                                                                              | 36 |
|                                | Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                | 36 |
|                                | Item 3. Defaults Upon Senior Securities                                                             | 36 |
|                                | Item 4. Submission of Matters to a Vote of Security  Holders                                        | 37 |
|                                | Item  5. Other Information                                                                          | 37 |
|                                | Item 6.  Exhibits                                                                                   | 37 |

 

1

----

Table of Contents

 

# **PART I.                 FINANCIAL INFORMATION**

# ** **

## **Item1.                   Financial Statements**

## ** **

**CMR MORTGAGE FUND II, LLCCONDENSED BALANCE SHEETS**

 
| ** **                                                                                                                                                    | ** ** | **September  30, 2008  (Unaudited)** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                    |       |                                      |       |                        |       |
| Cash and cash equivalents                                                                                                                                     |       | $                                         | 1,014,907  |                        | $          | 1,458,635 |   |
| Loans, secured by deeds of trust, net of allowance for loan losses of  $33,024,309 as of September 30, 2008 and $6,309,000 as of  December 31, 2007 |       | 53,296,381                                |       | 87,474,484                  |       |
| Notes receivable from Manager, partially secured by deeds of trust                                                                                            |       | 4,004,885                                 |       | 8,598,011                   |       |
| Advances to borrowers                                                                                                                                         |       | 4,030,949                                 |       | 5,905,561                   |       |
| Due from related parties, net of reserve for uncollectible amounts of  $900,000 as of September 30, 2008, and none as of December 31, 2007          |       | 406,775                                   |       | 1,533,247                   |       |
| Real estate owned                                                                                                                                             |       | 19,262,858                                |       | 8,578,275                   |       |
| Accrued interest receivable and other assets                                                                                                                  |       | 4,160,595                                 |       | 2,831,203                   |       |
| **Total Assets**                                                                                                                                              |       | $                                         | 86,177,350 |                        | $          | 116,379,416 |   |
| **LIABILITIES AND MEMBERS’  CAPITAL**                                                                                                                    |       |                                      |       |                        |       |
| Liabilities:                                                                                                                                                  |       |                                      |       |                        |       |
| Accounts payable                                                                                                                                              |       | $                                         | 403,413    |                        | $          | 605,681 |   |
| Accrued expenses                                                                                                                                              |       | 714,243                                   |       | 116,035                     |       |
| Accrued distributions                                                                                                                                         |       | —                                    |       | 296,225                     |       |
| Due to related parties                                                                                                                                        |       | 753,378                                   |       | 258,118                     |       |
| Other payables and accrued interest - real estate owned                                                                                                       |       | 10,413,373                                |       | —                      |       |
| Note payable to related party - real estate owned                                                                                                             |       | 6,000,000                                 |       | 6,000,000                   |       |
| Note payable and accrued interest to related party                                                                                                            |       | 20,351,220                                |       | 21,395,630                  |       |
| **Total Liabilities**                                                                                                                                         |       | 38,635,627                                |       | 28,671,689                  |       |
| Commitments and contingencies                                                                                                                                 |       |                                      |       |                        |       |
| Members’ Capital                                                                                                                                         |       | 47,541,723                                |       | 87,707,727                  |       |
| **Total Liabilities and Members’ Capital**                                                                                                               |       | $                                         | 86,177,350 |                        | $          | 116,379,416 |   |

 

The accompanying notes are an integral part of theseunaudited condensed financial statements.

 

2

----

Table of Contents

 

**CMR MORTGAGE FUND II, LLCCONDENSED STATEMENTS OF OPERATIONS**(UNAUDITED)

 
| ** **                                        | ** ** | **For the Three Months  Ended  September 30,** | ** **  | **For the Nine Months  Ended  September 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------|-------------|-------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                                           | ** **  | **2007**                                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                         |       |                                                               |        |                                                              |       |   |   |   |   |
| Interest income:                                  |       |                                                               |        |                                                              |       |   |   |   |   |
| Interest on loans                                 |       | $                                                                  | 176,714     |                                                              | $          | 3,983,006 |   | $ | 3,853,589 |   | $ | 9,939,417 |   |
| Interest on notes receivable - related party      |       | 9,375                                                              |        | —                                                            |       | 409,502 |   | — |   |
| Interest on advances to borrowers                 |       | (4,801                                                             | )           | 90,549                                                            |       | 118,205 |   | 329,181 |   |
| Other interest income                             |       | 310,415                                                            |        | (33,652                                                           | )          | 754,039 |   | 417,203 |   |
| Total interest income                             |       | 491,703                                                            |        | 4,039,903                                                         |       | 5,135,335 |   | 10,685,801 |   |
| Less: Loan servicing fees                         |       | (105,293                                                           | )           | 789,246                                                           |       | 908,152 |   | 1,966,231 |   |
| Total interest income, net of servicing fees      |       | 596,996                                                            |        | 3,250,657                                                         |       | 4,227,183 |   | 8,719,570 |   |
| Loss on sale of real estate owned                 |       | —                                                             |        | —                                                            |       | (3,674 | ) | — |   |
| Total revenues, net of servicing fees             |       | 596,996                                                            |        | 3,250,657                                                         |       | 4,223,509 |   | 8,719,570 |   |
| Interest expense                                  |       | 498,728                                                            |        | 624,451                                                           |       | 1,536,091 |   | 2,146,851 |   |
| Interest expense — related party             |       | 246,715                                                            |        | 187,500                                                           |       | 621,715 |   | 187,500 |   |
| Provision for loan losses                         |       | 10,704,841                                                         |        | 1,411,078                                                         |       | 31,534,320 |   | 2,086,393 |   |
| Net revenues                                      |       | (10,853,288                                                        | )           | 1,027,628                                                         |       | (29,468,617 | ) | 4,298,826 |   |
| Operating expenses:                               |       |                                                               |        |                                                              |       |   |   |   |   |
| Professional services                             |       | 248,293                                                            |        | 144,320                                                           |       | 1,716,237 |   | 670,134 |   |
| Asset management fees                             |       | 177,593                                                            |        | 238,144                                                           |       | 487,374 |   | 731,719 |   |
| Impairment loss on amounts due from related party |       | 333,548                                                            |        | —                                                            |       | 1,233,548 |   | — |   |
| Impairment loss on investment in REO              |       | 5,485,187                                                          |        | —                                                            |       | 5,485,187 |   | — |   |
| Other Expenses - REO                              |       | 337,187                                                            |        | —                                                            |       | 431,946 |   | — |   |
| Other operating expenses                          |       | 478,204                                                            |        | 11,323                                                            |       | 696,125 |   | 19,551 |   |
| Total operating expenses                          |       | 7,060,012                                                          |        | 393,787                                                           |       | 10,050,417 |   | 1,421,404 |   |
| Net (loss) income                                 |       | $                                                                  | (17,913,300 | )                                                                 | $          | 633,841 |   | $ | (39,519,034 | ) | $ | 2,877,422 |   |

 

The accompanying notes are an integral part of theseunaudited condensed financial statements.

 

3

----

Table of Contents

 

**CMR MORTGAGE FUND II, LLCSTATEMENT OF CHANGES IN MEMBERS’ CAPITALFor the Nine Months Ended September 30, 2008(UNAUDITED)**

 
| ** **                        | ** ** | ** ** | ** ** | ** **  | ** ** | **Members’ Capital** | ** ** |
|-----------------------------------|------------|------------|------------|-------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **Units**  | ** ** | **Members** | ** ** | **Unallocated  Capital**       | ** ** | **Total  Members’  Capital** | ** ** |
| Balance January 1, 2008      |       | 87,708     |       | $           | 87,707,727 |                           | $          | — |   | $ | 87,707,727 |   |
| Net loss                          |       | (39,519    | )          |        |       | (39,519,034                    | )          | (39,519,034 | ) |
| Allocation of net loss to members |       |       |       | (39,519,034 | )          | 39,519,034                     |       |   |   |
| Distributions to members          |       | (647       | )          | (646,970    | )          |                           |       | (646,970 | ) |
|                              |       |       |       |        |       |                           |       |   |   |
| Balance September 30, 2008   |       | 47,542     |       | $           | 47,541,723 |                           | $          | — |   | $ | 47,541,723 |   |

 

The accompanying notes are an integral part of theseunaudited condensed financial statements.

 

4

----

Table of Contents

 

**CMR MORTGAGE FUND II, LLCCONDENSED STATEMENT OF CASH FLOWS(UNAUDITED)**

 
| ** **                                                                                          | ** ** | **For the Nine Months Ended  September 30,** | ** **  |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|-------------|
| ** **                                                                                          | ** ** | **2008**                                                              | ** **  | **2007** | ** ** |
| Cash flows from operating activities:                                                               |       |                                                                  |        |   |   |
| Net (loss) income                                                                                   |       | $                                                                     | (39,519,034 | ) | $ | 2,877,422 |   |
| Adjustments to reconcile net (loss) income to net cash (used in)  provided by operating activities: |       |                                                                  |        |   |   |
| Provision for loan losses                                                                           |       | 31,534,320                                                            |        | 2,086,393 |   |
| Impairment loss on amounts  due from related party                                                  |       | 1,233,548                                                             |        | — |   |
| Impairment loss on  investment in REO                                                               |       | 5,485,187                                                             |        | — |   |
| Loss on sale of REO                                                                                 |       | 3,674                                                                 |        | — |   |
| Net changes in operating assets and liabilities:                                                    |       |                                                                  |        |   |   |
| Accrued interest receivable and other assets                                                        |       | (1,329,392                                                            | )           | 6,313 |   |
| Accounts payable and accrued expenses                                                               |       | 395,941                                                               |        | 181,924 |   |
| Due from related parties                                                                            |       | (107,076                                                              | )           | 2,275,587 |   |
| Due to related parties                                                                              |       | 432,666                                                               |        | 731,797 |   |
| Net cash (used in) provided by operating activities                                                 |       | (1,870,166                                                            | )           | 8,159,436 |   |
| Cash flows from investing activities:                                                               |       |                                                                  |        |   |   |
| Proceeds from sale of real  estate owned                                                            |       | 216,757                                                               |        | — |   |
| Investment in REO                                                                                   |       | (246,668                                                              | )           | — |   |
| Net decrease (increase) advances to borrowers                                                       |       | 1,874,612                                                             |        | (2,654,233 | ) |
| Net (increase) decrease in loans                                                                    |       | (3,086,377                                                            | )           | 5,181,337 |   |
| Net decrease in notes receivable from Manager                                                       |       | 4,593,126                                                             |        | — |   |
| Net cash provided by investing activities                                                           |       | 3,351,450                                                             |        | 2,527,104 |   |
| Cash flows from financing activities:                                                               |       |                                                                  |        |   |   |
| Contributions from members                                                                          |       | —                                                                |        | 299,924 |   |
| Distributions/redemptions to members                                                                |       | (943,195                                                              | )           | (12,884,177 | ) |
| Repayment of note payable to related party                                                          |       | (981,817                                                              | )           | (2,094,244 | ) |
| Net cash used in financing activities                                                               |       | (1,925,012                                                            | )           | (14,678,497 | ) |
|                                                                                                |       |                                                                  |        |   |   |
| Net decrease in cash and cash equivalents                                                           |       | (443,728                                                              | )           | (3,991,957 | ) |
|                                                                                                |       |                                                                  |        |   |   |
| Cash and cash equivalents at beginning of period                                                    |       | 1,458,635                                                             |        | 4,138,948 |   |
| Cash and cash equivalents at end of period                                                          |       | $                                                                     | 1,014,907   |   | $ | 146,991 |   |
|                                                                                                |       |                                                                  |        |   |   |
| *Supplemental disclosure of cash flow information:*                                                 |       |                                                                  |        |   |   |
| Cash paid during the year for:                                                                      |       |                                                                  |        |   |   |
| Interest expense                                                                                    |       | $                                                                     | 2,282,899   |   | $ | 2,164,621 |   |
| Franchise taxes                                                                                     |       | $                                                                     | 12,590      |   | $ | 12,590 |   |
| Non-cash investing activities:                                                                      |       |                                                                  |        |   |   |
| Real estate acquired through foreclosure                                                            |       | $                                                                     | 6,197,160   |   | $ | 2,578,275 |   |
| Loans originated in connection with the sale of REO                                                 |       | $                                                                     | 467,000     |   | $ | — |   |
| Non-cash financing activities:                                                                      |       |                                                                  |        |   |   |
| Debt assumed REO related party                                                                      |       | $                                                                     | —      |   | $ | 6,000,000 |   |
| Debt assumed REO other                                                                              |       | $                                                                     | 10,940,942  |   | $ | — |   |
| Debt assumed by purchaser in sale of REO                                                            |       | $                                                                     | 527,569     |   | $ | — |   |

 

The accompanying notes are an integral part of theseunaudited condensed financial statements.

 

5

----

**Table of Contents**

** **

**CMR Mortgage Fund II, LLCNotes to Condensed Financial Statements (Unaudited)**

** **

**Note 1:  Organization and General Fund Provisions**

** **

CMR Mortgage Fund II, LLC (the “Fund”) is a Californialimited liability company organized for the purpose of making or investing inbusiness loans secured by deeds of trust and mortgages on realproperties—predominately commercial income producing structures or land held bybusinesses—located primarily in California. The land can be income producing (*e.g.*,farms, vineyards, parking lots) or may be held for commercial or residentialdevelopment.  The Fund’s loans arearranged and serviced by its manager, California Mortgage and Realty, Inc.,a Delaware corporation (the “Manager”), which is licensed as a California realestate broker and a California finance lender. In addition, the Fund has the ability to invest in loans that were notoriginated by the Manager.  The Managerprovides certain operating and administrative services to the Fund.  The Manager has complete control of the Fund’sbusiness, subject to the voting rights of the Fund’s members on specifiedmatters and on any other matters which the Manager wishes to submit to a vote.  Neither the Manager nor any of its affiliatedentities held any of the Fund’s membership interests at September 30,2008, December 31, 2007 or September 30, 2007.

 

In addition to arranging and servicing the Fund’sloans, the Manager sells loans in the Fund’s loan portfolio and purchasesexisting loans for the Fund, including partial undivided interests inloans.  The Manager sells and purchasesloans for the Fund primarily to and from its affiliates and its clients andoccasionally from non-affiliated third parties.

 

**Basis of Accounting**

** **

Theaccompanying unaudited condensed financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”) for interim financial statements and do not contain all ofthe information and footnotes required for annual financial statements underGAAP.  However, these condensed financialstatements contain all adjustments (consisting of normal recurring adjustmentsand accruals) which in the Fund’s opinion are necessary for a fair presentationof the interim periods.  These condensedfinancial statements should be read in conjunction with the audited financialstatements as of and for the year ended December 31, 2007, and the notesthereto included in the Fund’s Annual Report on Form 10-K for the yearended December 31, 2007  (the “2007Annual Report”) filed with the Securities and Exchange Commission (the “SEC”).

 

Theaccounting policies used by the Fund are described in Note 2 of the 2007 AnnualReport.

 

 The results of operations for the three andnine months ended September 30, 2008, may not be indicative of the resultsof operations that may be expected for any other interim periods or for theyear ending December 31, 2008.

 

**Management Estimates**

** **

Thepreparation of financial statements in conformity with GAAP requires theManager to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assetsand liabilities at the date of the financial statements and the reported amountsof revenues and expenses during the reported period.  Actual results could differ significantlyfrom these estimates.

 

The Manager estimates, at least quarterly, the valueof the collateral underlying the loans, the value of real estate owned (“REO”),and the related disposal costs.  Theestimates are derived from information available in the real estate markets,including similar property, and often require the experience and judgment ofthird parties, such as commercial real estate brokers and appraisers.  The estimates figure materially in theManager’s determination of the adequacy of the allowance for loan losses.

 

6

----

Table of Contents

 

**Going Concern**

** **

***The Fund***

** **

TheFund’s financial statements have been prepared on a going concern basis, whichcontemplates the realization of assets and the discharge of liabilities in thenormal course of business for the foreseeable future.  Due to unprecedented dislocations in the realestate and capital markets since 2007, the Fund has incurred a significantreduction in loan payoffs from borrowers and an increase in delinquencies,non-performing loans and REO, resulting in a substantial reduction of cashflows.  Substantially all of the Fund’sloans -and loans senior to the Fund’s loans, except in those instances wherethe Fund is making the payment on the senior debt - are in default.  The Fund’s illiquid position may prevent theFund from protecting its position with respect to properties/collateralsecuring these defaulted loans.

 

At September 30, 2008, $48,000,000 of the Fund’sloan portfolio was pledged as security for a note with an original principalbalance of $25,000,000 payable to CMR Income Fund, LLC (“Income Fund”), arelated party.  At September 30,2008, the Fund was in technical default under this loan, resulting in atechnical default under Income Fund’s note payable to Wells Fargo Foothill, thelender on a loan to Income Fund, also in the original principal amount of$25,000,000.  The carrying amount of theFund’s note payable to Income Fund includes principal of $20,199,951 andaccrued unpaid interest of $151,269. While in default, the Fund continued to make monthly interest paymentsof approximately $155,000.  The Managersubsequently negotiated amendments to the promissory notes between Income Fundand Wells Fargo Foothill and between Income Fund and the Fund that were madeeffective as of July 1, 2008, under which Wells Fargo Foothill and IncomeFund, respectively, waived the existing defaults and extended the maturity dateuntil December 31, 2008.  While noagreement to waive any existing defaults and to extend the maturity is inplace, the Fund continues to make the monthly interest payments.  Wells Fargo Foothill indicated that it willnot enter into a new, fourth amendment to the promissory notes at this time,and has sent a Notice of Reservation of Rights and Remedies.  No further actions are pending at this time.

 

In March 2008, the Fund began making debt servicepayments on the senior debt related to the collateral that secures the Fund’s$3,043,447 participation in a $42,900,000 subordinated loan made by a fundmanaged by the Manager following the borrower’s default on the senior andsubordinate loans.  Due to liquidityissues in the various funds managed by the Manager, it has become necessaryfrom time to time for one participant to pay more than its pro rata share ofthe senior debt service.  Through September 30,2008, the Fund has made payments totaling $328,399 compared to its pro ratashare of$129,735 relating to this obligation. Under an agreement among the various participating funds, these advanceswill have a priority repayment position relative to loan principal and accruedinterest.  On October 16, 2008 thesenior lender informed the borrower and the Manager of its intent to conduct aUCC foreclosure sale of the membership interests in the borrower on November 20,2008.  Under the co-lender agreement withthe senior lender, if the senior lender completes this foreclosure and acquiresthe membership interest at the foreclosure sale, the junior portion of the loan(and thus our interest) likely will terminate. On November 19, 2008, the fund from which we acquired ourparticipation interest filed a voluntary petition for relief under Chapter 11of the Bankruptcy Code.  The automaticstay of this fund’s bankruptcy has stayed the scheduled UCC foreclosuresale.  In response, the senior lenderfiled a motion for relief from stay.  On February 6,2009, the bankruptcy court issued an order and memorandum, granting the firstlien holder a relief from stay, which permits the holder to proceed toforeclosure sale on the property.  The first lien holder is constrained bythe court’s order from disposing of the property until litigation pending inthis matter is resolved.  The first lien holder is now seeking to amendthe order to be allowed to foreclose on the membership interests.  Ahearing on the motion is set for March 20, 2009.  The Fund is pursuing the defense of its lienand other remedies, including litigation against the first lien holder,vigorously.   Due to the uncertainty associated with the outcome ofthe pending legal matters — particularly the security interest of the juniorlien holder, the Fund recorded a specific reserve in its Allowance for LoanLosses, as of June 30, 2008 — sufficient to offset its investment in thenote secured by the second deed of trust.

 

On April 9,2008, the Manager, on behalf of the Fund and three other funds it manages,foreclosed on 20 of 22 properties which comprised approximately $16,095,000, or85% of the $18,857,100 total collateral securing three junior loans owned bythe funds.  The total amount of juniordebt secured by these properties, including principal, advances, and accruedinterest was approximately $21,858,000, including approximately $11,113,000owed to the Fund.  The senior liens,which are held by outside third parties, total approximately $7,368,569 andbear interest at an effective average interest rate of approximately 8.0%.  In order to fully maintain its junior liensecurity interests, the funds are obligated to keep the senior liens currentuntil these properties are sold.  The prorata share of this debt service of the Fund is approximately $30,000 per month.

 

7

----

Table of Contents

 

TheFund does not have sufficient funds to satisfy its obligations or repay all theoutstanding principal balances of the senior debt as they become due, whichwould allow the senior debt holders to foreclose on the underlying collateraland effectively eliminate the Fund’s equity therein.  At this time the primary source of cashgenerated by the Fund is from the sale of REO. These events have raised substantial doubt about the Fund’s ability tocontinue as a going concern.  Thefinancial statements do not include any adjustments that might result from theoutcome of these uncertainties, except where in the normal course ofbusiness,  the senior lien holderinitiated the foreclosure sale.

 

TheManager initiated the following actions in response to these unprecedentedmarket conditions to conserve cash and build cash reserves:

 

a)     Commencingin January 2008, the Manager set monthly distributions at an amount equalto the amount of net income (as compared to the targeted return as was done inprior periods).

 

b)    Asof March 31, 2008, the Manager suspended indefinitely monthly cashdistributions of net income and members’ redemption requests.  As of September 30, 2008 and December 31,2008, outstanding member redemption requests totaled $20,785,090 and$21,113,579 respectively.

 

c)     OnApril 11, 2008, David Choo, the sole director of the Manager, executed aContribution Agreement with the Fund and certain other entities that theManager manages.  Pursuant to theContribution Agreement, Mr. Choo agreed to use his diligent good faith andbest efforts to sell, or cause to be sold, certain properties that he owns orcontrols and to apply certain of the proceeds for specified purposes, one ofwhich is to contribute or advance funds to the Manager until the obligations ofthe Manager described below have been satisfied.  Contributions from Mr. Choo under theContribution Agreement are to approximate $6,100,000.  From these amounts, the Manager has agreed touse up to $5,000,000 of the funds to be received from Mr. Choo to paynotes and other obligations of the Manager to the Fund and other funds managedby the Manager, and all of the Manager’s debts to third parties.  The Contribution Agreement also commits theManager to use at least $1,100,000 of the funds to be received from Mr. Chooas an operating reserve to be used solely for the Manager’s operating costs andoverhead.

 

d)   Since the Contribution Agreement was signed, the following events haveoccurred: (1) proceeds of approximately $1,102,000 were contributed orhave been committed to the Manager from the sale of two properties listed inthe Contribution Agreement, net of $375,000 that was used to support the realestate property activities which were part of the Contribution Agreement; (2) anadditional $431,000 was contributed to the Manager, including $60,000 ofproceeds from the sale of an additional property not listed in the ContributionAgreement (although this was not required by the Contribution Agreement theproceeds counts toward the future contributions); (3) Mr. Chooaffected a sale in the second quarter 2008 of certain other mortgage and realproperty assets that were not listed in the Contribution Agreement, resultingin net cash proceeds of approximately $2,023,000 (net of $499,000 that waswithdrawn), which net proceeds were contributed to the Manager as an advance onand in lieu of the approximately $2,235,000 of net proceeds that he laterreceived from the subsequent sales of two other properties that were listed inthe Contribution Agreement.  The netproceeds from the sales of these latter two properties were then used to paypre-existing debts of Mr. Choo and were not contributed to theManager.  The sales of various propertieslisted in the Contribution Agreement have thus far yielded net cash proceeds toMr. Choo and his affiliates of approximately $3,712,000, of which Mr. Choohas contributed substantially all, totaling approximately $3,555,000 as of December 31,2008 ($2,517,000 as of September 30, 2008) to the Manager since theContribution Agreement was signed.  Theremaining commitment under the terms of the Contribution Agreement is$2,545,000, which proceeds are to be received if and when the remainingproperties are sold.

 

e)     TheManager is continuing a program begun in the third quarter of 2006 to pursue anassertive collection process, including timely filing of a notice of default(generally, within two days after the second missed payment or sooner), timelyfiling of notice of foreclosure sale (generally, as soon as permitted by law orregulation), preparing in advance of the foreclosure sale to marketaggressively the collateral/real estate taken 

 

8

----

Table of Contents

 

back (including interviewing and retainingbrokers), and filing legal claims against the borrower/guarantors.  As an alternate collection strategy beginningin 2007, the Fund has, when appropriate, entered into formal forbearanceagreements with certain borrowers which require the borrower to performspecific actions within agreed upon timeframes. These actions may include making partial loan payments, providingadditional collateral, listing the property for sale, or entering property salecontracts with the objective of full payoff or reinstatement of the Fund’sloan.

 

f)     TheManager is, and has been, negotiating actively with third-party senior lienholders to forebear and/or reduce payments due from the borrower.  Further, on November 19, 2008, CMRMortgage Fund LLC (“Fund I”, a different fund managed by the Manager) filed avoluntary petition for relief under Chapter 11 of the United States BankruptcyCode.  This action was taken in responseto an October 16, 2008 notification from the senior lender which holds thesenior $55,000,000 interest in a $97,000,000 loan facility that it was going toconduct a UCC foreclosure sale on November 20, 2008 of the membershipinterests in the borrower on which Fund I held the junior participation of theloan.  Fund I believed its bankruptcyfiling would stay the UCC foreclosure sale. In response, the senior lender filed a motion for relief from stay.  Concurrent with the bankruptcy filing, Fund Ifiled an adversary proceeding against the senior lender and other interestedparties to the property securing the $97,000,000 loan, complaining for breachof contract, breach of fiduciary duty, negligence, waste, aiding and abetting,declaratory relief, reformation, equitable estoppels and equitablesubordination.  As of the date hereof,this matter has not been heard by the court On February 6, 2009, thebankruptcy court issued an order and memorandum, granting the first lien holdera relief from stay, which permits the holder to proceed to foreclosure sale onthe property.  The first lien holder is constrained by the court’s orderfrom disposing of the property until the litigation pending in this matter isresolved.  The first lien holder is now seeking to amend the order to beallowed to foreclose on the membership interests.  A hearing on the motionis set for March 20, 2009.  The Fundis pursuing the defense of its lien and other remedies, including thelitigation against the first lien holder, vigorously.

 

g)    TheManager sold properties collateralizing the notes owing by the Manager to theFund with a loss on sale (borne by the Manager) to raise cash for theFund.  These transactions closed on April 25,2008 and July 1, 2008 and generated cash totaling $4,363,068 for the Fund.

 

The above actions, taken together, bolstered the Fund’scash resources and improved the likelihood of continued operations by the Fund,including the ability to pay the debt service to some but not all senior lienholders.  However, the Fund is dependenton the repayment of loan principal and sale of REO to continue operationsthroughout 2009 and beyond.  The Managerhas had certain of the collateral securing the Fund’s loans (with the consentand cooperation of the borrower), and most of the Fund’s REO listed withnationally recognized and otherwise experienced brokers with strong presence inthe applicable local markets and experience with the collateral type.  These brokers are diligent and committed tocompleting a transaction, but caution against forecasting the timing andpricing of a transaction in a historically low-volume market with limited, ifany credit financing available.  Thedislocations and uncertainty in the real estate and capital markets havecreated a challenging environment which may continue through 2009 and into 2010and will necessitate further sales of assets at sub-optimum prices.

 

***The Fund’s Manager***

** **

Due to unprecedented dislocations in the real estateand capital markets since 2007, including an increase in the number of past dueloans and a decrease in the number of loan payoffs experienced by certain ofthe funds managed by the Manager, the Manager experienced significant decreasesin cash flows and has limited cash resources. While the funds that the Manager manages do continue to receive proceedsfrom the sale of real estate acquired through foreclosure, thereby allowing theManager to collect asset management fees, those cash flows are not sufficientto fund the Manager’s operating expenses as they become due.  The Manager generated additional cash fromthe collection of principal, advances, and interest on its loans, the sale ofits REO it acquired through foreclosure and from contributions under theContribution Agreement in 2008.  However,the Fund cannot be sure that additional sales of properties under theContribution Agreement will occur on a timely basis.  The Manager reduced staffing by more thanhalf (some of which was planned as new systems/technology were launched intooperations and accounting), lowered salaries, and is minimizing costs.  Further reductions in staffing are contemplatedby the sole director of the Manager. These will further constrain the Manager’s capabilities.  (CEO 

 

9

----

Table of Contents

 

and CFO James Gala wasnotified that his position(s) is to be eliminated, and his  employment is not expected to extend beyond March 31,2009.)  In March 2009 the Managerwas notified that the investors/members of First Street Commercial MortgageFund, LLC (“First Street”) had appointed a successor manager to replace theManager.  The Manager has not beennotified of its termination as servicer under the Loan Purchase and EquityInterest Agreement (the “Servicing Agreement”) under which First Streetacquired its interests in loans.  Underthe Servicing Agreement and applicable law, after an event of default, themajority in interest of co-owners of a loan may control the actions to be takenwith respect to such loans.  While REOsales and contribution actions would improve the likelihood of the Managercontinuing its operations, the limited cash resources compared to the operatingand debt service requirements of the Manager raise substantial doubt about theManager’s ability to continue as a going concern.  Should the Manager be unable to continue toserve as Manager to the Fund, the Fund may incur additional expenses to find areplacement manager and to support the operational needs, including regulatoryfilings, of the Fund.  While potentialreplacement managers exist within the marketplace, their capacity orwillingness to serve as the Fund’s manager is unknown.  A change in the manager may further impactnegatively the operating results of the Fund and the cash available fordistribution.  The Fund may need to continueaccepting sub-optimum prices to facilitate sales of REO in order to keep seniorlien positions current or forestall the foreclosure of properties serving ascollateral on the Fund’s junior liens.

 

**Note 2:  Summary of Significant Accounting Policies -Recent Accounting Pronouncements**

** **

*Fair ValueMeasurements*

* *

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *FairValue Measurements*(“SFAS 157”). SFAS 157 defines fairvalue, establishes a framework for measuring fair value and expands disclosuresabout fair value measurements. SFAS 157 applies whenever other standards require (or permit)assets or liabilities to be measured at fair value, but does not expand the useof fair value in any new circumstances. In this standard, the FASB clarifies the principle that fair valueshould be based on the assumptions market participants would use when pricingthe asset or liability.  In support ofthis principle, SFAS 157 establishes a fair value hierarchy thatprioritizes the information used to develop those assumptions.  The provisions of SFAS 157 are effectivefor financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  The Fund adopted SFAS 157 on January 1,2008.  The adoption did not have amaterial impact to the Fund’s financial position or results of operations orcash flows.

 

On October 10, 2008, the FASB issued FSP FAS157-3, *Determining the Fair Value of a Financial AssetWhen the Market for That Asset Is Not Active* (“FSP SFAS 157-3”).  The FSP clarifies the application of SFAS157, in a market that is not active and provides an example to illustrate keyconsiderations in determining the fair value of a financial asset when the marketfor that financial asset is not active. The FSP is effective immediately, and includes prior period financialstatements that have not yet been issued, and therefore the Fund is subject tothe provision of the FSP effective June 30, 2008.  The implementation of FSP SFAS 157-3 did notaffect the Funds fair value measurement.

 

*Fair Value Accounting*

* *

In February 2007,the FASB issued SFAS No. 159, *TheFair Value Option for Financial Assets and Financial Liabilities—Including anAmendment of FASB Statement 115* (“SFAS 159”).  SFAS 159 permits entities to choose tomeasure many financial instruments and certain other items at fair value atspecified election dates.  The entitywill report unrealized gains and losses on items for which the fair valueoption has been elected in earnings at each subsequent reporting date.  The fair value option (a) may be appliedinstrument by instrument, with a few exceptions, such as investments otherwiseaccounted for by the equity method, (b) is irrevocable (unless a new electiondate occurs), and (c) is applied only to entire instruments and not toportions of instruments.  The Fundadopted SFAS 159 on January 1, 2008 and the Manager did not elect thefair value option for any of the Fund’s financial instruments.

 

10

----

Table of Contents

 

*Accounting forBusiness Combinations*

* *

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS 141(R)”).  SFAS 141(R), among other things, establishesprinciples and requirements for how the acquirer in a business combination (i) recognizesand measures in its financial statements the identifiable assets acquired, theliabilities assumed, and any non-controlling interest in the acquired business,(ii) recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase, and (iii) determines whatinformation to disclose to enable users of the financial statements to evaluatethe nature and financial effects of the business combination.  The Fund is required to adopt SFAS 141(R) forall business combinations for which the acquisition date is on or after January 1,2009.  Earlier adoption isprohibited.  This standard will changethe accounting treatment for business combinations on a prospective basis.

 

*Hierarchy of GenerallyAccepted Accounting Principles*

* *

In May 2008, the FASB issued SFAS No. 162, *The Hierarchy of Generally Accepted Accounting Principles* (“SFAS162”)*. *This standard identifies the sources of accounting principlesand the framework for selecting the principles to be used in the preparation offinancial statements of nongovernmental entities that are presented inconformity with GAAP.  The provisions ofSFAS 162 did not have a material impact on the Fund’s financial statements.

 

**Note 3:  Related Party Transactions**

** **

TheManager is responsible for all management decisions related to the operationsand investments of the Fund.  Inaccordance with the Operating Agreement and other loan servicing agreementswith the Fund, the Manager is entitled to receive fees for the various servicesit provides and to be reimbursed for certain costs incurred on behalf of theFund.  The Manager may also, at its solediscretion, agree to forego the fees for services and expense reimbursementsotherwise due and payable from the Fund. When the Manager agrees to forego these items, the Manager may collectadditional fees and reimbursements, limited to the amount previously foregone,in subsequent years if and only if the rate of return of the Fund is in excessof 8.0% and limited each year to the amount in excess of that return.  The Manager elected to forego $155,704 inasset management fees in the quarter ended March 31, 2008, but did notelect to forgo any fees during the quarters ended June 30 and September 30,2008.  The Manager did not forego anyfees or reimbursements during the nine months ended September 30, 2007.

 

*Loan ServicingFees*

* *

TheManager is entitled to receive a monthly fee for loan servicing of up to 2% perannum (1/12th of 2% per month) of the outstanding principalbalance of each loan.  The fee is payablemonthly as the Fund receives interest payments from borrowers.  The Manager may at its sole discretion, agreeto forego loan servicing fees otherwise due and payable from the Fund.  Loan servicing fees for the quarters ended September 30,2008 and 2007 were $(105,293) and $789,246, respectively.  For the nine months ended September 30,2008 and 2007, loan servicing fees were $908,152 and $1,966,231, respectively.

 

*AssetManagement Fees*

* *

TheManager is entitled to receive a monthly fee for management services providedto the Fund equal to 1% per annum (1/12th of1% per month) of net assets under management, which is payable on the last dayof the month.  Net assets, as defined bythe Fund’s Operating Agreement, is equal to total members’ capital as of thefirst day of the month.  The Manager may,at its sole discretion, agree to forego asset management fees otherwise due andpayable from the Fund.  Asset managementfees for the quarters ended September 30, 2008 and 2007 were $177,593 and$238,144, respectively.  For the ninemonths ended September 30, 2008 and 2007, asset management fees were$487,374 and $731,719, respectively.  TheManager elected to forego $155,704 in asset management fees in the quarterended March 31, 2008, but did not elect to forgo any asset management feesduring the quarters ended June 30 and September 30, 2008.  The Manager did not forego any assetmanagement fees during the nine months ended September 30, 2007.

 

11

----

Table of Contents

 

*OperatingExpenses*

* *

TheManager may be reimbursed by the Fund for any operating expenses and othercosts it incurs on behalf of the Fund. The Manager may also, at its sole discretion, agree to forego operatingexpense reimbursement otherwise due and payable from the Fund or absorb theexpenses itself.  The Manager neitherabsorbed nor was reimbursed for operating expenses in the quarters ended September 30,2008 and September 30, 2007, or the nine months ended September 30,2007.  The Manager absorbed $45,621 inFund operating expenses in the nine months ended September 30, 2008.

 

*NoteReceivable From Manager Secured By Deeds of Trust*

* *

The Manager may take other actions in order to supportthe returns on the Fund.  On December 31,2007, the Manager took such action and purchased the principal, advance, andaccrued interest on three nonaccrual loans from the Fund for a total of$7,525,777.  The Manager made a cashpayment to the Fund of $1,279,590 and issued a note receivable from the Managerto the Fund in the amount of $6,246,187 and agreed to make monthly interestpayments to the Fund at the original interest rates on the loans.  The Manager also at December 31, 2007,made an additional $600,000 cash payment on an REO that was purchased by theManager from the Fund on December 30, 2006, which allowed the Fund torecognize a deferred gain of $1,263,195. During April 2008, the Manager sold one of the loans in which theFund held a $3,103,573 note receivable from the Manager.  The result of that sale left an unsecuredreceivable of $194,199 from the Manager at September 30, 2008, which waspaid in October 2008.  On July 1,2008, the Manager sold the other property for less than the amount of debtsecured by the property, resulting in the Fund holding an unsecured note.  The unsecured balance owed to the Fundtotaled $670,854 at September 30, 2008. Beginning on October 1, 2008, the Manager was in default on thecash payments to the Fund on the note receivable from the Manager, due to theilliquidity of the Manager.

 

*LendingArrangements*

* *

At September 30,2008, there was an outstanding balance of $2,124,278 on a loan to the Managerused to purchase real estate held for sale from the Fund and a remainingbalance of $3,336,813 on a loan to the Manager used to purchase certainimpaired loans from the Fund.  Inaddition, $9,324,632 of other payables and accrued interest related to seniorliens on REO held by the Fund were payable to other funds managed by theManager.

 

*BorrowingArrangements*

* *

In 2006, as discussed in Note 1, the Fund originated a$48,000,000 loan secured by deeds of trust (see Note 4 and 9).  As part of this transaction, the Fundinvested $23,000,000 of its own capital in the loan, and also entered into anagreement with Income Fund, a related party, to borrow $25,000,000 secured bythe Fund’s interest in the loan and all properties securing the loan.  At September 30, 2008, the related party loanpayable and accrued interest due was $20,351,220.  In conjunction with the loan, costs of$419,570 were deferred.  Amortization of $23,183and $208,003 of this amount was recorded in the three and nine months ended September 30,2007, with the remaining balance of the deferred costs fully amortized in2007.  The Fund was in technical defaulton this indebtedness as of September 30, 2008 resulting in a technicaldefault under Income Fund’s note to Wells Fargo Foothill, the lender.  While in default, the Fund continued to makemonthly interest payments of approximately $155,000.  The Manager subsequently negotiatedamendments to the promissory notes between Income Fund and Wells Fargo Foothilland between Income Fund and the Fund that were made effective as of July 1,2008, under which Wells Fargo Foothill and Income Fund, respectively, waivedthe existing defaults and extended the maturity date until December 31,2008.  While no agreement to waive anyexisting defaults and to extend the maturity is in place, the Fund continues tomake the monthly interest payments. Wells Fargo Foothill indicated that it will not enter into a new, fourthamendment to the promissory notes at this time, and has sent a Notice ofReservation of Rights and Remedies.  Nofurther actions are pending at this time.

 

As of the end of October 2008, the Fund hadacquired through foreclosure, interests in three properties related to twoloans with a total carrying value of approximately $38,685,000 as of September 30,2008.  One of those properties isencumbered by the deed of trust used to secure the Income Fund and Wells FargoFoothill note, which combined with accrued interest, had a balance of$20,351,220 at September 30, 2008.

 

12

----

Table of Contents

 

**Note 4:  Loans Secured by Deeds of Trust, Concentrationsand Characteristics**

** **

All ofthe Fund’s loans are fixed rate loans with interest rates that ranged from12.5% to 13.95% at September 30, 2008 and at December 31, 2007.

 

**Concentrations of CreditRisk**

** **

Whilethe Manager may consider the income level and general creditworthiness of aborrower to determine a borrower’s ability to repay the loan according to itsterms, such considerations are typically subordinate to a determination thatthe value of secured collateral will provide a sufficient source of funds forloan repayment.  When a loan iscollateralized by multiple property types, the loan is categorized as Mixed useproperties.  A significant portion of theFund’s loans are secured by two or more real estate parcels, which may besecured by differing positions for the deeds of trust.  When the collateral deed trust types aredifferent for a loan (*e.g*., securedby a combination of first, second and/or third trust deeds), the loan iscategorized as mixed.  The Fund’s loanportfolio as of September 30, 2008 and December 31, 2007 had thefollowing characteristics:

 

**Loan Portfolio in Dollars as of September 30,2008:**

 
| ** **                   | ** ** | **Trust Deeds** | ** ** |
|------------------------------|------------|----------------------|------------|
| ** **                   | ** ** | **First**            | ** ** | **Second** | ** ** | **Third** | ** ** | **Mixed** | ** ** | **Totals** | ** ** |
| Commercial real estate       |       | $                    | 670,145    |   | $ | 477,000 |   | $ | — |   | $ | 3,080,101 |   | $ | 4,227,246 |   |
| Residential real estate      |       | —               |       | 194,199 |   | — |   | — |   | 194,199 |   |
| Improved and unimproved land |       | 9,622,087            |       | 957,000 |   | 13,791,744 |   | 61,493,298 |   | 85,864,129 |   |
| Mixed use properties         |       | —               |       | 40,000 |   | — |   | — |   | 40,000 |   |
| Total(1)                     |       | $                    | 10,292,232 |   | $ | 1,668,199 |   | $ | 13,791,744 |   | $ | 64,573,399 |   | $ | 90,325,574 |   |

 

**Loan Portfolio in Dollarsas of December 31, 2007:**

 
| ** **                   | ** ** | **Trust Deeds** | ** ** |
|------------------------------|------------|----------------------|------------|
| ** **                   | ** ** | **First**            | ** ** | **Second** | ** ** | **Third** | ** ** | **Mixed** | ** ** | **Totals** | ** ** |
| Commercial real estate       |       | $                    | 2,351,824  |   | $ | 10,000 |   | $ | — |   | $ | 11,998,000 |   | $ | 14,359,824 |   |
| Residential real estate      |       | —               |       | 3,103,573 |   | — |   | — |   | 3,103,573 |   |
| Improved and unimproved land |       | 9,291,064            |       | 957,000 |   | 13,791,744 |   | 60,838,290 |   | 84,878,098 |   |
| Mixed use Properties         |       | —               |       | 40,000 |   | — |   | — |   | 40,000 |   |
| Total                        |       | $                    | 11,642,888 |   | $ | 4,110,573 |   | $ | 13,791,744 |   | $ | 72,836,290 |   | $ | 102,381,495 |   |

 

13

----

Table of Contents

 

**Number of Loans in thePortfolio as of September 30, 2008 and December 31, 2007:**

 
| ** **                   | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **Trust Deeds**             | ** ** | **Trust Deeds**            | ** ** |
| ** **                   | ** ** | **First**                        | ** ** | **Second**                      | ** ** | **Third** | ** ** | **Mixed** | ** ** | **Totals** | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Mixed** | ** ** | **Totals** | ** ** |
| Commercial real estate       |       | 1                                |       | 2                               |       | — |   | 3 |   | 6 |   | 1 |   | 1 |   | — |   | 3 |   | 5 |   |
| Residential real estate      |       | —                           |       | 1                               |       | — |   | — |   | 1 |   | — |   | 2 |   | — |   | 1 |   | 3 |   |
| Improved and unimproved land |       | 4                                |       | 1                               |       | 2 |   | 5 |   | 12 |   | 5 |   | 1 |   | 2 |   | 5 |   | 13 |   |
| Mixed use Properties         |       | —                           |       | 1                               |       | — |   | — |   | 1 |   | — |   | 1 |   | — |   | — |   | 1 |   |
| Total(2)                     |       | 5                                |       | 5                               |       | 2 |   | 8 |   | 20 |   | 6 |   | 5 |   | 2 |   | 9 |   | 22 |   |

 

**Schedule of Maturities asof September 30, 2008:**

 
| ** **             | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Mixed**  | ** ** | **Totals** |   |
|------------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|------------|--------|
| **September 30,** |       |      |       |       |       |      |       |       |       |       |   |
| 2008                   |       | $         | —     |       | $          | 957,000   |       | $          | 8,000,000  |       | $      | 3,080,101 |   | $ | 12,037,101 |   |
| 2009                   |       | 3,224,450 |       | 10,000     |       | 5,791,744 |       | 61,398,298 |       | 70,424,492 |   |
| 2010                   |       | 6,397,637 |       | 661,199    |       | —    |       | 95,000     |       | 7,153,836  |   |
| 2011                   |       | —    |       | 40,000     |       | —    |       | —     |       | 40,000     |   |
| 2012+                  |       | 670,145   |       | —     |       | —    |       | —     |       | 670,145    |   |
| Total(1)               |       | $         | 10,292,232 |       | $          | 1,668,199 |       | $          | 13,791,744 |       | $      | 64,573,399 |   | $ | 90,325,574 |   |

 

**Schedule of Maturities asof December 31, 2007:**

 
| ** **            | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Mixed**  | ** ** | **Totals** | ** ** |
|-----------------------|------------|-----------|------------|------------|------------|-----------|------------|------------|------------|------------|------------|
| **December 31,** |       |      |       |       |       |      |       |       |       |       |       |
| 2008                  |       | $         | —     |       | $          | 957,000   |       | $          | 8,000,000  |       | $          | 10,918,000 |   | $ | 19,875,000 |   |
| 2009                  |       | 3,224,450 |       | 10,000     |       | 5,791,744 |       | 60,838,290 |       | 69,864,484 |       |
| 2010                  |       | 6,062,614 |       | 3,103,573  |       | —    |       | 1,080,000  |       | 10,246,187 |       |
| 2011                  |       | 4,000     |       | 40,000     |       | —    |       | —     |       | 44,000     |       |
| Total(1),(3)          |       | $         | 9,291,064  |       | $          | 4,110,573 |       | $          | 13,791,744 |       | $          | 72,836,290 |   | $ | 100,029,671 |   |

 

14

----

**Tableof Contents**

 

**Number of Loans in thePortfolio by Maturity Date as of September 30, 2008 and December 31,2007:**

 
| ** ** | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **First**                        | ** ** | **Second**                      | ** ** | **Third** | ** ** | **Mixed** | ** ** | **Totals** | ** ** | **First** | ** ** | **Second** | ** ** | **Third** | ** ** | **Mixed** | ** ** | **Totals** | ** ** |
| 2008       |       | —                           |       | 1                               |       | 1 |   | 3 |   | 5 |   | — |   | 1 |   | 1 |   | 3 |   | 5 |   |
| 2009       |       | 2                                |       | 1                               |       | 1 |   | 4 |   | 8 |   | 2 |   | 1 |   | 1 |   | 5 |   | 9 |   |
| 2010       |       | 2                                |       | 2                               |       | — |   | 1 |   | 5 |   | 2 |   | 2 |   | — |   | 1 |   | 5 |   |
| 2011       |       | —                           |       | 1                               |       | — |   | — |   | 1 |   | 1 |   | — |   | — |   | 1 |   | 2 |   |
| 2012+      |       | 1                                |       | —                          |       | — |   | — |   | 1 |   | — |   | — |   | — |   | — |   | — |   |
| Total(2)   |       | 5                                |       | 5                               |       | 2 |   | 8 |   | 20 |   | 5 |   | 4 |   | 2 |   | 10 |   | 21 |   |

 

**Loan Portfolio Summarizedby Quartile as of September 30, 2008 and December 31, 2007:**

 
| ** **   | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------|------------|----------------------------------|------------|---------------------------------|------------|
| **Quartile** | ** ** | **Count**                        | ** ** | **Total**                       | ** ** | **Average** | ** ** | **Percent of  Total** | ** ** | **Count** | ** ** | **Total** | ** ** | **Average** | ** ** | **Percent  of  Total** | ** ** |
| 1            |       | 5                                |       | $                               | 339,199    |   | $ | 67,840 |   | 0 | % | 6 |   | $ | 1,172,000 |   | $ | 195,333 |   | 1 | % |
| 2            |       | 5                                |       | 2,335,145                       |       | 467,029 |   | 3 | % | 6 |   | 8,172,397 |   | 1,362,066 |   | 8 | % |
| 3            |       | 5                                |       | 11,303,392                      |       | 2,260,678 |   | 13 | % | 5 |   | 14,240,364 |   | 2,848,073 |   | 14 | % |
| 4            |       | 5                                |       | 76,347,838                      |       | 15,269,568 |   | 84 | % | 5 |   | 78,796,734 |   | 15,759,347 |   | 77 | % |
| Total(1)     |       | 20                               |       | $                               | 90,325,574 |   | $ | 4,516,279 |   | 100 | % | 22 |   | $ | 102,381,495 |   | $ | 4,653,704 |   | 100 | % |

 

----

(1)Includesnotes receivable from the Manager totaling $4,004,885 and $8,598,011 as of September 30,2008 and December 31,2007, respectively.

 

(2)Includesthree loans to the Manager as of September 30, 2008 and as of December 31,2007.  Excluded from the table is onefirst trust deed loan to the Manager for $2,351,824 that matures in 2032.

 

It isthe Fund’s experience that loans may not be repaid or refinanced in accordancewith contractual maturity date of the note; therefore the above tabulation ofscheduled maturities should not be used as a forecast of future cash receipts.

 

Loansvary by size and over time the mix in the portfolio changes.  The number of loans in the portfolio and theoutstanding balances of total loans at September 30, 2008 have decreased fromDecember 31, 2007.  The largestquartile of loans increased by seven percentage points from 77% as of December 31,2007 to 84% at September 30, 2008. Expressed as average dollar size of loans and due to the decrease inloans, the largest quartile decreased by $489,779 from $15,759,347 as of December 31,2007 to $15,269,568 as of September 30, 2008.

 

TheOperating Agreement specifies that no more than 25% of total Fund capital(equal to members’ equity) will be invested in any one loan, calculated as ofthe time the investment is made.  In2006, the Fund indirectly borrowed $25,000,000 from Wells Fargo Foothillthrough Income Fund (“Wells Fargo Foothill Loan”), in order to fund the$48,000,000 loan described in Notes 3 and 9. Although the entire $48,000,000 loan to the borrower was more than25% of the Fund’s total capital at the time the Fund made this loan, the Fund’sown investment in the loan was $23,000,000, which was 21.8% of the $105,569,652total capital at the time the investment was made in June 2006.  The Manager and its affiliates madeadditional loans to this borrower aggregating approximately $19,400,000.  The Manager believes the transaction is incompliance with the provisions of the Operating Agreement.

 

Becausethe terms of the original Wells Fargo Foothill Loan required monthly paymentsof interest and amortized principal, the original loan balance of the loandecreased.  As a consequence of theadditional loans and the reduced principal balance of the Wells Fargo FoothillLoan (which increased the carrying value of the Fund’s investment in the loanto $30,384,049), and the overall reduction in the level of capital to$47,541,723 at September 30, 2008, the amount of funds invested in loansto this borrower secured by the same property totaled 63.91% of total capitalat September 30, 2008.  Thepercentage of the Fund’s total capital that this investment represents maycontinue to grow if additional advances are made to this borrower or if theFund’s capital is further reduced.

 

15

----

**Tableof Contents**

 

**Note 5:  Allowance for Loan Losses**

** **

Changesin the allowance for loan losses were as follows:

 
| ** **                      | ** ** | **As of September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|
| ** **                      | ** ** | **2008**                               | ** ** | **2007** | ** ** |
|                            |       |                                   |       |   |   |
| Balance, beginning of period    |       | $                                      | 6,309,000  |   | $ | 684,845 |   |
| Provision charged to operations |       | 31,534,320                             |       | 2,086,393 |   |
| Losses charged to allowance     |       | (4,819,011                             | )          | — |   |
| Balance, end of period          |       | $                                      | 33,024,309 |   | $ | 2,771,238 |   |

 

**Loans ninety days or morepast due and still accruing interest:**

 
| ** **              | ** ** | **As of  September 30,  2008** | ** ** | **As of  September 30,  2007** | ** ** |
|-------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
|                    |       |                                     |       |                                     |       |
| Number of loans         |       | —                                   |       | 3                                        |       |
| Total principal balance |       | $                                        | —     |                                     | $          | 18,020,000 |   |
|                         |            |                                          |            |                                          |            |  |  |

 

**Impaired and nonaccrual loans:**

 
| ** **                                                                     | ** ** | **As of September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                     | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| Number of loans                                                                |       | 14                                     |       | 11 |   |
| Total principal balance plus advances and  accrued interest                    |       | $                                      | 88,416,901 |   | $ | 32,570,224 |   |
| Interest income recognized during the  quarter                                 |       | 109,267                                |       | 430,977 |   |
| Foregone interest income                                                       |       | 2,564,263                              |       | 574,542 |   |
| Total principal, advance and accrued  interest of loans with specific reserves |       | 73,232,416                             |       | 6,181,425 |   |
| Specific loan loss reserve                                                     |       | $                                      | 31,641,309 |   | $ | 2,257,000 |   |

 

At September 30,2008 and 2007, all impaired and non-accrual loans were in the process offoreclosure.  When a loan is placed onnonaccrual status, the accrual of interest is discontinued; however, previouslyrecorded accrued interest is not reversed. Payments received on impaired loans are applied to reduce principal tothe extent necessary to ensure collection of principal.  Subsequent payments on these loans, andpayments received on nonaccrual loans for which the ultimate collectability ofprincipal is not in doubt, are applied first to earned but unpaid interest andthen to principal.  Depending on theborrowers’ ability to bring a loan current through payment, refinancing by athird party or the Fund, and other legal courses of action available to theborrower and the Fund, the foreclosure of properties may be postponed or notcompleted.  At September 30, 2008 and2007, there were no outstanding commitments to lend additional funds toborrowers whose loans were identified as impaired.

 

Theweighted average balance of principal plus advances and accrued interest ofimpaired and nonaccrual loans during the quarters ended September 30,2008, and 2007 was $87,651,467 and $32,299,995, respectively.  For the nine months ended September 30,2008 and 2007, the weighted average balance of principal plus advances andaccrued interest of impaired and nonaccrual loans was $83,830,674 and$29,467,076, respectively.

 

**Note 6:  Real Estate Owned**

** **

During2007, the Fund foreclosed on two commercial properties that were loancollateral.  It is holding the firstproperty while actively marketing the property for sale.  The Fund recorded the REO at the netrealizable value of the property at the time of foreclosure of $24,340.  The Fund is also holding the other propertyand is funding ongoing entitlement, engineering and other site development workas it actively markets the property for sale. The 

 

16

----

Tableof Contents

 

Manager believes that the fair market value of thisother property less estimated costs to sell exceeds the carrying value of theREO at September 30, 2008.  The Fund’sportion of the carrying value of the property at the time of foreclosure was$8,553,935.

 

On April 9,2008, the Manager, on the Fund’s behalf, completed foreclosure sales and acquired20 of the 22 properties that secured $10,600,000 in loans held by theFund.  These loans were junior to seniordebt totaling $17,829,734.  Senior loansof $8,363,020 and $2,098,145 are held by other funds managed by theManager.  The remaining $7,368,569represents senior loans held by outside third parties.  In June 2008, one of the two remainingproperties was lost as a result of foreclosure by the holder of a senior lien,and the borrower on the other property filed bankruptcy.  The estimated net realizable value of thisremaining property is $536,792, net of $2,225,308 owed to third party seniorlien holders.

 

In June 2008,the Fund sold one of the properties that had been acquired on April 9,2008 and received $216,757 in net proceeds from the sale, in addition to a notein the amount of $467,000.

 

As of September 30,2008, the Fund held one loan with a carrying value totaling $50,081,199 andsecured by liens of various priorities on three properties.  The estimated value of the total collateralbase at September 30, 2008 was $82,050,000 securing total debt of$112,369,000.  Two of the threeproperties were subject to third party senior debt totaling approximating$39,101,000 at September 30, 2008, which includes the note payable toIncome Fund/Wells Fargo Foothill of $20,351,000.  On July 7, 2008, a limited liabilitycompany owned by the Fund and other funds managed by the Manager (specificallyorganized for the purpose of acquiring the property) acquired the firstproperty at a foreclosure sale conducted on behalf of the Fund.  Because the aforementioned limited liabilitycompany was unable to make debt service payments to the holder of the thirdparty senior loan and could not reach an agreement with the holder of that noteregarding restructuring of their note, the limited liability company was forcedto file for Chapter 11 bankruptcy protection on July 16, 2008 to preventthe loss of the collateral to a foreclosure sale being conducted by the seniorlender which was scheduled for July 17, 2008.  That bankruptcy case is pending as of thedate of this filing.  On September 16,2008, the Fund completed a foreclosure sale on the second property.  On October 14, 2008, Fund completed aforeclosure sale on the third property.

 

**Changes in the balance of real estate owned wereas follows:**

 
| ** **                               | ** ** | **As of September 30,** | ** ** |
|------------------------------------------|------------|----------------------------------------|------------|
| ** **                               | ** ** | **2008**                               | ** ** | **2007** | ** ** |
|                                     |       |                                   |       |   |   |
| Balance, beginning of period             |       | $                                      | 8,578,275  |   | $ | — |   |
| Real estate acquired through foreclosure |       | 17,138,102                             |       | 8,578,275 |   |
| Funded  improvements                     |       | 246,668                                |       | — |   |
| Impairment charges                       |       | (5,485,187                             | )          | — |   |
|                                     |       |                                   |       |   |   |
| Sales of real estate                     |       | (1,215,000                             | )          | — |   |
| Balance, end of period                   |       | $                                      | 19,262,858 |   | 8,578,275 |   |
|                                          |            |                                        |            |  |  |  |  |

 

**Note 7.  Commitments and Contingencies**

** **

**Financial Instrumentswith Off-Balance Sheet Risk**

** **

TheFund is a party to financial instruments with off-balance sheet risk in thenormal course of business in order to meet the financing needs of itsborrowers.  These financial instrumentsinclude commitments to extend credit. These instruments involve, to varying degrees, elements of credit andinterest rate risk in excess of the amount recognized on the balance sheet.

 

Commitmentsto extend credit are arrangements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and may require the payment of a fee payableto the Manager.  There were nooutstanding credit commitments as of September 30, 2008 or 2007.

 

17

----

Table of Contents

 

**Contingencies**

** **

TheFund is subject to legal proceedings and claims, particularly foreclosures onborrower collateral, that arise in the ordinary course of business.  In addition, on Thursday, March 12,2009, the Manager and David Choo were served with a lawsuit entitled JosephZadik v. David Choo, California Mortgage and Realty, Inc., CMR MortgageFund II, LLC et. al in the San Francisco County Superior Court.  The complaint was filed by an investor in theFund who  alleges twelve causes of actionincluding breach of contract, fraud and negligent misrepresentation and seeksdamages associated with Mr. Zadik’s investment in the Fund andcompensation for time, effort and costs associated with the action. The Managerintends to deny any liability and to defend this action vigorously.  The Fund may have an obligation to indemnify Mr. Chooand the Manager against any costs or liability arising from this lawsuit.

 

TheFund registered under Section 12(g) of the Securities Exchange Act of1934, as amended, effective as of January 8, 2008.  The SEC has notified the Manager that it isconducting an informal inquiry relating to the Manager and the Fund in order todetermine whether there have been violations of the federal securitieslaws.  In conjunction with this inquiry,certain information was requested from the Fund.  The Manager responded to the informationrequests related to the inquiry and will continue to cooperate with the SEC inresponding to its requests.  The Managerbelieves that there will not be a material impact on the Fund’s financialposition or operations as a result of the inquiry.

 

**Note 8.  Fair Value Disclosure**

** **

On January 1, 2008, the Fund adopted SFAS 157,which defines fair value, establishes a framework for measuring fair value,establishes a three-level valuation hierarchy for disclosure of fair valuemeasurement and enhances disclosure requirements for fair valuemeasurements.  The valuation hierarchy isbased upon the transparency of inputs to the valuation of an asset or liabilityas of the measurement date.  The threelevels are defined as follows:

 

Level 1:    Inputs to the valuationmethodology are quoted priced (unadjusted) for identical assets orliabilities in active markets.

 

Level 2:    Inputs to the valuationmethodology include quoted prices for similar assets and liabilities in activemarkets; or, for markets that are not active, inputs that are observable or canbe corroborated for the asset or liability, either directly or indirectly, forsubstantially the full term of the financial instrument.

 

Level 3:    Inputs that are significant tothe fair value measurement valuation methodology are unobservable and reflectthe Manager’s own assumptions about the assumptions that market participantswould use in pricing assets or liabilities.

 

The following is a description of the valuationmethodologies used by the Manager for instruments measured at fair value, aswell as the general classification of such instruments pursuant to thevaluation hierarchy:

 

***ASSETS***

** **

*Impaired loans*

* *

SFAS 157 requires loans to be measured forimpairment using methodologies as detailed by SFAS No. 114, *Accounting by Creditors for Impairment of a Loan*(“SFAS 114”), including impairedloans measured at an observable market price (if available), discounted cashflow, or at the fair value of the loan’s collateral (if the loan is collateraldependent).  Fair value of the loan’scollateral, when the loan is dependent on collateral, is determined by appraisalsor independent valuation which is then adjusted for the estimated costs to sellthe collateral.  All impaired loans as ofSeptember 30, 2008 were subject to SFAS 114 analysis.

 

18

----

Table of Contents

 

*Other RealEstate Owned*

* *

The fair value of real estate owned is based primarilyon the values obtained through appraisals of property with similarcharacteristics, less estimated costs to sell.

 

As of September 30, 2008, the Fund had no assetsor liabilities measured at fair value on a recurring basis.** **Impaired loans and otherREO are measured at fair value on a nonrecurring basis generally resulting fromthe provision of specific reserves in the allowance for loan losses forimpairment of individual loans and from the application of fair valueaccounting for REO.

 

The following table presents information about theFund’s assets and liabilities measured at fair value on a nonrecurring basis asof September 30, 2008.

 
| ** **                                                              | ** ** | **Fair Value at September 30, 2008** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **(Amounts in thousands)**                          | ** ** |
| ** **                                                              | ** ** | **Total**                                                     | ** ** | **Quoted Prices in  Active Markets  for Identical  Assets (Level 1)** | ** ** | **Significant Other  Observable Inputs  (Level 2)** | ** ** | **Significant Unobservable  Inputs (Level 3)** | ** ** |
| Principal balance plus advances and accrued  interest on impaired loans |       | $                                                             | 56,775,592 |   | — |   | $ | 48,303,021 |   | $ | 8,472,571 |   |
| Other real estate owned                                                 |       | $                                                             | 19,386,736 |   | — |   | — |   | $ | 19,386,736 |   |
|                                                                         |            |                                                               |            |  |  |  |  |  |  |  |  |  |

 

Level 2 impaired loans are commercial real estatesecured by collateral with fair values estimated by appraisals; REO marketvalue is estimated by both appraisals and internal analysis of fair marketvalue.

 

Level 3 impaired loans are commercial real estatesecured by collateral with fair values based upon appraisals and adjusted formore current information including but not limited to discounted cash flow ordiscounted valuations of collateral.

 

**Note 9.  Due From/To Related Parties**

** **

**Due from related partiesconsisted of the following as of:**

 
| ** **                                                                                                                                    | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Loans Receivable from Manager (Note 4)                                                                                                        |       | $                                | 4,004,885  |                            | $          | 8,598,011 |   |
| Due from Manager, net of reserve for  uncollectible amounts of $900,000 as of September 30, 2008, and none as  of December 31, 2007 |       | 128,359                          |       | 1,484,497                       |       |
| Due from other funds serviced by Manager                                                                                                      |       | 278,415                          |       | —                          |       |
| Due from escrowed interest reserve trust  account                                                                                             |       | —                           |       | 48,750                          |       |
|                                                                                                                                          |       | $                                | 4,411,659  |                            | $          | 10,131,258 |   |

 

Due to the uncertainty of both the timing and theamount of the net realized sales proceeds on those properties included in theContribution Agreement, the Fund provided a $900,000 allowance for loan loss atSeptember 30, 2008 on the unsecured Due from Manager balance of$1,020,026, resulting in a net Due from Manager of $128,359.  During April 2008, the Manager sold aloan in which the Fund held a $3,103,573 note receivable from the Manager.  The result of that sale left an unsecuredreceivable of $194,199 from the Manager at September 30, 2008, which waspaid in October 2008.

 

19

----

**Tableof Contents**

 

**Due to related partiesconsisted of the following as of:**

 
| ** **                             | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Servicing fees payable to Manager      |       | $                                | 629,251    |                            | $          | 121,557 |   |
| Due to other funds serviced by Manager |       | 124,127                          |       | 136,561                         |       |
|                                   |       | $                                | 753,378    |                            | $          | 258,118 |   |

 

**Other payables andaccrued interest - real estate owned:**

 
| ** **                                               | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Other payables and accrued interest - real  estate owned |       | $                                | 10,413,373 |                            | $          | — |   |
|                                                     |       | $                                | 10,413,373 |                            | $          | — |   |

 

**Note payable to relatedparty - real estate owned:**

 
| ** **                                         | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Note payable to related party - real estate  owned |       | $                                | 6,000,000  |                            | $          | 6,000,000 |   |
|                                               |       | $                                | 6,000,000  |                            | $          | 6,000,000 |   |

 

**Notes payable and accruedinterest to related party:**

 
| ** **                                               | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Note payable to CMR Income Fund LLC,  principal          |       | $                                | 20,199,951 |                            | $          | 21,181,768 |   |
| Accrued interest on note payable to CMR  Income Fund LLC |       | 151,269                          |       | 213,862                         |       |
|                                                     |       | $                                | 20,351,220 |                            | $          | 21,395,630 |   |

 

In June 2007,the Fund foreclosed on its lien junior to a $6,000,000 note serviced by theManager on behalf of Fund I, CMR Mortgage Fund III, LLC (“Fund III”), andothers for whom the Manager provides loan servicing.  As owner of the property, the Fund is makingpayments on the senior note to protect its equity in the property until suchtime as it sells the asset.  The Fundrecorded interest expense of $246,715 on this note during the quarter ended September 30,2008 and $621,715 during the nine months ended September 30, 2008.

 

On April 8,2008, the Fund held a $600,000 loan secured by 22 properties.  This loan was junior to a $10,000,000 loanfrom the Fund and other senior debt totaling $17,829,734.  Senior loans of $8,363,020 and $2,098,145 areheld by other funds managed by the Manager. Senior loans held by outside third parties amounted to $7,368,569.  On April 9, 2008, the Manager, on theFund’s behalf, completed foreclosure sales and acquired 20 of the 22properties.  In June, one of the tworemaining properties was lost as a result of foreclosure by the holder of asenior lien, and the borrower on the other property filed bankruptcy.  The estimated net realizable value of thisremaining property is $579,100, net of $2,183,000 owed to third party seniorlien holders.

 

**Note 10. Subsequent Events**

 

***Subsequentdelinquency experience***

 
| **Delinquent Status** | ** ** | **Outstanding Loan  Balance at  December 31,  2008** | ** ** | **Percent of Total  Balance at  December 31,  2008** | ** ** | **Outstanding Loan  Balance at  September 30, 2008** | ** ** | **Percent of Total  Balance at  September  30, 2008** | ** ** |
|----------------------------|------------|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| 30 — 59 Days          |       | $                                                                             | 5,896,744  |                                                                     | 14         | %                                                                        | $          | —                                                                    |       | 0 | % |
| 60 — 89 Days          |       | 3,810,686                                                                     |       | 9                                                                        | %          | —                                                                   |       | 0                                                                         | %          |
| 90+ Days                   |       | 28,932,495                                                                    |       | 69                                                                       | %          | 76,732,495                                                               |       | 85                                                                        | %          |
| Total                      |       | $                                                                             | 38,639,925 |                                                                     | 92         | %                                                                        | $          | 76,732,495                                                                |       | 85 | % |

 

20

----

Tableof Contents

 

Delinquencieswithin the loan portfolio decreased by $38,092,570 due to a $48,000,000 loanwhich became REO on October 14, 2008 and $9,707,430 in loans that became30 or more days delinquent subsequent to September 30, 2008.

 

**Impaired loans**

 

As of November 30,2008, the Fund held a $3,257,096 participation interest in a loan with aprincipal balance of $41,855,381 and bearing interest at a rate of 13% perannum for which the borrower was in default. The balance of the participation interests are held by other fundsmanaged by the Manager and a limited liability company owned by related andunrelated parties.  This loan is a juniorportion of a $97,900,000 total loan facility with a $55,000,000 senior positionheld by an entity unaffiliated with the Fund or the Manager.  The securityfor the loan is approximately 161 acres of residentially zoned property.  The borrower has defaulted on both the seniorand the Fund’s junior note.  The Managerhas been attempting to negotiate with the holder of the senior participation toassume the debt service payments under the senior participation on a modifiedpayment schedule and to acquire ownership of the collateral.  The participants in the loans do notcurrently have sufficient liquid assets to pay the full amount of past duepayments and to assure payment of future payments.  On March 11, 2008, the Manager made ashort-term loan of $1,375,000 to the funds it manages that participate in thisloan which enabled them to pay an extension fee of $1,375,000 to the seniorlender.  The various funds managed by theManager have paid down the short-term note by $727,471.  Under agreements among the various participatingfunds, these advances will have a priority repayment position relative to loanprincipal and interest earned thereon. The Fund’s pro rata share of payments made as of November 30, 2008was $123,447 and its share of the balance owed was $0.  The Manager also paid an extension fee of$90,000 to a third party lender participating in the junior note.  On October 16, 2008, the senior lenderinformed the borrower and the Manager of its intent to conduct a UCCforeclosure sale of the membership interests in the borrower on November 20,2008.  Under the co-lender agreement withthe senior lender, if the senior lender completes this foreclosure and acquiresthe membership interest at the foreclosure sale, the junior portion of the loan(and thus the Fund’s interest) will likely terminate.  On November 19, 2008, the fund fromwhich the Fund acquired its participation interest filed a voluntary petitionfor relief under Chapter 11 of the Bankruptcy Code.  The automatic stay of this fund’s bankruptcyhas stayed the scheduled UCC foreclosure sale. The senior lender has filed a motion for relief from stay and a decisionon this motion and if relief from stay is granted, the senior lender willpresumably complete its foreclosure sale and terminate the Fund’s interest.

 

**Realestate owned**

 

As discussedin Note 6, on October 14, 2008, the Fund completed a foreclosure sale onthe third of three properties securing a loan with September 30, 2008carrying value of $50,081,199.

 

21

----

## **Table of Contents**

 

## **Item 2.                    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

##  

**FORWARD-LOOKING STATEMENTS**

** **

*ThisQuarterly Report on Form 10-Q, including particularly**the Management’s Discussion and Analysis of Financial Condition andResults of Operations (“MD&A”) contains “forward-looking” statements withinthe meaning of the Private Securities Litigation Reform Act of 1995, which providesa “safe harbor” for statements about future events, products and futurefinancial performance that are based on the beliefs of, estimates made by andinformation currently available to the management of CMR Mortgage Fund II, LLC(“we,” “our” or the “Company”).  Theoutcome of the events described in these forward-looking statements is subjectto risks and uncertainties.  Actualresults and the outcome or timing of certain events may differ significantlyfrom those projected in these forward-looking statements due to the factorslisted under “Risk Factors,” in our Annual Report on Form 10-K for theyear ended December 31, 2007 (the “2007 Annual Report”) and from time totime in our other filings with the Securities and Exchange Commission (“SEC”).  For this purpose, statements concerningfuture liquidity, interest rates, availability of mortgage credit, and economicconditions and their effect on us and our assets, trends in real estate marketsin which we do business, future loan payoffs, foreclosures and value recoveredfrom property sales, estimates as to the allowance for loan losses and thevaluation of real estate held for sale, our growth and estimates of futuremember distributions or redemptions, and actions expected to be taken byCalifornia Mortgage and Realty, Inc., (the “Manager”)  and David Choo, the sole director of theManager, as well as our ability and that of the Manager to continue operationsin 2009; and any statements using the terms “believe,” “expect,” “expectation,”“anticipate,” “can,” “should,” “would,” “could,” “estimate,” “appear,” “basedon,” “may,” “intended,” “potential, “are emerging” and “possible” or similarstatements are forward-looking statements that involve risks and uncertaintiesthat could cause our actual results and the outcome and timing of certainevents to differ materially from those projected or management’s currentexpectations.  By making forward-lookingstatements, we have not assumed any obligation to, and you should not expect usto, update or revise those statements because of new information, future eventsor otherwise.*

 

Thefollowing discussion is designed to provide a better understanding ofsignificant trends related to our financial condition and results ofoperations.  The discussion should beread in conjunction with our financial statements and notes thereto appearingelsewhere in this Quarterly Report on Form 10-Q and in the 2007 AnnualReport, as well as the Management’s Discussion and Analysis of FinancialCondition and Results of Operations contained in the 2007 Annual Report.

 

***Overview***

** **

We are a California limited liability companyorganized for the purpose of making or investing in business loans secured bydeeds of trust or mortgages on real properties located primarily inCalifornia.  The loans are arranged andserviced for us by the Manager.  Wepreviously funded our lending activities through loan pay downs or pay offs, aswell as by selling our membership interests, and by selling all or a portion ofour interests in the loans to individual investors.  We commenced operations in February 2004.  We ceased accepting new members in the thirdquarter of 2006 and are unlikely to accept new members for the foreseeablefuture, if ever.

 

All ofour loans are fixed-rate mortgage loans. Interest that we earn on our loans has been and is expected to continueto represent our primary source of revenue so long as loan defaults by ourborrowers do not ultimately result in significant foreclosure of the underlyingproperty collateral.  In the case of realestate owned (“REO”), revenue, gains or losses would result from the operationof the property and/or its sale.

 

Our currentoperating results are primarily affected by:

 

·                  the level of loan losses experienced,including the gains and losses from the operation and/or disposition offoreclosed properties;

·                  general national and local economicconditions and trends that influence the real estate investment industry,investment activity and property prices which in turn impact the demand for thefinancing of real estate investments;

·                  the amount of funding availablethrough borrowing; and

·                  our operating costs, which consist ofamounts paid to the Manager (servicing and asset management fees) andprofessional services, primarily legal, accounting, audit and tax.

 

22

----

Table of Contents

 

Generallyspeaking, the underwriting by the Manager has focused primarily on the value ofthe collateral securing the loan, and secondarily on the generalcreditworthiness and reputation of the borrower.  The collateral is generally realproperty—predominantly land held by businesses or individuals, or commercialbuildings.  As a result of the nature ofour underwriting and lending, our business model generally results in higherdelinquency and foreclosures than experienced by conventional commercialmortgage lenders.  The Manager has alwaysbelieved in the cyclical nature of the real estate market and that downturns,such as that which began in the residential area after 2006 and in thecommercial real estate market after the third quarter of 2007 areinevitable.  Since the third quarter of2007, commercial real estate values have generally fallen.  In addition, there have been unprecedenteddislocations in the credit markets negatively affecting not only mortgagelending but also corporate financing and consumer lending, creating a generallack of liquidity for many financial institutions.

 

In thedifficult present economic environment, generally, and given the lack ofliquidity and the unprecedented turmoil in the capital markets and the gridlockin the real estate markets, specifically, there are presently significant risksof losses and higher charge-offs.  In addition,certain loans have been and will be written down in value to reflect what webelieve may be risks to full recovery of the loan amount.

 

Due tothe significance of loans collateralized by land held for residentialdevelopment, the continued deterioration of the housing markets and the turmoilof the capital markets, particularly those elements that provide funding tosubprime, Alt-A, and prime jumbo (non-conforming) lenders and borrowers, areexpected to challenge our results of operations and cash flows.  Housing prices are generally declining withmuch of the larger declines in California, Nevada, Florida and Arizona.  Taken together, the slow home absorptionrates and an increasing inventory of vacant developed lots are creatingfinancial difficulties and an uncertain future for the home builders and landdevelopers who are our borrowers.  Thereis no way to predict when conditions will improve.

 

TheManager reviews the collateral value for each project in making thedetermination on when to recognize interest income for financial reportingpurposes and to determine if adjustments to the allowance for loan lossesand/or adjustments to the carrying values of REO are required.  However, because the number of commercialreal estate sales and financings dropped dramatically during the past year, itis difficult to ascertain actual current market values of commercial realestate.  The lack of availability of realestate financing and the fact that sellers are unwilling to sell at what may besignificantly lower prices has led to gridlock in the real estate markets.

 

As described in the 2007 Annual Report filed on Form 10-K,there are indications that land values have dropped quickly and reached pricesat which buyers are prepared to buy and sellers are prepared to sell.  The sales prices have reflected deepdiscounts to previously stated values. In our portfolio of land loans and considering valuation from thisperspective, we have noted a substantial increase in loan-to-value ratios.  In some situations the amounts owed to usexceed the current collateral values. Furthermore, if we acquire title to the underlying land collateral as aresult of foreclosure, it is not our general intent to quickly sell into adepressed market and realize potential losses.  We believe that holding onto land in adepressed market may allow us to realize higher prices if and when the economyand real estate markets, including those for land, stabilize and transactionvolumes increase.  Our ability to do so,however, depends on maintaining a continued forbearance from Wells FargoFoothill, Inc. (“Wells Fargo Foothill”) and CMR Income Fund, LLC (“IncomeFund”) and our access to funds that are sufficient to keep senior loanscurrent, make other advances to protect our interests, and support our ongoingoperations.

 

***Liquidity and Capital Resources***

** **

Ourfinancial statements have been prepared assuming that we will continue as agoing concern.  However, our independentregistered public accounting firm has included in its audit report on ourfinancial statements for our fiscal years ended December 31, 2007, agoing-concern explanatory paragraph indicating that we have experienced asignificant decrease in cash flows. Substantially all of our loans and loans senior to our loans, except inthose instances where we are making payment on the senior debt, are indefault.  Our illiquid position mayprevent us from protecting our position with respect to the property securingthe defaulted loans.  In addition, we arein default on a loan collateralized by a significant portion of the loanportfolio.  These conditions causesubstantial doubt about 

 

23

----

Tableof Contents

 

our ability to continue as a going-concern.  By issuing an opinion stating that there issubstantial doubt about our ability to continue as a going concern, ourauditors have indicated that they are uncertain as to whether we have theability to continue our operations without additional funding.

 

Netcash used by financing activities totaled $1.9 million in the first nine monthsof 2008 compared to net cash used by financing activities of $14.7 million inthe first nine months of 2007.  The netchange of $12.8 million was primarily the result of decreases in distributionsto members of $11.9 million (since distributions and redemptions were suspendedon March 31, 2008) and repayments on a note held by a related party of$1.1 million between the first nine months of 2007 and the first nine months of2008.  The effects of these uses of cashwere partially offset by $0.3 million in capital contributions from new andexisting members during the first nine months of 2007.  Cash distributions to members totaled $0.9million including a $0.3 million reduction in accrued distributions, in thefirst nine months of 2008 compared to $12.4 million in the first ninemonths of 2007.

 

Investingactivities provided cash totaling $3.4 million in the first nine months of 2008compared to cash provided of $2.5 million in the first nine months of2007.  The net increase of $0.8 millionresulted from a $4.6 million decrease in loans from the Manager in the firstnine months of 2008 compared to the first nine months of 2007, a $4.5 netdecrease in advances from borrowers in the first nine months of 2008 comparedto the first nine month of 2007, and $0.2 million in proceeds from sale of REO,partially offset by a $8.3 million net increase in loans and $0.2 millioninvestment in REO improvements.

 

Operatingactivities used cash of $1.9 million in the first nine months of 2008, a $10.0million net decrease from the $8.2 million of cash provided in the first ninemonths of 2007.  The decrease between thefirst nine months of 2008 and the first nine months of 2007 was comprised of anet decrease in earnings of $42.1 million, an increase of $2.4 million inamounts due from related parties, an increase of $1.6 million in accruedinterest receivable, and an  increase of$0.3 million in amounts due to related parties, partially offset by a $29.4million increase in the loan loss provision, an increase of $5.5 million in animpairment loss on investment in REO, an increase of $1.2 million in animpairment loss on amounts due from related party, and a $0.2 million decreasein accounts payable.  Our cash and cashequivalents amounted to $1.0 million at September 30, 2008, compared to$1.5 million at December 31, 2007, a level insufficient to fund memberdistributions or to provide for loan payments necessary to prevent foreclosureby senior lien-holders, or otherwise provide for payment of taxes, insurance orother expenses on properties securing our loans.  To generate liquidity sufficient to providefor these latter amounts requires that we sell partial or whole  interests insome of our loans and REO.

 

Oursignificant obligations at September 30, 2008 consisted of our $20.4million promissory note to Income Fund bearing interest at 8.99% and a $6.0million senior note bearing interest at 12.5% to which an REO was subject whenwe foreclosed.  See Note 3 of theCondensed Financial Statements.

 

Ourcash balances are insufficient to satisfy our obligations or repay all theoutstanding principal balances of the senior debt as they come due.  We must depend on sales of foreclosedproperties and any support we receive as a result of the Contribution Agreementdescribed below to meet cash needs and to continue operations.  The Manager initiated the following actionsin response to these unprecedented market conditions to conserve cash and buildcash reserves:

 

·                  Commencing in January 2008, theManager set monthly distributions at an amount equal to the amount of netincome (as compared to the targeted return as was done in prior periods).

 

·                  On March 31, 2008, the Managersuspended indefinitely monthly cash distributions of net income and members’redemptions.  As of September 30,2008 and December 31, 2008, outstanding member redemption requests totaled$20.8 million and 21.1 million, respectively.

 

·                  On April 11,2008, David Choo, the sole director of the Manager, executed a ContributionAgreement with us and certain other entities that the Manager manages.  Pursuant to the Contribution Agreement, Mr. Chooagreed to use his diligent good faith and best efforts to sell, or cause to besold, certain properties that he owns or controls and to apply certain of theproceeds for specified purposes, one of which is to contribute or advance fundsto the Manager until the obligations of the Manager described 

 

24

----

Table of Contents

 

below have been satisfied.  Contributions from Mr. Choo under theContribution Agreement are to approximate $6.1 million.  From these amounts, the Manager has agreed touse up to $5.0 million of the funds to be received from Mr. Choo to paynotes and other obligations of the Manager to us and other funds managed by theManager, and all of the Manager’s debts to third parties.  The Contribution Agreement also commits theManager to use at least $1.1 million of the funds to be received from Mr. Chooas an operating reserve to be used solely for the Manager’s operating costs andoverhead.

 

·                  Since theContribution Agreement was signed, the following events have occurred: (1) proceedsof approximately $1.1 million were contributed or have been committed to theManager from the sale of two properties listed in the Contribution Agreement,net of $0.4 million that was used to support the real estate propertyactivities which were part of the Contribution Agreement; (2) anadditional $0.4 million was contributed to the Manager, including $60,000 ofproceeds from the sale of an additional property not listed in the ContributionAgreement (although this was not required by the Contribution Agreement theproceeds counts toward the future contributions); (3) Mr. Chooaffected a sale  in the second quarter2008 of certain other mortgage and real property assets that were not listed inthe Contribution Agreement resulting in net cash proceeds of approximately $2.0million (net of $0.5 million that was withdrawn), of which net proceeds werecontributed to the Manager as an advance on and in lieu of the approximately$2.2 million of net proceeds that he later received from the subsequent salesof two other properties that were listed in the Contribution Agreement.  The net proceeds from the sales of theselatter two properties were then used to pay pre-existing debts of Mr. Chooand were not contributed to the Manager. The sales of various properties listed in the Contribution Agreementhave thus far yielded net cash proceeds to Mr. Choo and his affiliates ofapproximately $3.7 million, of which Mr. Choo has contributedsubstantially all, totaling approximately $3.6 million as of December 31,2008 ($2.5 million as of September 30, 2008) to the Manager since theContribution Agreement was signed.  Theremaining commitment under the terms of the Contribution Agreement is $2.5million, which proceeds are to be received if and when the remaining propertiesare sold.

 

·                  The Manager iscontinuing a program begun in the third quarter of 2006 to pursue an assertivecollection process, including timely filing of a notice of default (generallywithin two days after the second missed payment — or sooner), timely filing ofnotice of foreclosure sale (generally as soon as permitted by law orregulation), preparing in advance of the foreclosure sale to marketaggressively the collateral/real estate taken back (including interviewing andretaining brokers) and filing legal claims against theborrower/guarantors.  As an alternatecollection strategy we have, when appropriate, entered into formal forbearanceagreements with specific borrowers which require the borrower to performspecific actions within agreed upon timeframes. These actions may include making partial loan payments, providingadditional collateral, listing the property for sale, or entering property salecontracts with the objective of full payoff or reinstatement of our loan.

 

·                  The Manager is and has been,negotiating actively with third-party, senior lien holders to forebear and/orreduce payments owing from the borrower.

 

·                  The Manager sold propertiescollateralizing the notes owing by the Manager to us at a loss on sale (borneby the Manager) to raise cash for us. These transactions closed on April 25, 2008 and July 1, 2008and generated cash totaling $4.4 million for us.

 

Theabove actions, taken together, bolstered our cash resources and improved thelikelihood of our continuing operations, including our ability to meet the debtservice on loans with liens senior to ours. However, we are dependent on the repayment of loan principal and sale ofREO to continue operations throughout 2009 and beyond.  The Manager has had certain of the collateralsecuring our loans (with the consent and cooperation of the borrower) and mostof our REO listed with nationally recognized and otherwise experienced brokerswith strong presence in the applicable local markets and experience with thecollateral type.  These brokers are diligentand committed to completing a transaction, but caution against forecasting thetiming and pricing of a transaction in a historically low-volume market withlimited, if any, credit financing available. The dislocations and uncertainty in the real estate and capital marketshave created a challenging environment which may continue through 2009 and into2010 and will necessitate further liquidations of assets at sub-optimum prices.

 

25

----

Tableof Contents

 

Furthermore due to unprecedented dislocations in thereal estate and capital markets since 2007, including an increase in the numberof past due loans and a decrease in the number of loan payoffs experienced bycertain of the funds managed by the Manager, the Manager experienced asignificant decrease in cash flows and has limited cash resources.  While the funds that the Manager manages docontinue to receive proceeds from the sale of real estate acquired throughforeclosure, thereby allowing the Manager to collect asset management fees,those cash flows are not sufficient to fund the Manager’s operating expenses asthey become due.  The Manager generatedadditional cash from the collection of principal, advances, and interest on itsloans, the sale of its REO it acquired through foreclosure and fromcontributions under the Contribution Agreement in 2008.  However, we cannot be sure that additionalsales of properties under the Contribution Agreement will be made on a timelybasis.  While REO sales and contributionactions and reduction of expenses would improve the likelihood of the Managercontinuing its operations, the limited cash resources compared to the operatingand debt service requirements of the Manager raise substantial doubt about theManager’s ability to continue as a going concern.  Should the Manager be unable to continue toserve as our Manager, we may incur additional expenses to find a replacementmanager and to support our operational needs, including regulatoryfilings.  While potential replacementmanagers exist within the marketplace, their capacity or willingness to serveas our manager is unknown.  A change inthe manager may impact negatively our operating results and the cash availablefor distribution.  We may need tocontinue accepting sub-optimum prices to facilitate sales of REO in order tokeep senior lien positions current or forestall the foreclosure of propertiesserving as collateral on our junior liens.

 

In addition,another fund managed by the Manager, CMR Mortgage Fund, LLC (“Fund I”) wasforced to file for bankruptcy protection in order to enhance the possibility ofdelaying or avoiding foreclosure by a senior lien holder on its major property.  See Note 1 of the Notes to CondensedFinancial Statements (Unaudited) — “Organization and General Fund Provisions —Going Concern — The Fund.”  The Managercontinues to evaluate this option for us in view of the ongoing difficulty in meetingour debt payment and other obligations and continuing to protect our interestsin our assets and it is increasingly likely that we will pursue this option.

 

26

----

**Tableof Contents**

 

***Results of Operations***

** **

Set forth below are summaries of our financial resultsfor the three and nine months ended September 30, 2008 and 2007.

 
| ** **                                         | ** ** | **Three  Months  Ended  September  30, 2008** | ** **  | **Percent of  Revenues,  net** | ** ** | **Three  Months  Ended  September  30,  2007** | ** ** | **Percent of  Revenues,  net** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------|-------------|-------------------------------------|------------|------------------------------------------------|------------|-------------------------------------|------------|
| Revenues:                                          |       |                                               |        |                                |       |                                           |       |                                |       |
| Interest income:                                   |       |                                               |        |                                |       |                                           |       |                                |       |
| Interest on loans                                  |       | $                                                  | 176,714     |                                | 29.6       | %                                              | $          | 3,983,006                           |       | 122.5 | % |
| Interest on notes receivable — related  party |       | 9,375                                              |        | 1.6                                 |       | —                                         |       | —                              |       |
| Interest on advances to borrowers                  |       | (4,801                                             | )           | (0.8                                | )          | 90,549                                         |       | 2.8                                 |       |
| Other interest income                              |       | 310,415                                            |        | 52.0                                |       | (33,652                                        | )          | (1.0                                | )          |
| Total interest income                              |       | 491,703                                            |        | 82.4                                |       | 4,039,903                                      |       | 124.3                               |       |
| Less: Loan servicing fees                          |       | (105,293                                           | )           | (17.6                               | )          | 789,246                                        |       | 24.3                                |       |
| Total interest income, net of servicing  fees      |       | 596,996                                            |        | 100.0                               |       | 3,250,657                                      |       | 100.0                               |       |
| Loss on sale of real estate owned                  |       | —                                             |        | —                              |       | —                                         |       | —                              |       |
| Total revenues, net of servicing fees              |       | 596,996                                            |        | 100.0                               |       | 3,250,657                                      |       | 100.0                               |       |
| Interest expense                                   |       | 498,728                                            |        | 83.5                                |       | 624,451                                        |       | 19.2                                |       |
| Interest expense — related party              |       | 246,715                                            |        | 41.3                                |       | 187,500                                        |       | 5.8                                 |       |
| Provision for loan losses                          |       | 10,704,841                                         |        | 1,793.1                             |       | 1,411,078                                      |       | 43.4                                |       |
| Net revenues                                       |       | (10,853,288                                        | )           | (1,817.9                            | )          | 1,027,628                                      |       | 31.6                                |       |
| Operating expenses:                                |       |                                               |        |                                |       |                                           |       |                                |       |
| Professional services                              |       | 248,293                                            |        | 41.6                                |       | 144,320                                        |       | 4.4                                 |       |
| Asset management fees                              |       | 177,593                                            |        | 29.7                                |       | 238,144                                        |       | 7.3                                 |       |
| Impairment loss on amounts due from related  party |       | 333,548                                            |        | 55.9                                |       | —                                         |       | —                              |       |
| Impairment loss on investment in REO               |       | 5,485,187                                          |        | 918.8                               |       | —                                         |       | —                              |       |
| Other Expenses - REO                               |       | 337,187                                            |        | 56.5                                |       | —                                         |       | —                              |       |
| Other operating expenses                           |       | 478,204                                            |        | 80.1                                |       | 11,323                                         |       | 0.3                                 |       |
| Total operating expenses                           |       | 7,060,012                                          |        | 1182.6                              |       | 393,787                                        |       | 12.1                                |       |
| Net (loss) income                                  |       | $                                                  | (17,913,300 | )                                   | (3,000.5   | )%                                             | $          | 633,841                             |       | 19.5 | % |

 

27

----

Tableof Contents

 
| ** **                                         | ** ** | **Nine Months  Ended  September  30,2008** | ** **  | **Percent of  Revenues,  net** | ** ** | **Nine Months  Ended  September  30, 2007** | ** ** | **Percent of  Revenues,  net** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|-------------|-------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------|------------|
| Revenues:                                          |       |                                            |        |                                |       |                                                  |       |                                |       |
| Interest income:                                   |       |                                            |        |                                |       |                                                  |       |                                |       |
| Interest on loans                                  |       | $                                               | 3,853,589   |                                | 91.2       | %                                                     | $          | 9,939,417                           |       | 114.0 | % |
| Interest on notes receivable — related  party |       | 409,502                                         |        | 9.7                                 |       | —                                                |       | —                              |       |
| Interest on advances to borrowers                  |       | 118,205                                         |        | 2.8                                 |       | 329,181                                               |       | 3.8                                 |       |
| Other interest income                              |       | 754,039                                         |        | 17.8                                |       | 417,203                                               |       | 4.8                                 |       |
| Total interest income                              |       | 5,135,335                                       |        | 121.5                               |       | 10,685,801                                            |       | 122.5                               |       |
| Less: Loan servicing fees                          |       | 908,152                                         |        | 21.5                                |       | 1,966,231                                             |       | 22.5                                |       |
| Total interest income, net of servicing  fees      |       | 4,227,183                                       |        | 100.0                               |       | 8,719,570                                             |       | 100.0                               |       |
| Loss on sale of real estate owned                  |       | (3,674                                          | )           | (0.1                                | )          | —                                                |       | —                              |       |
| Total revenues, net of servicing fees              |       | 4,223,509                                       |        | 99.9                                |       | 8,719,570                                             |       | 100.0                               |       |
| Interest expense                                   |       | 1,536,091                                       |        | 36.3                                |       | 2,146,851                                             |       | 24.6                                |       |
| Interest expense — related party              |       | 621,715                                         |        | 14.7                                |       | 187,500                                               |       | 2.2                                 |       |
| Provision for loan losses                          |       | 31,534,320                                      |        | 746.0                               |       | 2,086,393                                             |       | 23.9                                |       |
| Net revenues                                       |       | (29,468,617                                     | )           | (697.1                              | )          | 4,298,826                                             |       | 49.3                                |       |
| Operating expenses:                                |       |                                            |        |                                |       |                                                  |       |                                |       |
| Professional services                              |       | 1,716,237                                       |        | 40.6                                |       | 670,134                                               |       | 7.7                                 |       |
| Asset management fees                              |       | 487,374                                         |        | 11.5                                |       | 731,719                                               |       | 8.4                                 |       |
| Impairment loss on amounts due from related  party |       | 1,233,548                                       |        | 29.2                                |       | —                                                |       | —                              |       |
| Impairment loss on investment in REO               |       | 5,485,187                                       |        | 129.8                               |       | —                                                |       | —                              |       |
| Other Expenses - REO                               |       | 431,946                                         |        | 10.2                                |       | —                                                |       | —                              |       |
| Other operating expenses                           |       | 696,125                                         |        | 16.5                                |       | 19,551                                                |       | 0.2                                 |       |
| Total operating expenses                           |       | 10,050,417                                      |        | 237.8                               |       | 1,421,404                                             |       | 16.3                                |       |
| Net (loss) income                                  |       | $                                               | (39,519,034 | )                                   | (934.9     | )%                                                    | $          | 2,877,422                           |       | 33.0 | % |

 

*InterestIncome, Net of Servicing Fees*

* *

Totalinterest income amounted to 82.4% of total interest income, net of servicingfees in the quarter ended September 30, 2008 and 124.3% in the quarterended September 30, 2007.  Interestincome totaled approximately $0.5 million in the quarter ended September 30,2008, a $3.5 million (87.8%) decrease over the quarter ended September 30,2007.  Total interest income amounted to121.5% of total interest income, net of servicing fees in the nine months endedSeptember 30, 2008 and 122.5% in the nine months ended September 30,2007.  Interest income totaledapproximately $5.1 million in the nine months ended September 30, 2008, a$5.6 million (51.9%) decrease compared to the nine months ended September 30,2007.  The decrease in interest incomewas due to the overall decrease in the level of earning assets due to anincrease in both non-accrual loans and REO. Non-accrual loan principal plus advances and accrued interest averaged$87.7 million in the quarter ended September 30, 2008 compared to $32.3million for the quarter ended September 30, 2007, while REO averaged $27.1million for the quarter ended September 30, 2008 as compared to $8.6million for the quarter ended September 30, 2007.  Non-accrual loan principal plus advances andaccrued interest averaged $83.8 million for the nine months ended September 30,2008 compared to $29.5 million for the nine months ended September 30,2007, while REO averaged $19.1 million for the nine months ended September 30,2008 as compared to $3.8 million for the nine months ended September 30,2007.

 

Theyield on loans and advances for the quarter ended September 30, 2008 was0.75% on average loans and advances of $96.3 million (loans: $91.8 million plusadvances: $4.5 million) compared to 14.50% in the quarter ended September 30,2007 on average loans and advances of $112.4 million (loans: $109.6 millionplus advances: $2.7 million).  The yieldon loans and advances for the nine months ended September 30, 2008 was5.76% on 

 

28

----

Tableof Contents

 

average loans and advances of $101.4 million (loans:$96.7 million plus advances: $4.7 million) compared to 11.96% for the ninemonths ended September 30, 2007 on average loans and advances of $114.5million (loans: $112.3 million plus advances: $2.2 million).  The decline in yields of 1,276 basis pointsbetween quarters and 588 basis points between nine months periods is primarilyattributable to the increases in loans on non-accrual status and REO.

 

Loanservicing fees decreased to approximately $(0.1) million in the quarterended September 30, 2008 (a decrease of $0.9 million or 113.3%) from$0.8 million in the quarter ended September 30, 2007, primarily dueto a $0.3 million decrease in accrued loan servicing fees related to the Manager’sforegoing a portion of loan servicing fees. Loan servicing fees decreased to approximately $0.9 million in thefirst nine months of 2008 (a decrease of $1.1 million or 53.8%) from$2.0 million in the first nine months of 2007.  The decreases were primarily due to thenumber and amount of loans on non-accrual status in the quarter and nine monthsended September 30, 2008.  Loanservicing fees were 2% of the principal of each loan and were paid as interestincome was received.

 

*InterestExpense*

* *

Duringthe quarter ended September 30, 2008, interest expense (including relatedparty interest expense) was approximately $0.7 million, a decrease of $0.1million from the $0.8 million in interest expense for the quarter ended September 30,2007.  The decrease resulted from adecrease of $0.2 million on a $20.4 million note payable to Income Fund, due toa decline in the one month LIBOR interest rate. The effective rate of this borrowing was 8.97% during the quarter ended September 30,2008, as compared to 12.17% for the quarter ended September 30, 2007.  Partially offsetting the decrease was a $0.1million increase in interest expense on the $6.0 million note payable toFund I, Fund III and others for whom the Manager provides loanservicing secured by our REO.  Theeffective rate of this borrowing was 12.50% at September 30, 2008.  For the nine months ended September 30,2008, interest expense (including related party interest expense) wasapproximately $2.1 million, a decrease of $0.2 million from the $2.3 millionin interest expense for the nine months ended September 30, 2007.  The decrease resulted from $0.6 milliondecrease in interest expense on a $20.4 million note payable to Income Fund, dueto a decline in the one month LIBOR interest rate.  The effective rate of this borrowing was9.45% during the first nine months of 2008, as compared to 13.47% during thefirst nine months of 2007.  Partiallyoffsetting these decreases was a $0.4 million increase in interest as a resultof the $6.0 million note payable being assumed in connection with a REOforeclosure in June 2007.

 

*Provision forLoan Losses*

* *

Theprovision for loan losses increased by $9.3 million to $10.7 million in thequarter ended September 30, 2008 compared to $1.4 million for the quarterended September 30, 2007.  For thenine months ended September 30, 2008, the provision for loan lossesincreased by $29.4 million compared to the same period in 2007.  The increases were due to the decline in realestate property values which secure the loan portfolio.

 

*ImpairmentLosses*

* *

Impairmentlosses on amounts due from related party and investment in REO were $0.3million and $5.5 million, respectively, for the quarter ended September 30,2008.  For the nine months ended September 30,2008, impairment losses on amounts due from related party and investment in REOwere $1.2 million and $5.5 million, respectively.  There were no impairment losses for thequarter or nine months ended September 30, 2007.

 

*OperatingExpenses*

* *

Operatingexpenses increased $0.5 million in the quarter ended September 30, 2008compared to the quarter ended September 30, 2007.  The increase primarily resulted fromincreases of $0.5 million in expenses associated with senior lien payments toentities not affiliated with the Manager and $0.1 million in professionalservices, partially offset by $0.1 million decrease in asset management feesresulting from lower average Members’ Capital balances.  Operating expenses increased $1.6 million inthe nine months ended September 30, 2008 compared to the nine months endedSeptember 30, 2007.  The increaseconsisted of a $1.0 million increase in professional services and a $0.8million increase in expenses associated with senior lien payments to entitiesnot affiliated with the Manager, partially offset by a $0.2 million decrease inasset management fees resulting from the Manager’s forgoing of these fees forthe first two months of 2008.

 

29

----

Table of Contents

 

*NetLoss/Income*

* *

Thenet loss for the quarter ended September 30, 2008 was $17.9 million, adecrease of $18.5 million from the $0.6 million net income for the quarterended September 30, 2007.  Thedecrease in net income resulted from a $9.3 million increase in the loan lossprovision, a $5.5 million impairment write down on REO, a $3.5 million decreasein total interest income, a $0.5 million increase in other operating expensesassociated with senior lien payments to entities not affiliated with theManager, a $0.3 million impairment on the receivable balance due from theManager, and a $0.1 million increase in professional services expenses,partially offset by a decrease of $0.9 million in loan servicing fees betweenthe quarter ended September 30, 2007 and the quarter ended September 30,2008 and a $0.1 million decrease in interest expense (including related partyinterest expense).  For the first ninemonths of 2008, the net loss was $39.5 million, a decrease of $42.4 millionfrom the net income of $2.9 million for the first nine months of 2007.  The decrease in net income resulted from a$29.4 million increase in the loan loss provision, a $5.5 million impairmentwrite down on REO, a $5.6 million decrease in total interest income, a $1.2million impairment on the receivable balance due from the Manager, a $1.0million increase in professional services expenses, and a $0.8 million increasein other operating expenses, partially offset by a $1.1 reduction in loanservicing fees, a $0.2 million decrease in interest expenses (including relatedparty interest expense) and a $0.2 million reduction in asset management fees.

 

***Loan Portfolio and Asset Quality***

** **

As of September 30,2008 and December 31, 2007, our mortgage investments aggregated $90.3million and $102.4 million, respectively. The average loan and advance balance was $96.3 million as of September 30,2008 and $113.4 million as of December 31, 2007.

 

Approximately$76.7 million (85%) and $21.7 million (21.2%) of the loans we invested in weremore than 90 days delinquent in monthly payments as of September 30,2008 and December 31, 2007, respectively. Of these loans, the amounts attributable to borrowers who filedbankruptcy were approximately $20.4 million as of September 30, 2008 and$1.6 million as of December 31, 2007. (For financial reporting purposes the Total Outstanding Loan Balance ispresented net of the allowance for loan losses and the amounts in trusts forinterest reserves and future advances; for purposes of the discussion above itis presented on a gross basis.)

 

As of September 30,2008 and December 31, 2007, we held the following types of mortgages.

 
| ** **                            | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|---------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Trust Deeds:                          |       |                         |       |                        |       |
| First                                 |       | $                            | 10,292,232 |                        | $          | 11,642,888 |   |
| Second                                |       | 1,668,199                    |       | 4,110,573                   |       |
| Third                                 |       | 13,791,744                   |       | 13,791,744                  |       |
| Mixed                                 |       | 64,573,399                   |       | 72,836,290                  |       |
| Total                                 |       | $                            | 90,325,574 |                        | $          | 102,381,495 |   |
|                                  |       |                         |       |                        |       |
| Collateral Type:                      |       |                         |       |                        |       |
| Commercial Real Estate                |       | $                            | 4,227,246  |                        | $          | 14,359,824 |   |
| Residential Real Estate               |       | 194,199                      |       | 3,103,573                   |       |
| Land Held for Residential Development |       | 85,864,129                   |       | 84,878,098                  |       |
| Mixed-Use Properties                  |       | 40,000                       |       | 40,000                      |       |
| Total Outstanding Loan Balance        |       | $                            | 90,325,574 |                        | $          | 102,381,495 |   |

 

30

----

**Tableof Contents**

 

***Asset Quality***

** **

Aconsequence of originating or investing in loans is that losses may occur.  The actual amount of such losses, if any, mayvary from time to time.  Factors thataffect such potential risks include general economic conditions of the realestate market as well as specific conditions in a particular sub-market (*e.g.*, land development), availability offunds in the capital market, and the experience and expertise of theborrower.  While many of these factorsare beyond the control of the Manager, they can be monitored and used by theManager in assessing potential risks.

 

TheManager also estimates at least quarterly, the value of the collateralunderlying the loans, the cost to dispose of the property, and the costs tomaintain the property, including insurance and payments made to retaindevelopment rights and entitlements.  Asnecessary, provisions are made for loan losses to adjust the allowance for loanlosses to an amount considered by the Manager to be adequate, with dueconsideration for the value of the properties securing these loans (estimatedbased on information available in the real estate market including appraisalsand reviews of similar properties), to provide for probable losses on loans andreceivables, including impaired loans, other loans, accrued interest, late feesand advances on loans and other accounts receivable (unsecured).

 

Loanlosses deemed to be uncollectible are charged against the allowance for loanlosses.  Recoveries of previously writtenoff amounts are credited to the allowance for loan losses.  The Manager believes that the allowance forloan losses of $33.0 million at September 30, 2008 was adequate in amountto cover probable losses.

 

Changes in the allowance for loan losses for the threemonths ended September 30, 2008 and 2007 were as follows.

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Balance, beginning of period    |       | $                                                    | 24,646,611 |                                                | $          | 1,360,160 |   | $ | 6,309,000 |   | $ | 684,845 |   |
| Provision charged to operations |       | 10,704,841                                           |       | 1,411,078                                           |       | 31,534,320 |   | 2,086,393 |   |
| Losses charged to allowance     |       | (2,327,143                                           | )          | —                                              |       | (4,819,011 | ) | — |   |
| Balance, end of period          |       | $                                                    | 33,024,309 |                                                | $          | 2,771,238 |   | $ | 33,024,309 |   | $ | 2,771,238 |   |

 

**Mortgage LoanDelinquencies**

 
| **Delinquent  Status  (Days)** | ** ** | **Outstanding  Loan Balance  at September  30, 2008** | ** ** | **Percent of  Total Balance  at September  30, 2008** | ** ** | **Outstanding  Loan Balance  at December  31, 2007** | ** ** | **Percent of  Total  Balance at  December  31, 2007** | ** ** | **Outstanding  Loan Balance  at September  30, 2007** | ** ** | **Percent of  Total  Balance at  September  30, 2007** | ** ** |
|--------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| 30 — 59                   |       | $                                                                    | —     |                                                                      | 0          | %                                                                   | $          | —                                                               |       | 0                                                                    | %          | $                                                                     | —     |   | 0 | % |
| 60 — 89                   |       | —                                                               |       | 0                                                                         | %          | 10,254,290                                                          |       | 10                                                                   | %          | —                                                               |       | 0                                                                     | %          |
| 90+                            |       | 76,732,495                                                           |       | 85                                                                        | %          | 21,706,000                                                          |       | 21                                                                   | %          | 24,574,425                                                           |       | 22                                                                    | %          |
| Total                          |       | $                                                                    | 76,732,495 |                                                                      | 85         | %                                                                   | $          | 31,960,290                                                           |       | 31                                                                   | %          | $                                                                     | 24,574,425 |   | 22 | % |

 

The $47,772,205 increase in delinquencies from December 31,2007 is primarily due to one loan with a principal balance of $48,000,000, andanother of $3,257,096, which were current as of December 31, 2007 but areincluded in the 90+ days delinquent category as of September 30,2008.  One loan for $957,000 that wascurrent on December 31, 2007 was 90+ days delinquent as of September 30,2008, and another for $40,000 was 60+ days delinquent as of September 30,2008.

 

These are offset by two loans with a principal balanceof $9,574,290 as of December 31, 2007 which were in the 60-89 dayscategory but had been brought current by a junior note as of September 30,2008.  One loan for $200,000 that was 90+days delinquent on December 31, 2007 had been brought current as of September 30,2008, and another for $4,000 was paid off. In addition two loans to the same borrower became REO during the period,resulting in a reduction of 90+ days delinquent principal balance totaling$7,837,899.

 

31

----

Tableof Contents

 

**Loans ninety days or morepast due and still accruing interest:**

 
| ** **              | ** ** | **As of  September 30,** | ** ** |
|-------------------------|------------|----------------------------------------------|------------|
| ** **              | ** ** | **2008**                                     | ** ** | **2007** | ** ** |
| Number of loans         |       | —                                       |       | 3 |   |
| Total principal balance |       | $                                            | —     |   | $ | 18,020,000 |   |
|                         |            |                                              |            |  |  |  |  |

 

**Impaired and non-accrualloans:**

 
| ** **                                                                             | ** ** | **As of  September 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                             | ** ** | **2008**                                     | ** ** | **2007** | ** ** |
| Number of loans                                                                        |       | 14                                           |       | 11 |   |
| Total principal balance plus advances and  accrued interest                            |       | $                                            | 88,416,901 |   | $ | 28,348,747 |   |
| Interest income recognized during the  quarter                                         |       | 109,267                                      |       | 430,977 |   |
| Foregone interest income                                                               |       | 2,564,263                                    |       | 574,542 |   |
| Total principal, advance and accrued interest  balance of loans with specific reserves |       | 73,232,416                                   |       | 6,181,425 |   |
| Specific loan loss reserve                                                             |       | $                                            | 31,641,309 |   | $ | 2,257,000 |   |

 

At September 30,2008 and 2007, all of the impaired and non-accrual loans were in the process offoreclosure.  When a loan is placed onnon-accrual, the accrual of interest is discontinued, however previouslyrecorded accrued interest is not reversed. Payments received on impaired loans are applied to reduce principal tothe extent necessary to ensure collection of principal.  Subsequent payments on these loans, andpayments received on non-accrual loans for which the ultimate collectability ofprincipal is not in doubt, are applied first to earned but unpaid interest andthen to principal.  Depending on theborrowers’ ability to bring a loan current through payment, refinancing by athird party or us, and other legal courses of action available to the borrowerand us, the foreclosure of properties may be postponed or not completed.  At September 30, 2008 and 2007, therewere no outstanding commitments to lend additional funds to borrowers whoseloans were identified as impaired.

 

Theweighted average balance of principal plus advances and accrued interest ofimpaired and non-accrual loans during the quarters ended September 30,2008, and 2007 was $87,651,467 and $32,299,995, respectively.  For the nine months ended September 30,2008 and 2007, the weighted average balance of principal plus advances andaccrued interest of impaired and nonaccrual loans were $83,830,644 and $29,467,076,respectively.

 

***Subsequent delinquency experience***

* *

Since September 30, 2008, delinquencies in ourportfolio have increased as shown below.

 
| **Delinquent Status  (Days)** | ** ** | **Outstanding Loan  Balance at  December 31, 2008** | ** ** | **Percent of Total  Balance at  December 31, 2008** | ** ** | **Outstanding Loan  Balance at  September 30, 2008** | ** ** | **Percent of Total  Balance at  September 30,2008** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| 30 — 59                       |       | $                                                                       | 5,896,744  |                                                                         | 14         | %                                                                        | $          | —                                                                  |       | 0 | % |
| 60 — 89                       |       | 3,810,686                                                               |       | 9                                                                            | %          | —                                                                   |       | 0                                                                       | %          |
| 90+                                |       | 28,932,495                                                              |       | 69                                                                           | %          | 76,732,495                                                               |       | 85                                                                      | %          |
| Total                              |       | $                                                                       | 38,639,925 |                                                                         | 92         | %                                                                        | $          | 76,732,495                                                              |       | 85 | % |

 

Delinquencieswithin the loan portfolio decreased by $38,092,570, due to 48,000,000 loanwhich became REO on October 14, 2008 and a $200,000 loan which becomecurrent, partially offset by three loans totaling $5,896,744 which became 30-59days delinquent and two loan to the Manager totaling $3,810,686 which became60-89 days delinquent.

 

32

----

Tableof Contents

 

***Real Estate Owned (REO)***

** **

*2007Foreclosures:* During 2007, we foreclosed on two commercialproperties that were loan collateral.  Weare holding the first property while actively marketing the property forsale.  We recorded the REO at the netrealizable value of the property at the time of foreclosure of $24,340.  We are also holding the other property andare funding ongoing entitlement, engineering and other site development work aswe actively market the property for sale. The Manager believes that the fair market value of this other propertyless estimated costs to sell exceeds the carrying value of the REO at September 30,2008.  Our portion of the carrying valueof the property at the time of foreclosure was $8,553,935.

 

*NorthernCalifornia Mixed use Portfolio Loan:*On April 9, 2008,the Manager, on our behalf, completed foreclosure sales and acquired 20 of the22 properties that secured $10,600,000 in loans held by us.  These loans were junior to senior debttotaling $17,829,734.  Senior loans of$8,363,020 and $2,098,145 are held by other funds managed by the Manager.  The remaining $7,368,569 represents seniorloans held by outside third parties.  In June 2008,one of the two remaining properties was lost as a result of foreclosure by theholder of a senior lien, and the borrower on the other property filedbankruptcy.  The estimated net realizablevalue of this remaining property is $536,792, net of $2,225,308 owed to thirdparty senior lien holders.

 

In June 2008,we sold one of the properties that had been acquired on April 9, 2008 andreceived $216,757 in net proceeds from the sale, in addition to a notereceivable in the amount of $467,000.

 

***Subsequent events***

* *

*Honolulu Loan*: As of November 30,2008, we held a $3,257,096 participation interest in a loan with a principalbalance of $41,855,381 and bearing interest at a rate of 13% per annum forwhich the borrower was in default.  Thebalance of the participation interests are held by other funds managed by theManager and a limited liability company owned by related and unrelatedparties.  This loan is a junior portionof a $97,900,000 total loan facility with a $55,000,000 senior position held byan entity unaffiliated with us or the Manager. The security for the loan is approximately 161 acres of residentiallyzoned property.  The borrower hasdefaulted on both the senior and our junior note.  The Manager has been attempting to negotiatewith the holder of the senior participation to assume the debt service paymentsunder the senior participation on a modified payment schedule and to acquireownership of the collateral.  Theparticipants in the loans do not currently have sufficient liquid assets to paythe full amount of past due payments and to assure payment of future payments.  On March 11, 2008, the Manager made ashort-term loan of $1,375,000 to the funds it manages that participate in thisloan which enabled them to pay an extension fee of $1,375,000 to the seniorlender.  The various funds managed by theManager have paid down the short-term note by $727,471.  Under agreements among the variousparticipating funds, these advances will have a priority repayment positionrelative to loan principal and interest earned thereon.  Our pro rata share of payments made as of October 31,2008 was $123,447 and our share of the balance owed was $0.  The Manager also paid an extension fee of$90,000 to a third party lender participating in the junior note.  On October 16, 2008 the senior lenderinformed the borrower and the Manager of its intent to conduct a UCC foreclosuresale of the membership interests in the borrower on November 20,2008.  Under the co-lender agreement withthe senior lender, if the senior lender completes this foreclosure and acquiresthe membership interest at the foreclosure sale, the junior portion of the loan(and thus our interest) will likely terminate. On November 19, 2008, the fund from which we acquired ourparticipation interest filed a voluntary petition for relief under Chapter 11of the Bankruptcy Code.  The automaticstay of this fund’s bankruptcy has stayed the scheduled UCC foreclosuresale.  In response, the senior lenderfiled a motion for relief from stay. Concurrent with the bankruptcy filing, Fund I filed an adversaryproceeding against the senior lender and other interested parties to theproperty securing the $97,000,000 loan, complaining for breach of contract,breach of fiduciary duty, negligence, waste, aiding and abetting, declaratoryrelief, reformation, equitable estoppels and equitable subordination.  As of the date hereof, this matter has notbeen heard by the court On February 6, 2009, the bankruptcy court issuedan order and memorandum, granting the first lien holder a relief from stay,which permits the holder to proceed to foreclosure sale on the property. The first lien holder is constrained by the court’s order from disposing of theproperty until the litigation pending in this matter is resolved.  Thefirst lien holder is now seeking to amend the order to be allowed to forecloseon the membership interests.  A hearing on the motion is set for March 20,2009.  The Fund is pursuing the defenseof its lien and other remedies, including the litigation against the first lienholder, vigorously.

 

33

----

Tableof Contents

 

*California/ArizonaLand Portfolio Loan:* As of September 30, 2008, we held aloan with carrying values totaling $50,081,199 and secured by liens of variouspriorities on three properties.  Theestimated value of the total collateral base at September 30, 2008 was$82,050,000 securing total debt of $112,369,000.  Two of the three properties were subject tothird party senior debt totaling approximating $39,101,000 at September 30,2008, which includes the note payable to Income Fund/Wells Fargo Foothill of$20,351,000.  On July 7, 2008, alimited liability company owned by us and other funds managed by the Managerspecifically organized for the purpose of acquiring the property) acquired thefirst property at a foreclosure sale conducted on behalf of us.  Because the aforementioned limited liabilitycompany was unable to make debt service payments to the holder of the thirdparty senior loan and could not reach an agreement with the holder of that noteregarding restructuring of their note, the limited liability company was forcedto file for Chapter 11 bankruptcy protection on July 16, 2008 to preventthe loss of the collateral to a foreclosure sale being conducted by the seniorlender which was scheduled for July 17, 2008.  That bankruptcy case is pending as of thedate of this filing.  On September 16,2008 we completed a foreclosure sale on the second property.  On October 14, 2008, we acquired thethird property at a foreclosure sale.

 

Beginningon October 1, 2008, the Manager was in default on the loan payments to uson the unsecured note due to the illiquidity of the Manager.

 

*Complaint: *  On Thursday, March 12, 2009, the Managerand David Choo were served with a lawsuit entitled Joseph Zadik v. David Choo,California Mortgage and Realty, Inc., CMR Mortgage Fund II, LLC et. al inthe San Francisco County Superior Court. The complaint was filed by an investor who  alleges twelve causes of action includingbreach of contract, fraud and negligent misrepresentation and seeks damagesassociated with Mr. Zadik’s investment in us and compensation for time,effort and costs associated with the action. The Manager intends to deny anyliability and to defend this action vigorously. We may have an obligation to indemnify Mr. Choo and the Manageragainst any costs or liability arising from this lawsuit.

 

***Off-Balance Sheet Arrangements***

** **

We have no off-balance sheet arrangements, except forthe obligations described above.

 

***Critical Accounting Estimates***

** **

Preparationof our financial statements requires the Manager to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses.  These estimates andassumptions are based on historical experience, independent evaluations (suchas appraisals of specific properties), market data on real estate and realestate transactions available from public sources, industry and market researchand forecasts, discussions with real estate brokers, developers and investors andvarious other sources and factors we believe to be reasonable and reliableunder the circumstances.  The Managerperiodically reviews our accounting policies and these estimates andassumptions and make adjustments when facts and circumstances dictate.  Our accounting policies that are affected byestimates principally relate to the determination of (i) the allowance forloan losses (*i.e.*, the amount ofallowance established against loans receivable as an estimate of probable loanlosses), including the accrued interest and advances that are estimated to beunrecoverable based on estimates of amounts to be collected plus estimates ofthe value of the property as collateral, and (ii) the valuation of REOowned through foreclosure.  Thesepolicies and their key characteristics are discussed in detail in the 2007Annual Report.  Different estimates andassumptions in the application of these policies could result in materialchanges in our financial condition, results of operations, or cash flows andactual results may differ substantially.

 

***Recent Accounting Pronouncements***

** **

SeeNote 2 of the condensed unaudited Financial Statements for further discussion.

 

34

----

## **Table of Contents**

 

## **Item3.                Quantitative andQualitative Disclosures about Market Risk**

##  

Notapplicable.

 

## **Item4.                Controls and Procedures**

##  

*Evaluation of disclosure controlsand procedures.*  Basedon the evaluation of our disclosure controls and procedures (as defined in the Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) required by Exchange Act Rules 13a-15(b) or 15d-15(b), theprincipal executive officer and principal financial officer of the Manager haveconcluded that as of the end of the period covered by this Quarterly Report on Form 10-Q,our disclosure controls and procedures were not effective to ensure thatinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in SEC rules and forms, and includes controlsand procedures designed to ensure that information required to be disclosed byus in such reports is accumulated and communicated to our management, includingthe principal executive officer and principal financial officer of the Manager,as appropriate to allow timely decisions regarding required disclosure becauseof material weaknesses identified in our internal control over financialreporting and our failure to timely file our Annual Report on Form 10-Kfor the year ended December 31, 2007, the Quarterly Reports for thequarterly periods ended March 31, 2008 and June 30, 2008 and thisQuarterly Report on Form 10-Q.  Amaterial weakness is a deficiency or combination of deficiencies, in internalcontrol over financial reporting such that there is a more than reasonablepossibility that a material misstatement of our annual or interim financial statementswill not be prevented or detected on a timely basis.  In our case, the material weaknesses stemfrom:

 

·                  Managerpersonnel in the accounting function do not have the specific, requisitequalifications and training necessary to ensure the financial statements andall necessary disclosures are prepared and included in accordance withgenerally accepted accounting principles and other SEC reporting requirements.

 

·                  TheManager monitors property values supporting loan balances and REO by obtainingmarket information through a variety of sources, including appraisals, currentmarket data, and broker quotations.  Incertain instances where adjustments were made to property values based onmarket data or broker quotations, the Manager did not maintain sufficientcontemporaneous documentation related to the analysis, considerations andconclusions in support of the adjustments to the property values.

 

*Changes in internal control over financialreporting. *There wereno changes in our internal control over financial reporting that occurredduring the third quarter of 2008 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

# **PART II.             OTHER INFORMATION**

#  

## **Item 1.                 LegalProceedings**

##  

We area party to foreclosures on borrower collateral in the ordinary course of ourbusiness.

 

Inaddition, on March 12, 2009, the Manager and David Choo were served with alawsuit entitled Joseph Zadik v. David Choo, California Mortgage and Realty, Inc.,CMR Mortgage Fund II, LLC et. al in the San Francisco County SuperiorCourt.  The complaint was filed by aninvestor who  alleges twelve causes ofaction including breach of contract, fraud and negligent misrepresentation andseeks damages associated with Mr. Zadik’s investment in us andcompensation for time, effort and costs associated with the action. The Managerintends to deny any liability and to defend this action vigorously.  We may have an obligation to indemnify Mr. Chooand the Manager against any costs or liability arising from this lawsuit.

 

TheSEC has notified the Manager that it is conducting an informal inquiry relatingto the Manager and us in order to determine whether there have been violationsof the federal securities laws.  Inconjunction with this inquiry, certain information has been requested fromus.  The Manager has responded torequests for information related to the inquiry and is continuing to cooperatewith the SEC in response to its requests. The Manager believes that there will not be a material impact on ourfinancial position or operations as a result of this inquiry.

 

35

----

Tableof Contents

 

FundIII (a different fund managed by the Manager) had been offering and selling itsmembership interests during the first quarter of 2008 under a permit issued toit by the California Department of Corporations (the “DOC”) on January 4,2008 for the period expiring on January 3, 2009.  Because of the turmoil in the capitalmarkets, including the failure of a major investment bank in mid-March 2008,the concurrent dislocation in the real estate and credit markets as theeconomic crisis began spreading beyond sub-prime lending, the increasinguncertainty and difficultly in determining the fair value of Fund III’s loanportfolio and REO, the need to conserve cash and discontinue payingdistributions and suspend member redemptions, Fund III ceased accepting newsubscriptions as of April 10, 2008. By letter dated November 3, 2008, Fund III had sought tovoluntarily surrender the permit, but this action was declined by the DOC infavor of an anticipated summary revocation of the permit by the DOC.

 

Byorder dated December 9, 2008, the DOC summarily suspended Fund III’spermit , which has now expired according to its terms.  The order was accompanied by an accusationalleging that Fund III and the Manager violated terms of the permit by failingto timely provide its members with audited financial statements, a summaryreport for 2007 and monthly account statements since May 2008.  The accusation also alleges that Fund III andthe Manager violated the California Corporate Securities Law by omitting tostate certain allegedly material facts in Fund III’s Offering Circular dated January 4,2008, including the following: (1) that Fund III had already receivedredemption requests exceeding 10% of Fund III’s aggregate capital and thatthere was a substantial probability that investors in Fund III would not beable to withdraw their investments during 2008: and (2) that Fund I (adifferent fund managed by the Manager), had violated certain terms of its ownDOC offering permit which expired January 16, 2004, by (i) sellinginterests to an investor who did not meet the suitability standards imposed bythe DOC, and (ii) by investing in a loan that exceeded the geographicaland concentration limits applicable to Fund I, which limits are similar tothose applicable to Fund III.

 

Inaddition, on March 4, 2009, the DOC served us with a subpoena requestingnumerous documents and records relating to our history of satisfying ourmembers’ redemption requests. The same subpoena was served on Fund III and theManager. The subpoena was issued in connection with an examination andinvestigation of Fund III, the Manager and us, but no specific claims or allegationshave been made by the DOC in connection with this subpoena beyond those raisedin the accusation described above.

 

As ofthe date hereof, the DOC has not sought any relief or sanction against us, FundIII or the Manager by reason of the matters described in the accusation orsubpoena other than the suspension and revocation of Fund III’s offeringpermit.

 

## **Item1A.             Risk Factors**

##  

Not applicable.

 

## **Item 2.                UnregisteredSales of Equity Securities and Use of Proceeds**

##  

Not applicable.

 

## **Item3.                Defaults Upon SeniorSecurities**

##  

As described elsewhere in this Form 10-Q, we have onepromissory note outstanding in favor of Income Fund, an affiliate of theManager, which Income Fund in turn assigned to Wells Fargo Foothill. AtSeptember 30, 2008, the outstanding balance was $20,199,951 and accruedinterest amounted to $151,269.  Ourpromissory note to Income Fund, as well as the Wells Fargo Foothill promissorynote to Income Fund, matured on June 30, 2007.  The Wells Fargo Foothill loan wasrenegotiated as of June 30, 2007 to provide for interest only payments anda maturity of August 31, 2007.  Ourpromissory note to Income Fund was concurrently amended to extend the maturitydate until June 30, 2008.  WellsFargo Foothill and Income Fund entered into an agreement (and an amendmentthereto) in which Wells Fargo Foothill agreed not to exercise remedies until November 30,2007.  The agreement also increased theinterest rate on the loan to LIBOR plus 6.5% (9.64% at September 30,2008), increasing our payments to Income Fund correspondingly.  While in default, the Fund continued to makemonthly interest payments of approximately $155,000.  The Manager subsequently negotiatedamendments to the promissory notes between Income Fund and Wells Fargo Foothilland between Income Fund and the Fund that were made effective as of July 1,2008, under which Wells Fargo Foothill and Income Fund, respectively, waivedthe existing defaults and extended the maturity date until December 31,2008.

 

No agreement to waive defaults after January 1, 2009or to extend the maturity is in place as of this filing. The Fund, however,continues to make the monthly interest payments.  Wells Fargo Foothill has indicated that itwill not enter into a new, fourth amendment to the promissory notes at thistime and has sent a Notice of Reservation of Rights.  No further actions are pending at this time.

 

36

----

Tableof Contents

 

We arecurrent on the interest payments to Income Fund and Income Fund is, in turn,current on its interest payments to Wells Fargo Foothill.

 

## **Item4.                Submission of Matters toa Vote of Security Holders**

##  

None

 

## **Item5.                Other Information**

##  

None

 

## **Item6.                Exhibits**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                   |
|-------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|
| 31.1                    |       | Chief Executive Officer Certification Pursuant to  Rule 13a-14(a) of the Securities Exchange Act.                       |
| 31.2                    |       | Chief Financial Officer Certification Pursuant to  Rule 13a-14(a) of the Securities Exchange Act.                       |
| 32.1                    |       | Certification pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

37

----

**Table of Contents**

 

**SIGNATURES**

** **

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                | CMR Mortgage Fund II, LLC |
|---------------------|---------------------------|
|                |                      |
|                | By:                       | California Mortgage and  Realty, Inc., its Manager |
|                |                      |
|                |                      |
| March 24, 2009 | By:                       | /s/ David Choo |
|                |                      | Name: David Choo |
|                |                      | Title: President |
|                |                      |   |
| March 24, 2009 | By:                       | /s/ James Gala |
|                |                      | Name: James Gala |
|                |                      | Title: Chief Executive Officer and Chief Financial Officer  (Principal Executive Officer, Principal Financial  Officer and Principal Accounting Officer) |

 

38

----

**Table of Contents**

 

**EXHIBIT INDEX**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                   |
|-------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|
| 31.1                    |       | Chief Executive Officer Certification Pursuant to  Rule 13a-14(a) of the Securities Exchange Act.                       |
| 31.2                    |       | Chief Financial Officer Certification Pursuant to  Rule 13a-14(a) of the Securities Exchange Act.                       |
| 32.1                    |       | Certification pursuant to 18 U.S.C. Section 1350 as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

39

----