##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q







|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended: September 30, 2008

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number: 001-32026





ALESCO FINANCIAL INC.

(Exact name of registrant as specified in its governing
instruments)







|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 16-1685692                          
|(State or other jurisdiction of Incorporation or organization) |  | (IRS Employer Identification Number)

Cira Centre

2929 Arch Street, 17thFloor

Philadelphia, Pennsylvania 19104

(Address of principal executive offices, Zip Code)

(215) 701-9555

(Registrants telephone number, including area code)





Indicate by check mark whether the Registrant (1) has filed all reports and reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    Yes  x    No   ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer,
accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.



|                        |  |   |  |                           |  |  
|----------------------- |  | - |  | ------------------------- |  | -
|Large accelerated filer |  |  ̈ |  | Accelerated filer         |  | x
|                        |  |   | 
|Non-accelerated filer   |  |  ̈ |  | Smaller reporting company |  |  ̈

Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the
Exchange Act).    Yes   ̈    No  x

As of November 4, 2008 there were 59,174,846 shares of common stock ($0.001 par value per share) of Alesco Financial Inc. outstanding.









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##### Table of Contents

ALESCO FINANCIAL INC.

TABLE OF CONTENTS



|                              |  |                                                                                       |  |   
|----------------------------- |  | ------------------------------------------------------------------------------------- |  | --
|Part I. Financial Information |  | 1                                                                                    
|                              |  |                                                                                      
|Item 1.                       |  | Financial Statements (Unaudited)                                                      |  | 1 
|                              |  |                                                                                      
|Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 23
|                              |  |                                                                                      
|Item 3.                       |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 47
|                              |  |                                                                                      
|Item 4.                       |  | Controls and Procedures                                                               |  | 48
|                              | 
|Part II. Other Information    |  | 48                                                                                   
|                              |  |                                                                                      
|Item 1.                       |  | Legal Proceedings                                                                     |  | 48
|                              |  |                                                                                      
|Item 1A.                      |  | Risk Factors                                                                          |  | 49
|                              |  |                                                                                      
|Item 2.                       |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 49
|                              |  |                                                                                      
|Item 3.                       |  | Defaults Upon Senior Securities                                                       |  | 49
|                              |  |                                                                                      
|Item 4.                       |  | Submission of Matters to a Vote of Security Holders                                   |  | 49
|                              |  |                                                                                      
|Item 5.                       |  | Other Information                                                                     |  | 49
|                              |  |                                                                                      
|Item 6.                       |  | Exhibits                                                                              |  | 49



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##### Table of Contents

PART I. FINANCIAL INFORMATION



|ITEM 1. | FINANCIAL STATEMENTS (UNAUDITED).
|------- | ---------------------------------

Alesco
Financial Inc.

Consolidated Balance Sheets

(Unaudited and in thousands, except share and per share information)



|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | --------- | - | ---------------------- | - | ---------- | -
|                                                                                                                                                                                                            |  | As ofSeptember 30, 2008 |           |   | As ofDecember 31, 2007 |  
|Assets                                                                                                                                                                                                      |  |                         |           |   |                        |   |            |  
|Investments in debt securities and security-related receivables (including amounts at fair value of $2,971,208 and $5,888,650, respectively)                                                                |  | $                       | 2,971,208 |   |                        | $ | 6,628,991  |  
|Investments in loans                                                                                                                                                                                        |  |                         |           |   |                        |   |            |  
|Residential mortgages                                                                                                                                                                                       |  |                         | 933,019   |   |                        |   | 1,047,195  |  
|Commercial mortgages                                                                                                                                                                                        |  |                         | 7,464     |   |                        |   | 7,332      |  
|Leveraged loans                                                                                                                                                                                             |  |                         | 877,091   |   |                        |   | 836,953    |  
|Loan loss reserve                                                                                                                                                                                           |  |                         | (46,376   | ) |                        |   | (18,080    | )
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Total investments in loans, net                                                                                                                                                                             |  |                         | 1,771,198 |   |                        |   | 1,873,400  |  
|Cash and cash equivalents                                                                                                                                                                                   |  |                         | 96,219    |   |                        |   | 80,176     |  
|Restricted cash and warehouse deposits                                                                                                                                                                      |  |                         | 68,490    |   |                        |   | 95,476     |  
|Accrued interest receivable                                                                                                                                                                                 |  |                         | 34,073    |   |                        |   | 49,806     |  
|Other assets                                                                                                                                                                                                |  |                         | 46,165    |   |                        |   | 207,527    |  
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Total assets                                                                                                                                                                                                |  | $                       | 4,987,353 |   |                        | $ | 8,935,376  |  
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Liabilities and stockholders equity (deficit)                                                                                                                                                              |  |                         |           |   |                        |   |            |  
|Indebtedness                                                                                                                                                                                                |  |                         |           |   |                        |   |            |  
|Trust preferred obligations (including amounts at fair value of $152,660 and $0, respectively)                                                                                                              |  | $                       | 152,660   |   |                        | $ | 382,600    |  
|Securitized mortgage debt                                                                                                                                                                                   |  |                         | 866,004   |   |                        |   | 959,558    |  
|CDO notes payable (including amounts at fair value of $2,491,125 and $0, respectively)                                                                                                                      |  |                         | 3,186,455 |   |                        |   | 9,409,027  |  
|Warehouse credit facilities                                                                                                                                                                                 |  |                         | 133,206   |   |                        |   | 155,984    |  
|Recourse indebtedness                                                                                                                                                                                       |  |                         | 110,793   |   |                        |   | 189,614    |  
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Total indebtedness                                                                                                                                                                                          |  |                         | 4,449,118 |   |                        |   | 11,096,783 |  
|Accrued interest payable                                                                                                                                                                                    |  |                         | 31,473    |   |                        |   | 54,380     |  
|Related party payable                                                                                                                                                                                       |  |                         | 6,428     |   |                        |   | 2,800      |  
|Other liabilities                                                                                                                                                                                           |  |                         | 127,897   |   |                        |   | 161,408    |  
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Total liabilities                                                                                                                                                                                           |  |                         | 4,614,916 |   |                        |   | 11,315,371 |  
|Minority interests                                                                                                                                                                                          |  |                         | 104,604   |   |                        |   | 19,543     |  
|Stockholders equity (deficit)                                                                                                                                                                              |  |                         |           |   |                        |   |            |  
|Preferred stock, $0.001 par value per share, 50,000,000 shares authorized, no shares issued and outstanding                                                                                                 |  |                         |          |   |                        |   |           |  
|Common stock, $0.001 par value per share, 100,000,000 shares authorized, 60,323,877 and 60,548,032 issued and outstanding, including 1,191,389
and 1,228,234 unvested restricted share awards, respectively |  |                         | 59        |   |                        |   | 59         |  
|Additional paid-in-capital                                                                                                                                                                                  |  |                         | 482,351   |   |                        |   | 481,850    |  
|Accumulated other comprehensive loss                                                                                                                                                                        |  |                         | (23,160   | ) |                        |   | (1,545,464 | )
|Accumulated deficit                                                                                                                                                                                         |  |                         | (191,417  | ) |                        |   | (1,335,983 | )
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Total stockholders equity (deficit)                                                                                                                                                                        |  |                         | 267,833   |   |                        |   | (2,399,538 | )
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  
|Total liabilities and stockholders equity (deficit)                                                                                                                                                        |  | $                       | 4,987,353 |   |                        | $ | 8,935,376  |  
|                                                                                                                                                                                                            |  |                         |           |   |                        |   |            |  

See accompanying notes.



1



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##### Table of Contents

Alesco Financial Inc.

Consolidated Statements of Income (Loss)

(Unaudited and in thousands, except share and per share
information)



|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|---------------------------------------------------------------------------------------- |  | ------------------------------------------------ | ---------- | - | ------------------------------------------------ | - | ---------- | ----------------------------------------------- |  | - | ----------------------------------------------- | - |  | - | ---------- | -
|                                                                                         |  | For theThree-MonthPeriod EndedSeptember 30, 2008 |            |   | For theThree-MonthPeriod EndedSeptember 30, 2007 |   |            | For theNine-MonthPeriod EndedSeptember 30, 2008 |  |   | For theNine-MonthPeriod EndedSeptember 30, 2007 |  
|Net investment income:                                                                   |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Investment interest income                                                               |  | $                                                | 125,585    |   |                                                  | $ | 194,649    |                                                 |  | $ | 436,999                                         |   |  | $ | 529,299    |  
|Investment interest expense                                                              |  |                                                  | (95,954    | ) |                                                  |   | (168,794   | )                                               |  |   | (337,326                                        | ) |  |   | (462,230   | )
|Provision for loan losses                                                                |  |                                                  | (12,840    | ) |                                                  |   | (4,055     | )                                               |  |   | (28,295                                         | ) |  |   | (9,514     | )
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Net investment income                                                                    |  |                                                  | 16,791     |   |                                                  |   | 21,800     |                                                 |  |   | 71,378                                          |   |  |   | 57,555     |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Expenses:                                                                                |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Related party management compensation                                                    |  |                                                  | 6,711      |   |                                                  |   | 4,886      |                                                 |  |   | 15,653                                          |   |  |   | 12,612     |  
|General and administrative                                                               |  |                                                  | 3,591      |   |                                                  |   | 3,113      |                                                 |  |   | 10,750                                          |   |  |   | 8,510      |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Total expenses                                                                           |  |                                                  | 10,302     |   |                                                  |   | 7,999      |                                                 |  |   | 26,403                                          |   |  |   | 21,122     |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Income before interest and other income, minority interest and taxes                     |  |                                                  | 6,489      |   |                                                  |   | 13,801     |                                                 |  |   | 44,975                                          |   |  |   | 36,433     |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Interest and other income                                                                |  |                                                  | 1,282      |   |                                                  |   | 4,327      |                                                 |  |   | 3,907                                           |   |  |   | 15,981     |  
|Net change in fair value of investments in debt securities and non-recourse indebtedness |  |                                                  | 70,028     |   |                                                  |   |           |                                                 |  |   | 140,236                                         |   |  |   |           |  
|Net change in fair value of derivative contracts                                         |  |                                                  | (25,967    | ) |                                                  |   | 25,308     |                                                 |  |   | (71,775                                         | ) |  |   | 44,899     |  
|Credit default swap premiums                                                             |  |                                                  |           |   |                                                  |   | (1,411     | )                                               |  |   | (2,872                                          | ) |  |   | (1,595     | )
|Impairments on other investments and intangible assets                                   |  |                                                  | (1,533     | ) |                                                  |   | (535,057   | )                                               |  |   | (14,378                                         | ) |  |   | (609,485   | )
|Loss on disposition of consolidated entities                                             |  |                                                  |           |   |                                                  |   | 10,293     |                                                 |  |   | (5,558                                          | ) |  |   | 10,293     |  
|Gain on repurchase of debt                                                               |  |                                                  | 43,912     |   |                                                  |   |           |                                                 |  |   | 43,912                                          |   |  |   |           |  
|Net realized loss on sale of assets                                                      |  |                                                  | (2,196     | ) |                                                  |   | (11,182    | )                                               |  |   | (5,387                                          | ) |  |   | (15,579    | )
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Income (loss) before minority interest and benefit for income taxes                      |  |                                                  | 92,015     |   |                                                  |   | (493,921   | )                                               |  |   | 133,060                                         |   |  |   | (519,053   | )
|Minority interest                                                                        |  |                                                  | (29,802    | ) |                                                  |   | (4,467     | )                                               |  |   | (70,567                                         | ) |  |   | (14,164    | )
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Income (loss) before benefit for income taxes                                            |  |                                                  | 62,213     |   |                                                  |   | (498,388   | )                                               |  |   | 62,493                                          |   |  |   | (533,217   | )
|Benefit for income taxes                                                                 |  |                                                  | 1,841      |   |                                                  |   | 1,784      |                                                 |  |   | 5,243                                           |   |  |   | 1,174      |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Net income (loss)                                                                        |  | $                                                | 64,054     |   |                                                  | $ | (496,604   | )                                               |  | $ | 67,736                                          |   |  | $ | (532,043   | )
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Earnings (loss) per sharebasic:                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Basic earnings (loss) per share                                                          |  | $                                                | 1.07       |   |                                                  | $ | (8.36      | )                                               |  | $ | 1.14                                            |   |  | $ | (9.59      | )
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Weighted-average shares outstandingBasic                                                |  |                                                  | 59,660,289 |   |                                                  |   | 59,425,920 |                                                 |  |   | 59,470,678                                      |   |  |   | 55,456,088 |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Earnings (loss) per sharediluted:                                                       |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Diluted earnings (loss) per share                                                        |  | $                                                | 1.07       |   |                                                  | $ | (8.36      | )                                               |  | $ | 1.14                                            |   |  | $ | (9.59      | )
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Weighted-average shares outstandingDiluted                                              |  |                                                  | 59,660,289 |   |                                                  |   | 59,425,920 |                                                 |  |   | 59,470,678                                      |   |  |   | 55,456,088 |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Distributions declared per common share                                                  |  | $                                                |           |   |                                                  | $ | 0.31       |                                                 |  | $ | 0.50                                            |   |  | $ | 0.92       |  
|                                                                                         |  |                                                  |            |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  

See accompanying notes.



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##### Table of Contents

Alesco Financial Inc.

Consolidated Statements of Other Comprehensive Income (Loss)

(Unaudited and in thousands)



|                                                              |  |                                                  |        |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|------------------------------------------------------------- |  | ------------------------------------------------ | ------ | - | ------------------------------------------------ | - | ---------- | ----------------------------------------------- |  | - | ----------------------------------------------- | - |  | - | ---------- | -
|                                                              |  | For theThree-MonthPeriod EndedSeptember 30, 2008 |        |   | For theThree-MonthPeriod EndedSeptember 30, 2007 |   |            | For theNine-MonthPeriod EndedSeptember 30, 2008 |  |   | For theNine-MonthPeriod EndedSeptember 30, 2007 |  
|Net income (loss)                                             |  | $                                                | 64,054 |   |                                                  | $ | (496,604   | )                                               |  | $ | 67,736                                          |   |  | $ | (532,043   | )
|Other comprehensive income (loss):                            |  |                                                  |        |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Net change in the fair value of cash-flow hedges              |  |                                                  | 1,495  |   |                                                  |   | (54,742    | )                                               |  |   | 46,002                                          |   |  |   | (11,320    | )
|Net change in the fair value of available-for-sale securities |  |                                                  |       |   |                                                  |   | (1,213,904 | )                                               |  |   |                                                |   |  |   | (1,222,427 | )
|Allocation to minority interests                              |  |                                                  | (627   | ) |                                                  |   | 148,136    |                                                 |  |   | (1,922                                          | ) |  |   | 89,284     |  
|                                                              |  |                                                  |        |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Total other comprehensive income (loss)                       |  |                                                  | 868    |   |                                                  |   | (1,120,510 | )                                               |  |   | 44,080                                          |   |  |   | (1,144,463 | )
|                                                              |  |                                                  |        |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  
|Comprehensive income (loss)                                   |  | $                                                | 64,922 |   |                                                  | $ | (1,617,114 | )                                               |  | $ | 111,816                                         |   |  | $ | (1,676,506 | )
|                                                              |  |                                                  |        |   |                                                  |   |            |                                                 |  |   |                                                 |   |  |   |            |  

See accompanying notes.



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##### Table of Contents

Alesco Financial Inc.

Consolidated Statements of Stockholders Equity (Deficit)

(Unaudited and in thousands, except
share information)



|                                                              |  |              |   |  |            |    |   |                |   |         |                   |  |   |                   |   |  |                 |            |   |  |   |            |  
|------------------------------------------------------------- |  | ------------ | - |  | ---------- | -- | - | -------------- | - | ------- | ----------------- |  | - | ----------------- | - |  | --------------- | ---------- | - |  | - | ---------- | -
|                                                              |  |              |   |  |            |    |   | Accumulated    |   |         |                   |  |   | Total             |  
|                                                              |  | Common Stock |   |  | Additional |    |   | Other          |   |         | Accumulated       |  |   | Stockholders     |  
|                                                              |  | Shares       |   |  | ParValue   |    |   | Paid InCapital |   |         | ComprehensiveLoss |  |   | Earnings(Deficit) |   |  | Equity(Deficit) |           
|Balance, December 31, 2007                                    |  | 59,319,798   |   |  | $          | 59 |   |                | $ | 481,850 |                   |  | $ | (1,545,464        | ) |  | $               | (1,335,983 | ) |  | $ | (2,399,538 | )
|Net income                                                    |  |             |   |  |            |   |   |                |   |        |                   |  |   |                  |   |  |                 | 67,736     |   |  |   | 67,736     |  
|Cumulative effect of adjustment from adoption of SFAS No. 159 |  |             |   |  |            |   |   |                |   |        |                   |  |   | 1,478,224         |   |  |                 | 1,107,205  |   |  |   | 2,585,429  |  
|Other comprehensive income                                    |  |             |   |  |            |   |   |                |   |        |                   |  |   | 44,080            |   |  |                 |           |   |  |   | 44,080     |  
|Stock-based compensation expense                              |  | 442,286      |   |  |            | 1  |   |                |   | 1,139   |                   |  |   |                  |   |  |                 |           |   |  |   | 1,140      |  
|Repurchase of common stock                                    |  | (629,596     | ) |  |            | (1 | ) |                |   | (638    | )                 |  |   |                   |   |  |                 |            |   |  |   | (639       | )
|Dividends declared on common stock                            |  |             |   |  |            |   |   |                |   |        |                   |  |   |                  |   |  |                 | (30,375    | ) |  |   | (30,375    | )
|                                                              |  |              |   |  |            |    |   |                |   |         |                   |  |   |                   |   |  |                 |            |   |  |   |            |  
|Balance, September 30, 2008                                   |  | 59,132,488   |   |  | $          | 59 |   |                | $ | 482,351 |                   |  | $ | (23,160           | ) |  | $               | (191,417   | ) |  | $ | 267,833    |  
|                                                              |  |              |   |  |            |    |   |                |   |         |                   |  |   |                   |   |  |                 |            |   |  |   |            |  

See accompanying notes.



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##### Table of Contents

Alesco Financial Inc.

Consolidated Statements of Cash Flows

(Unaudited and in thousands)



|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|----------------------------------------------------------------------------------------- |  | ----------------------------------------------- | -------- | - | ----------------------------------------------- | - | ---------- | -
|                                                                                          |  | For theNine-MonthPeriod EndedSeptember 30, 2008 |          |   | For theNine-MonthPeriod EndedSeptember 30, 2007 |  
|Operating activities:                                                                     |  |                                                 |          |   |                                                 |   |            |  
|Net income (loss)                                                                         |  | $                                               | 67,736   |   |                                                 | $ | (532,043   | )
|Adjustments to reconcile net income to cash flow from operating activities:               |  |                                                 |          |   |                                                 |   |            |  
|Minority interest                                                                         |  |                                                 | 70,567   |   |                                                 |   | 14,164     |  
|Provision for loan losses                                                                 |  |                                                 | 28,295   |   |                                                 |   | 9,514      |  
|Stock-based compensation expense                                                          |  |                                                 | 1,140    |   |                                                 |   | 1,512      |  
|Net premium and discount amortization on investments and loans                            |  |                                                 | 4,277    |   |                                                 |   | 779        |  
|Amortization of deferred financing costs                                                  |  |                                                 | 1,553    |   |                                                 |   | 6,095      |  
|Accretion of discounts on indebtedness                                                    |  |                                                 | 849      |   |                                                 |   | 767        |  
|Net change in fair value of derivative contracts                                          |  |                                                 | 45,809   |   |                                                 |   | (41,045    | )
|Net change in fair value of investments in debt securities and non-recourse indebtedness  |  |                                                 | (140,236 | ) |                                                 |   |           |  
|Impairments on other assets                                                               |  |                                                 | 14,378   |   |                                                 |   | 609,485    |  
|Net realized loss on sale of assets                                                       |  |                                                 | 5,387    |   |                                                 |   | 15,579     |  
|Net realized gain on repurchase of indebtedness                                           |  |                                                 | (43,912  | ) |                                                 |   |           |  
|Loss on disposition of consolidated entities                                              |  |                                                 | 5,558    |   |                                                 |   | (10,293    | )
|Changes in assets and liabilities:                                                        |  |                                                 |          |   |                                                 |   |            |  
|Accrued interest receivable                                                               |  |                                                 | 14,003   |   |                                                 |   | (8,907     | )
|Other assets                                                                              |  |                                                 | 66,865   |   |                                                 |   | 5,066      |  
|Accrued interest payable                                                                  |  |                                                 | (27,218  | ) |                                                 |   | 20,227     |  
|Related party payable                                                                     |  |                                                 | 3,876    |   |                                                 |   | 452        |  
|Other liabilities                                                                         |  |                                                 | (3,356   | ) |                                                 |   | 14,133     |  
|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|Net cash provided by operating activities                                                 |  |                                                 | 115,571  |   |                                                 |   | 105,485    |  
|Investing activities:                                                                     |  |                                                 |          |   |                                                 |   |            |  
|Purchase of investments in debt securities and security-related receivables               |  |                                                 | (17,176  | ) |                                                 |   | (2,711,394 | )
|Principal repayments from investments in debt securities and security-related receivables |  |                                                 | 21,554   |   |                                                 |   | 43,047     |  
|Purchase of loans                                                                         |  |                                                 | (197,708 | ) |                                                 |   | (792,356   | )
|Principal repayments from loans                                                           |  |                                                 | 197,433  |   |                                                 |   | 423,897    |  
|Proceeds from sale of loans                                                               |  |                                                 | 69,889   |   |                                                 |   | 529,680    |  
|Proceeds from sale of investments in debt securities and security-related receivables     |  |                                                 | 17,518   |   |                                                 |   | 988,706    |  
|Decrease in restricted cash and warehouse deposits                                        |  |                                                 | 22,429   |   |                                                 |   | 168,650    |  
|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|Net cash provided by (used in) investing activities                                       |  |                                                 | 113,939  |   |                                                 |   | (1,349,770 | )
|Financing activities:                                                                     |  |                                                 |          |   |                                                 |   |            |  
|Proceeds from repurchase agreements                                                       |  |                                                 |         |   |                                                 |   | 191,696    |  
|Repayments of repurchase agreements                                                       |  |                                                 |         |   |                                                 |   | (3,215,965 | )
|Proceeds from issuance of CDO notes payable                                               |  |                                                 | 57,386   |   |                                                 |   | 2,548,160  |  
|Repayments of CDO notes payable                                                           |  |                                                 | (56,252  | ) |                                                 |   | (17,250    | )
|Proceeds from issuance of trust preferred obligations                                     |  |                                                 |         |   |                                                 |   | 198,103    |  
|Proceeds from warehouse credit facilities                                                 |  |                                                 | 136,633  |   |                                                 |   | 898,932    |  
|Repayments of warehouse credit facilities                                                 |  |                                                 | (159,411 | ) |                                                 |   | (444,133   | )
|Proceeds from issuance of recourse indebtedness                                           |  |                                                 |         |   |                                                 |   | 208,995    |  
|Repayment of recourse indebtedness                                                        |  |                                                 |         |   |                                                 |   | (40,000    | )
|Repurchases of recourse indebtedness                                                      |  |                                                 | (32,972  | ) |                                                 |   |           |  
|Proceeds from issuance of securitized mortgage debt                                       |  |                                                 |         |   |                                                 |   | 1,014,600  |  
|Repayments of securitized mortgage debt                                                   |  |                                                 | (94,403  | ) |                                                 |   | (40,333    | )
|Proceeds from other derivative contracts                                                  |  |                                                 |         |   |                                                 |   | 5,143      |  
|Repayments of other derivative contracts                                                  |  |                                                 | (3,758   | ) |                                                 |   |           |  
|Proceeds from cash flow hedges                                                            |  |                                                 |         |   |                                                 |   | 6,356      |  
|Proceeds from issuance of preference shares of CDOs                                       |  |                                                 |         |   |                                                 |   | 9,924      |  
|Distributions to minority interest holders in CDOs                                        |  |                                                 | (10,937  | ) |                                                 |   | (14,529    | )
|Payments for deferred debt issuance costs                                                 |  |                                                 |         |   |                                                 |   | (30,496    | )
|Proceeds from issuance of common stock                                                    |  |                                                 |         |   |                                                 |   | 71,996     |  
|Repurchase of common stock                                                                |  |                                                 | (229     | ) |                                                 |   | (34,534    | )
|Distributions paid to common stockholders                                                 |  |                                                 | (49,524  | ) |                                                 |   | (33,058    | )
|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|Net cash provided by (used in) financing activities                                       |  |                                                 | (213,467 | ) |                                                 |   | 1,283,607  |  
|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|Net change in cash and cash equivalents                                                   |  | $                                               | 16,043   |   |                                                 | $ | 39,322     |  
|Cash and cash equivalents at the beginning of the period                                  |  |                                                 | 80,176   |   |                                                 |   | 51,821     |  
|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|Cash and cash equivalents at the end of the period                                        |  | $                                               | 96,219   |   |                                                 | $ | 91,143     |  
|                                                                                          |  |                                                 |          |   |                                                 |   |            |  
|Supplemental cash flow information:                                                       |  |                                                 |          |   |                                                 |   |            |  
|Non-cash decrease in assets upon disposition of consolidated entity                       |  | $                                               | 313,950  |   |                                                 | $ | 72,831     |  
|Non-cash decrease in liabilities upon disposition of consolidated entity                  |  |                                                 | 313,950  |   |                                                 |   | 59,865     |  
|Distributions payable                                                                     |  |                                                 |         |   |                                                 |   | 18,770     |  

See accompanying notes.



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Alesco Financial Inc.

Notes to Consolidated Financial Statements

As of September 30, 2008

(Unaudited and in thousands, except share and per share amounts)

NOTE 1: THE COMPANY

Alesco Financial Trust was organized as a Maryland real estate investment trust
on October 25, 2005 and commenced operations on January 31, 2006. On January 31, 2006, February 2, 2006, and March 1, 2006, Alesco Financial Trust completed the sale of 11,107,570 common shares of beneficial interest at
an offering price of $10.00 per share in a private offering. Alesco Financial Trust received proceeds from this offering of $102.4 million, net of placement fees and offering costs.

On October 6, 2006, Alesco Financial Trust completed its merger with Alesco Financial Inc. (formerly Sunset Financial Resources, Inc.). Pursuant to
the terms of the Amended and Restated Agreement and Plan of Merger, as amended by letter agreements dated September 5, 2006 and September 29, 2006, upon the completion of the merger each share of beneficial interest of Alesco Financial
Trust was converted into 1.26 shares of common stock of Sunset Financial Resources, Inc. (Sunset), which resulted in the issuance of 14,415,530 shares of common stock. In accordance with U.S. generally accepted accounting principles
(GAAP) the transaction was accounted for as a reverse acquisition, and Alesco Financial Trust was deemed to be the accounting acquirer and all of Sunsets assets and liabilities were required to be revalued as of the acquisition
date. As used in these consolidated financial statements, the term the Company, we, us and our refer to the operations of Alesco Financial Trust from January 31, 2006 through October 6, 2006,
and the combined operations of the merged company subsequent to October 6, 2006. Sunset refers to the historical operations of Sunset Financial Resources, Inc. through October 6, 2006, the merger date.

Sunset was incorporated in Maryland on October 6, 2003, completed its initial public offering of common stock on March 22, 2004 and was traded
on the New York Stock Exchange (the NYSE) under the ticker symbol SFO. Sunset elected to be taxed as a real estate investment trust (REIT) for U.S. Federal income tax purposes and the Company intends to continue
to comply with these tax provisions. On October 9, 2006, the Company began trading on the NYSE under the ticker symbol AFN. On November 27, 2006, the Company closed a public offering of 30,360,000 shares of the Companys
common stock, par value $0.001 per share, at a public offering price of $9.00 per share, net of placement fees and offering costs. On June 25, 2007, the Company closed a public offering of 8,000,000 shares of the Companys common stock,
par value $0.001 per share, at a public offering price of $9.25 per share, net of placement fees and offering costs.

The Company is a
specialty finance company that invests in multiple asset classes with the objective of generating risk-adjusted returns and predictable cash distributions for its stockholders, subject to maintaining the Companys status as a real estate
investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, and its exemption from regulation under the Investment Company Act of 1940, as amended, or the Investment Company Act. The Company seeks to
achieve its investment objectives by investing primarily in the following target asset classes:



| |  |  | subordinated debt financings originated by the Companys manager or third parties, primarily in the form of trust preferred securities, or TruPS, issued by
banks or bank holding companies and insurance companies, and surplus notes issued by insurance companies;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | leveraged loans made to small and mid-sized companies in a variety of industries characterized by companies with relatively low volatility and overall leverage
compared to their industry peers, including the consumer products and manufacturing industries; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | mortgage loans, other real estate-related senior and subordinated debt securities, residential mortgage-backed securities, or RMBS, and commercial mortgage-backed
securities, or CMBS.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The Company typically finances investments in these target asset classes on a short-term basis with
on and off-balance sheet warehouse facilities or other short-term financing arrangements and on a long-term basis with securitization vehicles, including collateralized debt obligations (CDOs) and collateralized loan obligations
(CLOs).

The Company may also invest opportunistically from time to time in other types of investments within its
managers and Cohen Brothers, LLCs (Cohen & Company) areas of expertise and experience, subject to maintaining its qualification as a REIT and an exemption from regulation under the Investment Company Act.



NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying
unaudited interim condensed consolidated financial statements have been prepared by management in accordance with GAAP. Certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance
with GAAP have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures included are adequate to make the information presented not misleading. The unaudited interim consolidated financial



6



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##### Table of Contents

statements should be read in conjunction with our audited financial statements for the period ended December 31, 2007, included in our Annual Report on
Form 10-K. See Item 15-Exhibits and Financial Statement Schedules included in our Annual Report on Form 10-K for the year ended December 31, 2007. In the opinion of management, all adjustments, consisting only of normal
recurring adjustments necessary to present fairly our consolidated financial position and consolidated results of operations and cash flows are included. The results of operations for the interim periods presented are not necessarily indicative of
the results for the full year.

The preparation of consolidated financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements reflect the accounts of the
Company and its majority-owned and/or controlled subsidiaries and those entities for which the Company is determined to be the primary beneficiary in accordance with Financial Accounting Standard Board (FASB) Interpretation No. 46R,
Consolidation of Variable Interest Entities (FIN 46R). The portions of these entities to which the Company does not have an economic interest are presented as minority interests in the consolidated financial statements. The
creditors of each variable interest entity (VIE) consolidated within the Companys consolidated financial statements have no recourse to the general credit of the Company. The Companys maximum exposure to loss as a result of
its involvement with each VIE is the capital that the Company has invested in warehouse first-loss deposits and the preference shares or debt of the CDO, CLO or other types of securitization structures. All significant intercompany accounts and
transactions have been eliminated in consolidation.

When the Company obtains an explicit or implicit interest in an entity, the Company
evaluates the entity to determine if the entity is a VIE, and, if so, whether or not the Company is deemed to be the primary beneficiary of the VIE in accordance with FIN 46R. The Company consolidates VIEs of which the Company is deemed to be the
primary beneficiary or non-VIEs which the Company controls. The primary beneficiary of a VIE is the variable interest holder that absorbs the majority of the variability in the expected losses or potentially the residual returns of the VIE. When
determining the primary beneficiary of a VIE, the Company considers its aggregate explicit and implicit variable interests as a single variable interest. If the Companys variable interest absorbs the majority of the variability in the expected
losses or the residual returns of the VIE, the Company is considered the primary beneficiary of the VIE. The Company reconsiders its determination of whether an entity is a VIE and whether the Company is the primary beneficiary of such VIE if
certain events occur. If the Company determines that it is no longer the primary beneficiary of a VIE, the deconsolidation of the VIE is accounted for as a sale of the entity for no proceeds.

The Company has determined that certain special purpose trusts formed by third party issuers of TruPS to issue such securities are VIEs (Trust
VIEs) and that the holder of the majority of the TruPS issued by the Trust VIEs would be the primary beneficiary of the special purpose trust. In most instances, the Company is the primary beneficiary of the Trust VIEs because it holds, either
explicitly or implicitly, the majority of the TruPS issued by the Trust VIEs. The acquisition of TruPS issued by Trust VIEs may be initially financed directly by CDOs, through on-balance sheet warehouse facilities or through off-balance sheet
warehouse facilities. Under the TruPS-related off-balance sheet warehouse agreements, the Company usually deposits cash collateral with an investment bank and bears the first dollar risk of loss, up to the Companys collateral deposit, if an
investment held under the warehouse facility is liquidated at a loss. This arrangement causes the Company to hold an implicit interest in the Trust VIEs that issued TruPS held by warehouse providers. The primary assets of the Trust VIEs are
subordinated debentures issued by third party sponsors of the Trust VIEs in exchange for the TruPS proceeds and the common equity securities of the Trust VIE. These subordinated debentures have terms that mirror the TruPS issued by the Trust VIEs.
Upon consolidation of the Trust VIEs, these subordinated debentures, which are assets of the Trust VIE, are included in the Companys consolidated financial statements and the related TruPS are eliminated. Pursuant to Emerging Issues Task Force
Issue No. 85-1: Classifying Notes Received for Capital Stock, subordinated debentures issued to Trust VIEs as payment for common equity securities issued by Trust VIEs to third party sponsors are recorded net of the common equity
securities issued.



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##### Table of Contents

Fair Value of Financial Instruments

Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (SFAS No. 157), which
establishes a framework for measuring fair value by creating a three-level fair value hierarchy that ranks the quality and reliability of information used to determine fair value, and requires new disclosures of assets and liabilities measured at
fair value based on their level in the hierarchy. SFAS No. 157 also defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement
date.

SFAS No. 157 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and
minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the financial instrument developed based on market data obtained
from sources independent of the Company. Unobservable inputs are inputs that reflect the Companys estimates about what assumptions market participants would use in pricing the financial instrument developed based on the best information
available in the circumstances. The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows:



| |  |  | Level 1: Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Since
valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Financial instruments utilizing Level 1 inputs generally include exchange-traded equity securities listed in active markets and most U.S. Government securities.



| |  |  | Level 2: Valuations based on quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not
active or for which all significant inputs are observable, either directly or indirectly.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Financial instruments utilizing Level 2 inputs
generally include certain mortgage-backed securities, or MBS, and corporate debt securities and certain financial instruments classified as derivatives, including interest rate swap contracts and credit default swaps, where fair value is based on
observable market inputs.



| |  |  | Level 3: Inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or
liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has
been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and
considers factors specific to the asset or liability.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Financial instruments utilizing Level 3 inputs generally include investments in
TruPS and TruPS security-related receivables, certain MBS, and CDO notes payable.

The fair value of the Companys financial
instruments is generally based on observable market prices or inputs or derived from such prices or inputs. When quoted market prices are not available because certain financial instruments do not actively trade in the public markets, fair value is
based on comparisons to similar instruments or from internal valuation models.

The availability of observable inputs can vary depending on
the financial instrument and is affected by a wide variety of factors, including, for example, the type of financial instrument, its age, whether the financial instrument is traded on an active exchange or in the secondary market, the current market
conditions, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment.
Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value
hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in
its entirety.

Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the
liability rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Companys own assumptions are set to reflect those that management believes market participants would use in pricing the
asset or liability at the measurement date. The Company uses prices and inputs that management believes are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of
prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3.



8



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Many financial instruments have bid and ask prices that can be observed in the marketplace. Bid prices
reflect the highest price that the Company and others are willing to pay for an asset. Ask prices represent the lowest price that the Company and others are willing to accept for an asset. For financial instruments whose inputs are based on bid-ask
prices, the Company does not require that fair value always be a predetermined point in the bid-ask range. The Companys policy is to allow for mid-market pricing and adjusting to the point within the bid-ask range that results in the
Companys best estimate of fair value.

Fair value for certain of the Companys Level 3 financial instruments is derived using
internal valuation models. These internal valuation models include discounted cash flow analyses developed by management using current interest rates, estimates of the term of the particular contract, specific issuer information and other market
data for securities without an active market. In accordance with SFAS No. 157, the impact of the Companys own credit and creditworthiness of consolidated CDOs is also considered when measuring the fair value of liabilities, including
derivative contracts. Where appropriate, valuation adjustments are made to account for various factors, including bid-ask spreads, credit quality and market liquidity. These adjustments are applied on a consistent basis and are based upon observable
inputs where available. Managements estimate of fair value requires significant management judgment and is subject to a high degree of variability based upon market conditions, the availability of specific issuer information and
managements assumptions.

Financial instruments that are generally classified in Level 3 of the fair value hierarchy primarily
consist of investments in TruPS and TruPS security-related receivables, certain MBS, and CDO notes payable. The valuation techniques used for those financial instruments classified in Level 3 are described below.

TruPS and TruPS Security-Related Receivables: The fair value of investments in TruPS is estimated using internal valuation models. These
investment securities generally do not trade in an active market and, therefore observable price quotations are not available. In the absence of observable price quotations, fair value is determined based on discounted cash flow models using current
interest rates, estimates of the term of the particular contract, specific issuer information, including estimates of comparable market credit spreads and other market data.

MBS:The fair value of investments in MBS is determined based on external price and spread data. When position-specific external price data are
not observable, the valuation is based on prices of comparable bonds.

CDO Notes Payable: The fair value of CDO notes payable
liabilities is estimated using external price data (where observable), or internal valuation models. In the absence of observable price quotations, fair value is determined based on prices of comparable notes payable, or discounted cash flow models
using current interest rates, estimates of the term of the particular contract, specific underlying collateral information, including estimates of credit spreads and other market data for securities without an active market.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities (SFAS No. 159). SFAS No. 159 provides entities with an irrevocable option to report most financial assets and liabilities at fair value, with subsequent changes in fair value reported in earnings.
The election can be applied on an instrument-by-instrument basis. SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar
types of assets and liabilities, and became effective for the Company on January 1, 2008. The Company elected to apply the fair value option for its investments in TruPS and TruPS security-related receivables, MBS, TruPS CDO notes payable, MBS
CDO notes payable, and TruPS obligations. The Company has elected the fair value option for these instruments to enhance the transparency of its financial condition. The transition adjustment to beginning accumulated deficit that was recorded as of
January 1, 2008 due to the adoption of SFAS No. 159 was an increase to accumulated deficit of $1.1 billion. The following table presents information about the eligible instruments for which the Company elected the fair value option and for
which transition adjustments were recorded as of January 1, 2008 (amounts in thousands):



|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|----------------------------------------------------------- |  | ---------------------------------------------------------------- | --------- | ------------------------------------------------------------- | - | --------- | --------------------------------------------------------------- |  | - | ---------
|Financial Instrument Description                            |  | Carrying Value atJanuary 1,
2008(Before Adoption ofSFAS No. 159) |           | TransitionAdjustment toAccumulated DeficitIncrease/(Decrease) |   |           | Carrying Value atJanuary 1,
2008(After Adoption ofSFAS No. 159)
|Assets:                                                     |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|TruPS and subordinated debentures                           |  | $                                                                | 3,793,930 |                                                               | $ | (924,053  | )(1)                                                            |  | $ | 3,793,930
|TruPS security-related receivables                          |  |                                                                  | 740,342   |                                                               |   | (113,123  | )                                                               |  |   | 627,219  
|MBS                                                         |  |                                                                  | 2,091,007 |                                                               |   | (554,171  | )(1)                                                            |  |   | 2,091,007
|Liabilities:                                                |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|TruPS CDO notes payable                                     |  |                                                                  | 4,924,033 |                                                               |   | 838,109   | (2)                                                             |  |   | 4,085,924
|MBS CDO notes payable                                       |  |                                                                  | 3,852,837 |                                                               |   | 1,804,175 | (3)                                                             |  |   | 2,048,662
|TruPS obligations                                           |  |                                                                  | 382,600   |                                                               |   | 79,005    |                                                                 |  |   | 303,595  
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|Cumulative effect of the adoption                           |  |                                                                  |           |                                                               |   | 1,129,942 |                                                                 |  |   |          
|Minority interest allocation of cumulative adjustment       |  |                                                                  |           |                                                               |   | (22,737   | )                                                               |  |   |          
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|Cumulative effect of the adoption to accumulated deficit(4) |  |                                                                  |           |                                                               |   | 1,107,205 |                                                                 |  |   |          
|Adjustments related to other comprehensive loss             |  |                                                                  |           |                                                               |   | 1,478,224 |                                                                 |  |   |          
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|Cumulative effect of the adoption to stockholders equity   |  |                                                                  |           |                                                               | $ | 2,585,429 |                                                                 |  |   |          
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          



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|(1) | Prior to January 1, 2008, TruPS and subordinated debentures and MBS were classified as available-for-sale and carried at fair value. Accordingly, the election of the fair value
option for these securities did not change their carrying value and resulted in a reclassification from accumulated other comprehensive loss to beginning accumulated deficit.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes write-off of deferred issuance costs of $76.9 million.
|--- | ---------------------------------------------------------------

|(3) | Includes write-off of deferred issuance costs of $21.0 million.
|--- | ---------------------------------------------------------------

|(4) | Amount includes $1.9 million of a deferred tax asset recorded upon adoption of SFAS No. 159.
|--- | --------------------------------------------------------------------------------------------

Investments

The Company invests primarily in TruPS and MBS debt securities, residential and
commercial mortgage portfolios, and leveraged loans and may invest in other types of real estate-related assets. The Company accounts for its investments in debt securities under Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity Securities, as amended and interpreted (SFAS No. 115), and designates each investment as a trading security, an available-for-sale security, or a held-to-maturity
security based on managements intent at the time of acquisition. Under SFAS No. 115, trading securities are recorded at their fair value each reporting period with fluctuations in fair value reported as a component of earnings.
Available-for-sale securities are recorded at fair value with changes in fair value reported as a component of other comprehensive income (loss). Fair value of investments is based on quoted market prices from independent pricing sources, or when
quoted market prices are not available because certain securities do not actively trade in the public markets, based on comparisons to similar instruments or from internal pricing models. These internal valuation models include discounted cash flow
analyses developed by management using current interest rates, estimates of the term of the particular contract, specific issuer information and other market data for securities without an active market. Managements estimate of fair value
requires significant management judgment and is subject to a high degree of variability based upon market conditions, the availability of specific issuer information and managements assumptions. Upon the sale of a security, the realized gain
or loss is computed on a specific identification basis and is recorded as a component of earnings in the respective period.

Effective
January 1, 2008, the Company classifies its investments in TruPS and MBS as trading securities (see Fair Value of Financial Instruments). These investments are carried at estimated fair value, with changes in fair value of these
instruments reported in income. Unamortized premiums and discounts on trading securities that are highly rated are recognized over the contractual life, adjusted for estimated prepayments using the effective interest method. For securities
representing beneficial interests in securitizations that are not highly rated (i.e., subordinate tranches of MBS), unamortized premiums and discounts are recognized over the contractual life, adjusted for estimated prepayments and estimated credit
losses of the securities using the effective interest method. Actual prepayment and credit loss experience are reviewed quarterly and effective yields are recalculated when differences arise between prepayments and credit losses originally
anticipated compared to amounts actually received plus anticipated future prepayments.

Effective January 1, 2008, the Company
accounts for its investments in subordinated debentures owned by Trust VIEs that the Company consolidates at fair value, with changes in fair value of these instruments reported in income. These Trust VIEs have no ability to sell, pledge, transfer
or otherwise encumber a company or the assets of a company until such subordinated debentures maturity. The Company accounts for investments in securities where the transfer meets the criteria as a secured financing under Statement of
Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS No. 140) as secured loans at fair value. The Companys investments in
security-related receivables represent interests in securities that were transferred to CDO securitization entities by transferors that maintain some level of continuing involvement.

As it relates to available-for-sale securities, the Company exercises judgment to determine whether an investment security has sustained an
other-than-temporary decline in fair value. If the Company determines that an investment security has sustained an other-than-temporary decline in its fair value, the investment security is written down to its fair value by a charge to earnings, and
the Company establishes a new cost basis for the investment. The Companys evaluation of an other-than-temporary decline is dependent on specific facts and circumstances relating to the particular investment. Factors that the Company considers
in determining whether an other-than-temporary decline in fair value has occurred include, but are not limited to: the estimated fair value of the investment in relation to its cost basis; the length of time the security has had a decline in
estimated fair value below its amortized cost; the financial condition of the related entity and industry events; changes in estimated cash flows from the investment; external credit ratings and recent downgrades of such credit ratings; and the
intent and ability of the Company to hold the investment for a sufficient period of time to allow for recovery in the fair value of the investment. For MBS that are not of high credit quality at acquisition, the Company performs impairment analyses
in accordance with Emerging Issues Task Force Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF No. 99-20). When
adverse changes in estimated cash flows occur as a result of actual or expected prepayment and credit loss experience, an other-than-temporary impairment is deemed to have occurred. Accordingly, the security is written down to fair value, and the
loss is recognized in current earnings. The cost basis adjustment for other-than-temporary impairment is recoverable only upon sale or maturity of the security. Effective January 1, 2008, the Company is not classifying any of its investments as
available-for-sale.



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The Company accounts for its investments in residential and commercial mortgages and leveraged loans at
amortized cost. The carrying value of these investments is adjusted for origination discounts/premiums, nonrefundable fees and direct costs for originating loans which are amortized into income over the terms of the loans using the effective yield
method adjusted for the effects of estimated prepayments based on Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases (SFAS No. 91).

The Company maintains an allowance for residential and commercial mortgages and leveraged
loan losses based on managements evaluation of known losses and inherent risks in the portfolios, including historical and industry loss experience, economic conditions and trends, estimated fair values, the quality of collateral and other
relevant quantitative and qualitative factors. Specific allowances for losses may be established for potentially impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loans expected
cash flow, the loans estimated market price or the estimated fair value of the underlying collateral. The allowance is increased by charges to operations and decreased by charge-offs (net of recoveries).

An impaired loan may be left on accrual status during the period the Company is pursuing repayment of the loan; however, the loan is placed on
non-accrual status at such time as the Company believes that scheduled debt service payments may not be paid when contractually due or the loan becomes 90 days delinquent. While on non-accrual status, interest income is recognized only upon actual
receipt.

Transfers of Financial Assets

The Company accounts for transfers of financial assets under SFAS No. 140 as either sales or financing arrangements. Transfers of financial assets that result in sale accounting are those in which (a) the transfer legally isolates
the transferred assets from the transferor, (b) the transferee has the right to pledge or exchange the transferred assets and no condition both constrains the transferees right to pledge or exchange the assets and provides more than a
trivial benefit to the transferor, and (c) the transferor does not maintain effective control over the transferred assets. If the transfer does not meet each of these criteria, the transfer is accounted for as a financing arrangement.
Dispositions of financial assets that are treated as sales are removed from the Companys accounts with any realized gain (loss) reflected in earnings during the period of sale. Dispositions of financial assets that are treated as financings
are maintained on the balance sheet with proceeds received from the legal transfer reflected as secured borrowings and no gain or loss is recognized.

Revenue Recognition

The Company recognizes interest income from investments in debt and other securities,
residential and commercial mortgages, and leveraged loans over the estimated life of the underlying financial instruments on an estimated yield to maturity basis.

In accordance with EITF No. 99-20, the Company recognizes interest income from purchased interests in certain financial assets, including certain subordinated MBS, on an estimated effective yield to maturity
basis. Management estimates the current yield on the reference amount of the investment based on estimated cash flows after considering prepayment and credit loss expectations. The adjusted yield is then applied prospectively to recognize interest
income for the next reporting period.

Derivative Instruments

The Company uses derivative financial instruments to attempt to hedge all or a portion of the interest rate risk associated with its borrowings. In accordance with Statement of Financial Accounting Standards
No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted (SFAS No. 133), the Company measures each derivative instrument (including certain derivative instruments embedded in
other contracts) at fair value and records such amounts in its consolidated balance sheet as either an asset or liability. Derivatives qualifying and designated as cash-flow hedges are evaluated at inception and at subsequent balance sheet dates in
order to determine whether they qualify for hedge accounting under SFAS No. 133. The hedge instrument must be highly effective in achieving offsetting changes in cash flows of the hedged item attributable to the risk being hedged in order to
qualify for hedge accounting. Derivative contracts are carried on the consolidated balance sheet at fair value. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in
other comprehensive income (loss). Changes in the ineffective portions of cash flow hedges are recognized in earnings. Realized gains and losses on terminated contracts that were designated as hedges are maintained in accumulated other comprehensive
income or loss and amortized into the consolidated statement of income over the contractual life of the terminated contract unless it is probable that the forecasted transaction will not occur. In that case, the gain or loss in accumulated other
comprehensive income or loss is reclassified to realized gain or loss in the consolidated statement of income.

The Company may also enter
into derivatives that do not qualify for hedge accounting or for which the Company may not elect hedge accounting, including interest rate swaps, interest rate caps and floors, credit default and total return swaps, under SFAS No. 133. These
derivatives are carried at their fair value with changes in fair value reflected in the consolidated statement of income. The fair value of credit default swaps is based on quotations from third-party brokers.



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Accounting for Off-Balance Sheet Arrangements

The Company may maintain certain warehouse financing arrangements with various investment banks that are accounted for as off-balance sheet arrangements.
The Company receives the difference between the interest earned on the investments under the warehouse facilities and the interest charged by the warehouse providers from the dates on which the respective investments were acquired. Under the
warehouse agreements, the Company is typically required to deposit cash collateral with the warehouse provider and as a result, the Company bears the first dollar risk of loss, up to the warehouse deposit, if (i) an investment funded through
the warehouse facility becomes impaired or (ii) a CDO is not completed by the end of the warehouse period, and in either case, the warehouse provider is required to liquidate the securities at a loss. These off-balance sheet arrangements are
not consolidated because the collateral assets are maintained on the balance sheet of the warehouse providers. However, since the Company holds an implicit variable interest in many entities funded under its TruPS-related warehouse facilities, the
Company often does consolidate the Trust VIEs while the TruPS they issue are held on the warehouse facilities. The Company records the cash collateral as warehouse deposits in its financial statements. The net amount earned from these warehouse
facilities and any obligation associated with the warehouse arrangement are considered free-standing derivatives and are recorded at fair value in the financial statements with changes in fair value reflected in earnings in the respective period.

Income Taxes

For tax purposes,
Sunset is deemed to have acquired Alesco Financial Trust on October 6, 2006. Sunset elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code and subsequent to the merger the Company continues to comply with
these requirements. Accordingly, the Company generally will not be subject to U.S. federal income tax to the extent of its distributions to stockholders and as long as certain asset, income, distribution and share ownership tests are met. If the
Company were to fail to meet these requirements, it would be subject to U.S. federal income tax, which could have a material adverse impact on its results of operations and amounts available for distributions to its stockholders. Management believes
that all of the criteria to maintain the Companys REIT qualification have been met for the applicable periods, but there can be no assurances that these criteria will continue to be met in subsequent periods.

The Company maintains domestic taxable REIT subsidiaries (TRSs), which may be subject to U.S. federal, state and local income taxes. Current
and deferred taxes are provided for on the portion of earnings (losses) recognized by the Company with respect to its interest in domestic TRSs. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP
consolidated financial statements and the federal and state income tax basis of assets and liabilities as of the consolidated balance sheet date. We evaluate the realizability of our deferred tax assets and recognize a valuation allowance if, based
on the weight of available evidence, it is more likely than not that some portion or all of our deferred tax assets will not be realized. When evaluating the realizability of our deferred tax assets, we consider estimates of expected future taxable
income, existing and projected book/tax differences, tax planning strategies available, and the general and industry specific economic outlook. This realizability analysis is inherently subjective, as it requires management to forecast our business
and general economic environment in future periods. Changes in estimate of deferred tax asset realizability, if any, are included in income tax expense on the consolidated statements of income.

Certain TRS entities are domiciled in the Cayman Islands and, accordingly, taxable income generated by these entities may not be subject to local income
taxation, but generally will be included in the Companys income on a current basis, whether or not distributed. Upon distribution of any previously included income to the Company, no incremental U.S. federal, state, or local income taxes would
be payable by the Company.

Recent Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statementsan amendment of Accounting Research Bulletin No. 51 (SFAS
No. 160). SFAS No. 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity
and noncontrolling interests. SFAS No. 160 applies prospectively as of December 1, 2009, except for the presentation and disclosure requirements which will be applied retrospectively for all periods presented. Management is currently
evaluating the impact that this statement may have on our consolidated financial statements.

In March 2008, the FASB issued Statement of
Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities  an amendment of SFAS No. 133 (SFAS No. 161). SFAS No. 161 requires enhanced disclosure related
to derivatives and hedging activities and thereby seeks to improve the transparency of financial reporting. Under SFAS No. 161, entities are required to provide enhanced disclosures relating to: (a) how and why an entity uses derivative
instruments; (b) how derivative instruments and related hedge items are accounted for under SFAS No. 133 and its related interpretations; and (c) how derivative instruments and related hedged items affect an entitys financial
position, financial performance and cash flows. The statement is effective for fiscal years beginning after November 15, 2008. Management is currently evaluating the impact that this statement may have on our consolidated financial statements.



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In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in
Share-Based Payment Transactions Are Participating Securities (FSP EITF 03-6-1). FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and,
therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method as described in SFAS No. 128, Earnings per Share. Under the guidance in FSP EITF 03-6-1, unvested share-based
payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. FSP EITF
03-6-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. All prior-period earnings per share data presented shall be adjusted retrospectively. Early application is not permitted. The
Company is currently evaluating the potential impact of adopting FSP EITF 03-6-1.

In June 2008, the FASB ratified the consensus reached by
the EITF on Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entitys Own Stock  (EITF No. 07-5). EITF No. 07-5 provides guidance for determining whether an
equity-linked financial instrument (or embedded feature) is indexed to an entitys own stock. EITF No. 07-5 applies to any freestanding financial instrument or embedded feature that has all of the characteristics of a derivative or
freestanding instrument that is potentially settled in an entitys own stock (with the exception of share-based payment awards within the scope of SFAS 123(R)). To meet the definition of indexed to own stock, an instruments
contingent exercise provisions must not be based on (a) an observable market, other than the market for the issuers stock (if applicable), or (b) an observable index, other than an index calculated or measured solely by reference to
the issuers own operations, and the variables that could affect the settlement amount must be inputs to the fair value of a fixed-for-fixed forward or option on equity shares. EITF No. 07-5 is effective for fiscal years
beginning after December 15, 2008, and interim periods within those fiscal years. The Company is currently evaluating the potential impact of adopting EITF No. 07-5.

In September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB
Statement 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161 (FSP FAS 133-1 and FIN 45-4). FSP FAS 133-1 and FIN 45-4 is intended to improve disclosures about credit
derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance, and cash flows of the sellers of credit derivatives. FSP FAS 133-1 and FIN 45-4 will be
effective for the Companys fiscal 2008 annual consolidated financial statements.

In October 2008, the FASB issued FSP FAS 157-3,
Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP FAS 157-3). FSP FAS 157-3 clarifies the application of FASB Statement No. 157, Fair Value Measurements, in a
market that is not active. FSP FAS 157-3 is effective October 10, 2008, and for prior periods for which financial statements have not been issued. The adoption of FSP FAS 157-3 did not have a material effect on our consolidated financial
statements.

In September 2008, the FASB issued for comment revisions to SFAS No. 140 and FASB Interpretation No. 46, as revised
(FIN 46R), Consolidation of Variable Interest Entities. The changes proposed include a removal of the scope exemption from FIN 46R for QSPEs, a revision of the current risks and rewards-based FIN 46R consolidation model to a
qualitative model based on control and a requirement that consolidation of VIEs be re-evaluated on an ongoing basis. Although the revised standards have not yet been finalized, these changes may have a significant impact on the Companys
condensed consolidated financial statements as the Company may be required to deconsolidate certain assets and liabilities due to the ongoing evaluation of its primary beneficiary status. In addition, the Company may also be required to consolidate
other VIEs that are not currently consolidated based an analysis under the current FIN 46R consolidation model. The proposed revisions would be effective for fiscal years that begin after November 15, 2009.

NOTE 3: FAIR VALUE OF FINANCIAL INSTRUMENTS

Effective January 1, 2008, the Company adopted SFAS No. 157, which requires additional disclosures about the Companys assets and liabilities that are measured at fair value. The following table presents information about the
Companys assets and liabilities (including derivatives that are presented net) measured at fair value on a recurring basis as of September 30, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the
Company to determine such fair value. The Companys assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.



|                                                           |  |                                                               |   |         |   |         |  |       |           |  |   |          
|---------------------------------------------------------- |  | ------------------------------------------------------------- | - | ------- | - | ------- |  | ----- | --------- |  | - | ---------
|                                                           |  | Assets and Liabilities at Fair Value as of September 30, 2008
|(amounts in thousands)                                     |  | Level 1                                                       |   | Level 2 |   | Level 3 |  | Total
|Assets:                                                    |  |                                                               |   |         |   |         |  |       |           |  |   |          
|Investment in TruPS and TruPS security-related receivables |  | $                                                             |  |         | $ |        |  | $     | 2,226,031 |  | $ | 2,226,031
|MBS                                                        |  |                                                               |  |         |   |        |  |       | 744,547   |  |   | 744,547  
|Other investments                                          |  |                                                               |  |         |   |        |  |       | 630       |  |   | 630      
|                                                           |  |                                                               |   |         |   |         |  |       |           |  |   |          



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|                               |  |                                                               |   |         |   |         |  |       |           |  |   |          
|------------------------------ |  | ------------------------------------------------------------- | - | ------- | - | ------- |  | ----- | --------- |  | - | ---------
|                               |  | Assets and Liabilities at Fair Value as of September 30, 2008
|(amounts in thousands)         |  | Level 1                                                       |   | Level 2 |   | Level 3 |  | Total
|Total Assets                   |  | $                                                             |  |         | $ |        |  | $     | 2,971,208 |  | $ | 2,971,208
|                               |  |                                                               |   |         |   |         |  |       |           |  |   |          
|Liabilities:                   |  |                                                               |   |         |   |         |  |       |           |  |   |          
|TruPS CDO notes payable        |  | $                                                             |  |         | $ |        |  | $     | 1,793,809 |  | $ | 1,793,809
|MBS CDO notes payable          |  |                                                               |  |         |   |        |  |       | 697,316   |  |   | 697,316  
|TruPS obligations              |  |                                                               |  |         |   |        |  |       | 152,660   |  |   | 152,660  
|Interest rate swap liabilities |  |                                                               |  |         |   | 115,659 |  |       |          |  |   | 115,659  
|                               |  |                                                               |   |         |   |         |  |       |           |  |   |          
|Total Liabilities              |  | $                                                             |  |         | $ | 115,659 |  | $     | 2,643,785 |  | $ | 2,759,444
|                               |  |                                                               |   |         |   |         |  |       |           |  |   |          

The tables presented below summarize the change in asset and liability carrying values associated
with Level III financial instruments during the nine-month period ending September 30, 2008 (amounts in thousands):



|                                  |  |                                                         |            |   |                      |   |            |                  |  |   |          |   |  |   |            |  
|--------------------------------- |  | ------------------------------------------------------- | ---------- | - | -------------------- | - | ---------- | ---------------- |  | - | -------- | - |  | - | ---------- | -
|Assets                            |  | Investment inTruPS and TruPSSecurity-RelatedReceivables |            |   | MBS                  |   |            | OtherInvestments |  |   | Total    |  
|Balance at January 1, 2008        |  | $                                                       | 4,421,149  |   |                      | $ | 2,091,007  |                  |  | $ | 3,712    |   |  | $ | 6,515,868  |  
|Net payments, purchases and sales |  |                                                         | (2,671     | ) |                      |   | (329,318   | )                |  |   | (1,000   | ) |  |   | (332,989   | )
|Net transfers in/(out)            |  |                                                         |           |   |                      |   |           |                  |  |   |         |   |  |   |           |  
|Gains/(losses) recorded in income |  |                                                         | (2,192,447 | ) |                      |   | (1,017,142 | )                |  |   | (2,082   | ) |  |   | (3,211,671 | )
|                                  |  |                                                         |            |   |                      |   |            |                  |  |   |          |   |  |   |            |  
|Balance at September 30, 2008     |  | $                                                       | 2,226,031  |   |                      | $ | 744,547    |                  |  | $ | 630      |   |  | $ | 2,971,208  |  
|                                  |  |                                                         |            |   |                      |   |            |                  |  |   |          |   |  |   |            |  
|                                  |  |                                                         |            |  
|Liabilities                       |  | TruPS CDONotes Payable                                  |            |   | MBS CDONotes Payable |   |            | TruPSObligations |  |   | Total    |  
|Balance at January 1, 2008        |  | $                                                       | 4,009,015  |   |                      | $ | 2,027,682  |                  |  | $ | 303,595  |   |  | $ | 6,340,292  |  
|Net Payments, purchases and sales |  |                                                         | (28,738    | ) |                      |   | (318,138   | )                |  |   | 3,000    |   |  |   | (343,876   | )
|Net Transfers In/(Out)            |  |                                                         |           |   |                      |   |           |                  |  |   |         |   |  |   |           |  
|(Gains)/Losses Recorded in income |  |                                                         | (2,186,468 | ) |                      |   | (1,012,228 | )                |  |   | (153,935 | ) |  |   | (3,352,631 | )
|                                  |  |                                                         |            |   |                      |   |            |                  |  |   |          |   |  |   |            |  
|Balance at September 30, 2008     |  | $                                                       | 1,793,809  |   |                      | $ | 697,316    |                  |  | $ | 152,660  |   |  | $ | 2,643,785  |  
|                                  |  |                                                         |            |   |                      |   |            |                  |  |   |          |   |  |   |            |  



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NOTE 4: INVESTMENTS IN DEBT SECURITIES

The following table summarizes the Companys investments in debt securities and security-related receivables as of September 30, 2008:



|                                                                   |  |               |           |                         |   |            |                     |  |                       |           |  |                                  |   |  |     
|------------------------------------------------------------------ |  | ------------- | --------- | ----------------------- | - | ---------- | ------------------- |  | --------------------- | --------- |  | -------------------------------- | - |  | ----
|Investment Description                                             |  | AmortizedCost |           | Net Change inFair Value |   |            | EstimatedFair Value |  | WeightedAverageCoupon |           |  | Weighted-AverageYears toMaturity
|TruPS and subordinated debentures and security-related receivables |  | $             | 5,543,044 |                         | $ | (3,317,013 | )                   |  | $                     | 2,226,031 |  | 5.8                              | % |  | 27.6
|MBS                                                                |  |               | 2,054,468 |                         |   | (1,309,921 | )                   |  |                       | 744,547   |  | 3.8                              | % |  | 6.5 
|Other investments                                                  |  |               | 630       |                         |   |           |                     |  |                       | 630       |  |                                 |   |  | 6.7 
|                                                                   |  |               |           |                         |   |            |                     |  |                       |           |  |                                  |   |  |     
|Total                                                              |  | $             | 7,598,142 |                         | $ | (4,626,934 | )                   |  | $                     | 2,971,208 |  | 5.2                              | % |  | 21.9
|                                                                   |  |               |           |                         |   |            |                     |  |                       |           |  |                                  |   |  |     

TruPS shown above include (a) investments in TruPS issued by Trust VIEs of which the Company
is not the primary beneficiary and which the Company does not consolidate and (b) transfer of investments in TruPS to the Company that were accounted for as a sale pursuant to SFAS No. 140. Subordinated debentures included above represent
the primary assets of Trust VIEs that the Company consolidates pursuant to FIN 46R.

The Companys investments in security-related
receivables represent securities owned by CDO entities that are collateralized by TruPS and subordinated debentures owned by a consolidated subsidiary where the transfers are accounted for as financings under SFAS No. 140. These transactions
are accounted for as financings due to certain constraints that limit further pledging or exchanging of the assets and the continuing involvement of investment banks with each of these transactions. As of September 30, 2008, the Companys
consolidated financial statements included $390.8 million of security-related receivables held at fair value.

As of September 30,
2008, the aggregate principal amount of investments in the 25 TruPS investments that have defaulted or are currently deferring interest payments is $490.5 million, representing approximately 9.5% of the Companys combined TruPS portfolio. As of
September 30, 2008, the $162.5 million of defaulted securities, which includes securities issued by IndyMac Bancorp, have been completely written-off in the Companys consolidated financial statements. For the three-months ended
September 30, 2008, investment interest income is net of a $6.2 million reserve for interest income related to the $490.5 million of currently deferring or defaulted securities.

The TruPS deferrals and defaults described above have resulted in the over-collateralization tests being triggered in all eight CDOs in which the Company
holds equity interests. The trigger of an over-collateralization test in a TruPS CDO means that the Company, as a holder of equity securities, will not receive current distributions of cash in respect of its equity interests until sufficient cash or
collateral is retained in the CDOs to cure the over-collateralization tests.



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##### Table of Contents

The following table summarizes ratings of the MBS investments held by consolidated Kleros Real Estate
CDOs (categorized based on fair value as of September 30, 2008 as rated by Standard & Poors (S&P) as of October 2008):



|                    |  |                            |         |                                 |       |   |                                         |   |                                |  |       |                                        |  |                                   |       |  |       |  
|------------------- |  | -------------------------- | ------- | ------------------------------- | ----- | - | --------------------------------------- | - | ------------------------------ |  | ----- | -------------------------------------- |  | --------------------------------- | ----- |  | ----- | -
|S&P Rating Category |  | TotalMBS perRatingCategory |         | % of TotalMBS perRatingCategory |       |   | Amount ofSubprime perRatingCategory (1) |   | % ofSubprime perRatingCategory |  |       | Amount ofSecond-Lien perRatingCategory |  | % ofSecond-Lien perRatingCategory |      
|                    |  | (dollars in thousands)     |        
|AAA                 |  | $                          | 360,306 |                                 | 48.4  | % |                                         | $ | 6,252                          |  | 5.1   | %                                      |  | $                                 |      |  | 0.0   | %
|AA+                 |  |                            | 83,579  |                                 | 11.2  | % |                                         |   | 37,293                         |  | 30.3  | %                                      |  |                                   |      |  | 0.0   | %
|AA                  |  |                            | 96,206  |                                 | 12.9  | % |                                         |   | 11,215                         |  | 9.1   | %                                      |  |                                   |      |  | 0.0   | %
|AA-                 |  |                            | 26,927  |                                 | 3.6   | % |                                         |   | 6,994                          |  | 5.7   | %                                      |  |                                   |      |  | 0.0   | %
|A+                  |  |                            | 20,012  |                                 | 2.7   | % |                                         |   | 9,828                          |  | 8.0   | %                                      |  |                                   | 735   |  | 19.8  | %
|A                   |  |                            | 29,334  |                                 | 3.9   | % |                                         |   | 10,005                         |  | 8.1   | %                                      |  |                                   |      |  | 0.0   | %
|A-                  |  |                            | 1,338   |                                 | 0.2   | % |                                         |   | 618                            |  | 0.5   | %                                      |  |                                   |      |  | 0.0   | %
|BBB+                |  |                            | 493     |                                 | 0.1   | % |                                         |   | 201                            |  | 0.2   | %                                      |  |                                   |      |  | 0.0   | %
|BBB                 |  |                            | 30,603  |                                 | 4.1   | % |                                         |   | 5,432                          |  | 4.4   | %                                      |  |                                   | 215   |  | 5.8   | %
|BBB-                |  |                            | 124     |                                 | 0.1   | % |                                         |   |                               |  | 0.0   | %                                      |  |                                   | 124   |  | 3.4   | %
|BB+ and below       |  |                            | 95,625  |                                 | 12.8  | % |                                         |   | 35,233                         |  | 28.6  | %                                      |  |                                   | 2,632 |  | 71.0  | %
|                    |  |                            |         |                                 |       |   |                                         |   |                                |  |       |                                        |  |                                   |       |  |       |  
|Total               |  | $                          | 744,547 |                                 | 100.0 | % |                                         | $ | 123,071                        |  | 100.0 | %                                      |  | $                                 | 3,706 |  | 100.0 | %
|                    |  |                            |         |                                 |       |   |                                         |   |                                |  |       |                                        |  |                                   |       |  |       |  



|(1) | We generally consider a loan to a borrower with a FICO score of less than 625 to be a subprime loan.
|--- | ----------------------------------------------------------------------------------------------------

As previously disclosed, we received written notice from the trustees of Kleros Real Estate I, II, and III that each CDO experienced an event of default.
On October 30, 2008, we received written notice from the trustee of Kleros Real Estate IV that the CDO has experienced an event of default. These events of default resulted from the failure of certain additional over-collateralization tests
primarily due to credit rating agency downgrades. The events of default provide the controlling class debtholder in each CDO with the option to liquidate all of the MBS assets collateralizing the particular CDO. The proceeds of any such liquidation
would be used to repay the controlling class debtholder. As of the current date, the controlling class debtholders of Kleros Real Estate I, II and IV have not exercised their rights to liquidate either CDO. As previously disclosed, Kleros Real
Estate III was liquidated in June 2008. Since the Company is not receiving any cash flow from its investments in any of the Kleros Real Estate CDOs, the events of default described above do not have any further impact on the Companys cash
flows. However, the assets of the Kleros Real Estate I, II and IV CDOs and the income they generate for tax purposes are a component of the Companys REIT qualifying assets and income. If more than one of the three remaining Kleros Real Estate
CDOs is liquidated, the Company may have to deploy additional capital into REIT qualifying assets in order to continue to qualify as a REIT. If the Company is not able to invest in sufficient other REIT qualifying assets, its ability to qualify as a
REIT could be materially adversely affected.

Substantially all of the Companys investments in TruPS, subordinated debentures and MBS
collateralize debt issued through consolidated CDO entities, consolidated Trust VIEs, or warehouse credit facilities. Consolidated CDO entities are generally subject to an indenture which dictates substantially all of the operating activities of the
CDO. These indentures generally require that certain credit quality and over-collateralization tests are met. To the extent a CDO fails to pass such tests, cash flows from the assets may be directed to be used to repay the CDO debt obligations. The
assets of the Companys consolidated CDOs collateralize the debt of such entities and are not available to the Companys general creditors. Similarly, the debt of such entities is not recourse to the Company.



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NOTE 5: LOANS

The Companys investments in loans are accounted for at amortized cost. The following table summarizes the Companys investments in loans as of September 30, 2008:



|                                          |  |                        |           |                               |   |        |                |  |                |           |                              |       |  |                                         |   |  |          
|----------------------------------------- |  | ---------------------- | --------- | ----------------------------- | - | ------ | -------------- |  | -------------- | --------- | ---------------------------- | ----- |  | --------------------------------------- | - |  | ---------
|                                          |  | UnpaidPrincipalBalance |           | UnamortizedPremium/(Discount) |   |        | CarryingAmount |  | Numberof Loans |           | Weighted-AverageInterestRate |       |  | Weighted-AverageContractualMaturityDate
|                                          |  | (dollars in thousands)
|5/1Adjustable rate
residential mortgages  |  | $                      | 630,891   |                               | $ | 5,517  |                |  | $              | 636,408   |                              | 1,561 |  | 6.3                                     | % |  | July 2036
|7/1Adjustable rate
residential mortgages  |  |                        | 220,561   |                               |   | 3,019  |                |  |                | 223,580   |                              | 518   |  | 6.6                                     | % |  | Dec 2036 
|10/1Adjustable rate
residential mortgages |  |                        | 71,851    |                               |   | 1,180  |                |  |                | 73,031    |                              | 190   |  | 6.7                                     | % |  | Sept 2036
|Commercial loan                           |  |                        | 7,464     |                               |   |       |                |  |                | 7,464     |                              | 1     |  | 21.0                                    | % |  |         
|Leveraged loans                           |  |                        | 882,508   |                               |   | (5,417 | )              |  |                | 877,091   |                              | 422   |  | 6.8                                     | % |  | Apr 2013 
|                                          |  |                        |           |                               |   |        |                |  |                |           |                              |       |  |                                         |   |  |          
|Total                                     |  | $                      | 1,813,275 |                               | $ | 4,299  |                |  | $              | 1,817,574 |                              | 2,692 |  | 6.6                                     | % |  | (1)      
|                                          |  |                        |           |                               |   |        |                |  |                |           |                              |       |  |                                         |   |  |          



|(1) | Weighted-average interest rate excludes non-interest accruing commercial loan.
|--- | ------------------------------------------------------------------------------

The Company maintains an allowance for loan losses based on managements evaluation of known losses and inherent risks in the portfolios, which considers historical and industry loss experience, economic
conditions and trends, estimated fair values and the quality of collateral and other relevant quantitative and qualitative factors. Specific allowances for losses are established for potentially impaired loans based on a comparison of the recorded
carrying value of the loan to either the present value of the loans expected cash flow, the loans estimated market price or the estimated fair value of the underlying collateral. The allowance is increased by charges to operations and
decreased by charge-offs (net of recoveries). As of September 30, 2008, the Company maintained an allowance for loan losses of $46.4 million. As of September 30, 2008, the Company has placed $46.2 million of residential mortgage loans on
non-accrual status.

The following table summarizes the delinquency statistics of the Companys residential mortgage loans as of
September 30, 2008 (dollar amounts in thousands):



|                   |  |                |  |                 |        
|------------------ |  | -------------- |  | --------------- | -------
|Delinquency Status |  | Numberof Loans |  | PrincipalAmount
|30 to 59 days      |  | 63             |  | $               | 24,838 
|60 to 89 days      |  | 26             |  |                 | 11,354 
|90 days or more    |  | 199            |  |                 | 77,685 
|                   |  |                |  |                 |        
|Total              |  | 288            |  | $               | 113,877
|                   |  |                |  |                 |        

During the three and nine-month period ended September 30, 2008, the Company foreclosed on 18
and 48 residential mortgage loans with fair values of $4.8 million and $11.7 million, respectively, which are classified as real estate owned (REO). The Company records REO property at fair value within other assets in its consolidated balance
sheet. During the three and nine-month period ended September 30, 2008, the Company recorded charge-offs of $1.7 million and $7.7 million, respectively, as a result of foreclosing on these properties. As of September 30, 2008, the Company
had $12.1 million of REO property recorded within other assets in the consolidated financial statements.

As of September 30, 2008,
approximately $921.2 million of the principal amount of the Companys residential mortgages was pledged as collateral for securitized mortgage debt. In addition, substantially all of the carrying value of the Companys leveraged loan
portfolio is pledged as collateral for CLO notes payable or warehouse credit facility financing. The mortgage securitization, the CLOs and the warehouse facilities are each structured such that the Company is at risk for the first dollar losses
sustained in the respective portfolios, limited to the Companys equity investment.

As of September 30, 2008, 47.2% of the
carrying value of the Companys residential mortgages were concentrated in residential mortgages collateralized by property in California.



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NOTE 6: INDEBTEDNESS

The following table summarizes the Companys total indebtedness as of September 30, 2008 (includes recourse and non-recourse indebtedness):



|                                |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|------------------------------- |  | ------------- | --------- | ----------------------- | - | ---------- | -------------- |  | ------------------ | --------- | ------------------------------------ | ------------ |  | ----------------------------------- | - |  | --------
|Description                     |  | AmortizedCost |           | Net Changein Fair Value |   |            | CarryingAmount |  | Interest RateTerms |           | CurrentWeighted-AverageInterest Rate |              |  | Weighted-AverageContractualMaturity
|Non-recourse indebtedness:      |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|Trust preferred obligations     |  | $             | 385,600   |                         | $ | (232,940   | )              |  | $                  | 152,660   |                                      | 5.5% to 8.7% |  | 6.5                                 | % |  | Oct 2036
|Securitized mortgage debt       |  |               | 866,004   |                         |   |           |                |  |                    | 866,004   |                                      | 5.0% to 6.0% |  | 5.7                                 | % |  | Mar 2017
|CDO notes payable (1)           |  |               | 8,462,610 |                         |   | (5,276,155 | )              |  |                    | 3,186,455 |                                      | 2.7% to 7.9% |  | 3.3                                 | % |  | Apr 2039
|Warehouse credit facilities     |  |               | 133,206   |                         |   |           |                |  |                    | 133,206   |                                      | 4.2%         |  | 4.2                                 | % |  | May 2009
|                                |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|Total non-recourse indebtedness |  | $             | 9,847,420 |                         | $ | (5,509,095 | )              |  | $                  | 4,338,325 |                                      |              |  |                                     |   |  |         
|                                |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|Recourse indebtedness:          |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|Junior subordinated debentures  |  | $             | 49,614    |                         |   |           |                |  | $                  | 49,614    |                                      | 7.0% to 9.5% |  | 8.8                                 | % |  | Aug 2036
|Contingent convertible debt     |  |               | 61,179    |                         |   |           |                |  |                    | 61,179    |                                      | 7.6%         |  | 7.6                                 | % |  | May 2027
|                                |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|Total recourse indebtedness     |  | $             | 110,793   |                         |   |           |                |  | $                  | 110,793   |                                      |              |  |                                     |   |  |         
|                                |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         
|Total indebtedness              |  | $             | 9,958,213 |                         | $ | (5,509,095 | )              |  | $                  | 4,449,118 |                                      |              |  |                                     |   |  |         
|                                |  |               |           |                         |   |            |                |  |                    |           |                                      |              |  |                                     |   |  |         



|(1) | Excludes CDO notes payable purchased by the Company which are eliminated in consolidation. Carrying amount includes $2,491,125 of liabilities at fair value.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

Recourse indebtedness refers to indebtedness that is recourse to the general assets of the Company. During the three-month
period ended September 30, 2008, the Company repurchased and retired $78.8 million par value of its outstanding convertible debt securities for $33.0 million. The Company realized a gain of $43.9 million on these transactions, net of a $1.9
million write-off of related deferred costs. Subsequent to September 30, 2008, the Company repurchased and retired an additional $32.5 million par value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7
million principal amount of the Companys contingent convertible debt securities remains outstanding. The holders of the Companys remaining $28.7 million aggregate principal amount of convertible debt will have the right to require us to
repurchase their notes at 100% of their principal amount together with accrued but unpaid interest thereon if, among other things, the Companys common stock ceases to be listed on the NYSE, another established national securities exchange or
an automated over-the-counter trading market in the United States.

Non-recourse indebtedness consists of indebtedness of consolidated VIEs
(i.e. CDOs, CLOs and other securitization vehicles) which is recourse only to specific assets pledged as collateral to the lenders. The creditors of each consolidated VIE have no recourse to the general credit of the Company. As of
September 30, 2008, the Companys maximum exposure to economic loss as a result of its involvement with each VIE is the $460.7 million of capital that the Company has invested in warehouse first-loss deposits and the preference shares or
debt of the CDO, CLO or other types of securitization structures. None of the indebtedness shown in the table above subjects the Company to potential margin calls for additional pledges of cash or other assets.



|(a) | Repurchase agreements
|--- | ---------------------

As of
September 30, 2008, the Company is not financing any investments with short-term repurchase agreements that subject the Company to margin calls or potential recourse obligations in excess of posted first loss deposits.



|(b) | Trust preferred obligations
|--- | ---------------------------

Trust preferred
obligations finance subordinated debentures acquired by Trust VIEs that are consolidated by the Company for the portion of the total TruPS that are owned by entities outside of the consolidated group. These trust preferred obligations bear interest
at either variable or fixed rates until maturity, generally 30 years from the date of issuance. The Trust VIE has the ability to prepay the trust preferred obligation at any time, without prepayment penalty, after five years. The Company does not
control the timing or ultimate payment of the trust preferred obligations. Effective January 1, 2008, the Company has elected the fair value option pursuant to SFAS No. 159 for trust preferred obligations.



|(c) | CDO notes payable
|--- | -----------------

CDO notes payable
represent notes payable issued by CDO entities used to finance the acquisition of TruPS, MBS, and leveraged loans. Substantially all of the TruPS collateralizing CDO notes payable are obligations of banks, bank holding companies



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and insurance companies. The obligors under the leveraged loans come from a variety of industries. Generally, CDO notes payable are comprised of various
classes of notes payable, with each class bearing interest at variable or fixed rates. Effective January 1, 2008, the Company has elected the fair value option pursuant to SFAS No. 159 for TruPS and MBS CDO notes payable.



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|(d) | Warehouse Credit Facilities
|--- | ---------------------------

As of
September 30, 2008, the Companys consolidated financial statements included $133.2 million of warehouse credit facility debt in the form of short term notes payable. Warehouse credit facility debt relates to on-balance sheet warehouse
facilities entered into by a subsidiary of the Company utilized to finance the acquisition of leveraged loans on a short-term basis until longer-term financing is available. The Companys maximum economic exposure to loss on the warehouse
credit facility is limited to the amount of capital that the Company has invested pursuant to the terms of the arrangement. As of September 30, 2008, the Company has invested $40.8 million of capital in this financing arrangement, which
provides for $200 million of total borrowing capacity and bears interest of 125 basis points over the daily commercial paper rate and matures in May 2009.

NOTE 7: DERIVATIVE FINANCIAL INSTRUMENTS

The Company and the VIEs included in the Companys consolidated financial
statements may use derivative financial instruments to hedge all or a portion of the interest rate risk associated with its borrowings. The principal objective of such arrangements is to minimize the risks and/or costs associated with certain
operating and financial structures as well as to hedge specific anticipated transactions. The counterparties to these contractual arrangements are major financial institutions with which the Company and its consolidated VIEs may also have other
financial relationships. In the event of nonperformance by the counterparties, the Company and its consolidated VIEs are potentially exposed to credit loss. The Company does not anticipate that any of the counterparties will fail to meet their
obligations. As of September 30, 2008 and through the date of this filing, the Company does not have any direct counterparty risk as all derivative contracts are included within its consolidated VIE entities.

The table below summarizes the aggregate notional amount and estimated net fair value of the Companys derivative instruments which are included in
other liabilities (amounts in thousands):



|                       |  |                          |           |                |   |          |  
|---------------------- |  | ------------------------ | --------- | -------------- | - | -------- | -
|                       |  | As of September 30, 2008 |          
|                       |  | Notional                 |           | Net Fair Value |  
|Interest Rate Related: |  |                          |           |                |   |          |  
|Interest rate swaps    |  | $                        | 1,815,359 |                | $ | (114,613 | )
|Basis swaps            |  |                          | 385,000   |                |   | (1,046   | )
|                       |  |                          |           |                |   |          |  
|Total                  |  | $                        | 2,200,359 |                | $ | (115,659 | )
|                       |  |                          |           |                |   |          |  

The following table summarizes by derivative instrument type the effect on income for the
following periods (amounts in thousands):



|                                                          |  |                                                                     |        |   |                                                                                               |   |         |                                                                     |  |                                                                                               |       |  |   |        |  
|--------------------------------------------------------- |  | ------------------------------------------------------------------- | ------ | - | --------------------------------------------------------------------------------------------- | - | ------- | ------------------------------------------------------------------- |  | --------------------------------------------------------------------------------------------- | ----- |  | - | ------ | -
|                                                          |  | For the nine-month period endedSeptember 30,
2008                   |        |   | For the nine-month period endedSeptember 30,
2007                                             |  
|Type of Derivative                                        |  | Amounts Reclassifiedto Earnings
forEffective Hedges Gains (Losses) |        |   | AmountsReclassified toEarnings forHedgeIneffectiveness &Non-HedgedDerivatives Gains (Losses) |   |         | Amounts Reclassifiedto Earnings
forEffective Hedges Gains (Losses) |  | AmountsReclassified toEarnings forHedgeIneffectiveness &Non-HedgedDerivatives Gains (Losses) |      
|Interest rate swaps                                       |  | $                                                                   | (5,535 | ) |                                                                                               | $ | (82,788 | )                                                                   |  | $                                                                                             | 2,259 |  | $ | (3,094 | )
|Basis swaps                                               |  |                                                                     |       |   |                                                                                               |   | (567    | )                                                                   |  |                                                                                               |      |  |   | 384    |  
|Warehouse financing arrangements                          |  |                                                                     |       |   |                                                                                               |   |        |                                                                     |  |                                                                                               |      |  |   | 106    |  
|Credit default swaps                                      |  |                                                                     |       |   |                                                                                               |   | 17,115  |                                                                     |  |                                                                                               |      |  |   | 45,244 |  
|                                                          |  |                                                                     |        |   |                                                                                               |   |         |                                                                     |  |                                                                                               |       |  |   |        |  
|Net realized and unrealized gains (losses) on derivatives |  | $                                                                   | (5,535 | ) |                                                                                               | $ | (66,240 | )                                                                   |  | $                                                                                             | 2,259 |  | $ | 42,640 |  
|                                                          |  |                                                                     |        |   |                                                                                               |   |         |                                                                     |  |                                                                                               |       |  |   |        |  



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|                                                          |  |                                                                     |        |   |                                                                                               |   |         |                                                                     |  |   |                                                                                               |   |  |   |        |  
|--------------------------------------------------------- |  | ------------------------------------------------------------------- | ------ | - | --------------------------------------------------------------------------------------------- | - | ------- | ------------------------------------------------------------------- |  | - | --------------------------------------------------------------------------------------------- | - |  | - | ------ | -
|                                                          |  | For the three-month period endedSeptember 30,
2008                  |        |   | For the three-month period endedSeptember 30,
2007                                            |  
|Type of Derivative                                        |  | Amounts Reclassifiedto Earnings
forEffective Hedges Gains (Losses) |        |   | AmountsReclassified toEarnings forHedgeIneffectiveness &Non-HedgedDerivatives Gains (Losses) |   |         | Amounts Reclassifiedto Earnings
forEffective Hedges Gains (Losses) |  |   | AmountsReclassified toEarnings forHedgeIneffectiveness &Non-HedgedDerivatives Gains (Losses) |  
|Interest rate swaps                                       |  | $                                                                   | (1,495 | ) |                                                                                               | $ | (23,869 | )                                                                   |  | $ | (787                                                                                          | ) |  | $ | (6,191 | )
|Basis swaps                                               |  |                                                                     |       |   |                                                                                               |   | (603    | )                                                                   |  |   |                                                                                              |   |  |   | 537    |  
|Warehouse financing arrangements                          |  |                                                                     |       |   |                                                                                               |   |        |                                                                     |  |   |                                                                                              |   |  |   | (1,659 | )
|Credit default swaps                                      |  |                                                                     |       |   |                                                                                               |   |        |                                                                     |  |   |                                                                                              |   |  |   | 33,408 |  
|                                                          |  |                                                                     |        |   |                                                                                               |   |         |                                                                     |  |   |                                                                                               |   |  |   |        |  
|Net realized and unrealized gains (losses) on derivatives |  | $                                                                   | (1,495 | ) |                                                                                               | $ | (24,472 | )                                                                   |  | $ | (787                                                                                          | ) |  | $ | 26,095 |  
|                                                          |  |                                                                     |        |   |                                                                                               |   |         |                                                                     |  |   |                                                                                               |   |  |   |        |  

During the nine-month period ended September 30, 2008, the change in fair value of derivative
contracts included the impact of the reclassification to the income statement of $40.6 million of cash flow hedge losses that were previously recorded in accumulated other comprehensive loss. The reclassifications resulted from the Companys
determination that the forecasted transactions that the instruments hedge are no longer probable of occurring due to the likelihood of or actual liquidation of our Kleros Real Estate I, II and III portfolios.

Cash Flow Hedges

The Company enters into
various interest rate swap contracts to hedge interest rate exposure relating to CDO notes payable and warehouse credit facilities that are used to finance investments in our target asset classes.

The Company may designate interest rate swap contracts as cash flow hedges at inception and determine at each reporting period whether or not the
interest rate swap contracts are highly effective in offsetting interest rate fluctuations associated with the identified indebtedness. Certain of the Companys interest rate swap contracts were not designated as interest rate hedges at
inception, therefore the change in fair value during the period in which the interest rate swap contracts were not designated as hedges was recorded as an unrealized gain (loss) on interest rate swap contracts in the consolidated statements of
income (loss). Effective January 1, 2008, we adopted the fair value option under SFAS No. 159 for our TruPS and MBS CDO notes payable and therefore, have discontinued hedge accounting for all of the interest rate swaps associated with
those transactions.

Credit Default Swaps

During June 2008, the Company sold the subsidiary that owned $87.5 million notional of CDS positions for $70.4 million in proceeds. Following the June 2008 sale, the Company no longer holds any investments in CDS.

NOTE 8: EARNINGS (LOSS) PER SHARE

The
following table presents a reconciliation of basic and diluted earnings per share for the following periods (dollars in thousands, except per share data):



|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  
|----------------------------------------------------------------- |  | ------------------------------------------------- | ---------- | ------------------------------------------------- | - | ---------- | ------------------------------------------------ |  | ------------------------------------------------ | ---------- |  | - | ---------- | -
|                                                                  |  | For the three-monthperiod
endedSeptember 30, 2008 |            | For the three-monthperiod
endedSeptember 30, 2007 |   |            | For the nine-monthperiod
endedSeptember 30, 2008 |  | For the nine-monthperiod
endedSeptember 30, 2007 |           
|Net income (loss)                                                 |  | $                                                 | 64,054     |                                                   | $ | (496,604   | )                                                |  | $                                                | 67,736     |  | $ | (532,043   | )
|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  
|Weighted-average common shares outstandingBasic                  |  |                                                   | 59,660,289 |                                                   |   | 59,425,920 |                                                  |  |                                                  | 59,470,678 |  |   | 55,456,088 |  
|Unvested restricted common shares under the treasury stock method |  |                                                   |           |                                                   |   |           |                                                  |  |                                                  |           |  |   |           |  
|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  
|Weighted-average shares outstandingDiluted                       |  |                                                   | 59,660,289 |                                                   |   | 59,425,920 |                                                  |  |                                                  | 59,470,678 |  |   | 55,456,088 |  
|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  
|Earnings (loss) per shareBasic                                   |  | $                                                 | 1.07       |                                                   | $ | (8.36      | )                                                |  | $                                                | 1.14       |  | $ | (9.59      | )
|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  
|Earnings (loss) per shareDiluted                                 |  | $                                                 | 1.07       |                                                   | $ | (8.36      | )                                                |  | $                                                | 1.14       |  | $ | (9.59      | )
|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  
|Anti-dilutive shares                                              |  |                                                   | 693,199    |                                                   |   | 250,645    |                                                  |  |                                                  | 25,277     |  |   | 859,205    |  
|                                                                  |  |                                                   |            |                                                   |   |            |                                                  |  |                                                  |            |  |   |            |  

Shares of vested restricted common stock are included in basic weighted-average common shares and
shares of unvested restricted common stock are included in the diluted weighted-average shares under the treasury stock method, unless anti-dilutive.



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NOTE 9: MANAGEMENT AGREEMENT AND RELATED PARTY TRANSACTIONS

The Companys Chairman of the Board and other officers serve as executive officers of Cohen & Company, of which the manager is an affiliate.
The manager handles the Companys day-to-day operations, provides the Company with office facilities, and administers the Companys business activities through the resources of Cohen & Company. The management agreement was
executed on January 31, 2006 between the manager and Alesco Financial Trust and, upon the closing of the merger on October 6, 2006, the Company assumed the management agreement. The initial term expires on December 31, 2008 and shall
be automatically renewed for a one-year term on each anniversary date thereafter unless two-thirds of the independent directors or the holders of at least a majority of the outstanding shares of common stock vote not to automatically renew the
management agreement.

The management agreement provides, among other things, that in exchange for managing the day-to-day operations and
administering the business activities of the Company, the manager is entitled to receive from the Company certain fees and reimbursements, consisting of a base management fee, an incentive fee based on certain performance criteria, reimbursement for
certain operating expenses as defined in the management agreement, and a termination fee if the Company decides to terminate the management agreement without cause or if the manager terminates the management agreement due to the Companys
default. The base management fee and the incentive fee otherwise payable by the Company to the manager pursuant to the management agreement are reduced by the Companys proportionate share of the amount of any CDO and CLO collateral management
fees that are paid to Cohen & Company and its affiliates in connection with the CDOs and CLOs in which the Company invests, based on the percentage of equity it holds in such CDOs and CLOs.

During the three-month period ended September 30, 2008 and 2007, the Company incurred base and incentive management fees, net of asset management
fee credits, of $2.7 million and $0, respectively. The Company recognized stock-based compensation expense of $0.1 million and $0.4 million related to restricted common stock granted to the officers of the Company and key employees of the manager
and Cohen & Company during the three-month period ended September 30, 2008 and 2007, respectively.

During the nine-month
period ended September 30, 2008 and 2007, the Company incurred base and incentive management fees, net of asset management fee credits, of $2.7 million and $0, respectively. The Company recognized stock-based compensation expense of $0.9
million and $1.4 million related to restricted common stock granted to the officers of the Company and key employees of the manager and Cohen & Company during the nine-month period ended September 30, 2008 and 2007, respectively.

During the three-month period ended September 30, 2008 and 2007, the consolidated CDO entities that are included in the
Companys consolidated financial statements incurred collateral management fees that are payable to Cohen & Company of $4.0 million and $4.5 million, respectively. Due to the failure of overcollateralization tests in certain of our
CDOs, the manager was not paid $0.8 million of subordinate CDO manager fees that were accrued in the consolidated financial statements for the three-months ended September 30, 2008. These accrued liabilities are due and payable to the manager
once the overcollateralization tests are in compliance with the respective CDO indentures. During the three-month period ended September 30, 2008 and September 30, 2007, Cohen & Company earned origination, structuring and
placement fees of $0.3 million and $6.3 million, respectively, relating to services provided to warehouse facilities and CDOs that the Company is invested in. In addition, during the same periods, Cohen & Company received $14 thousand and
$35 thousand, respectively, from warehouse facilities and consolidated CDO entities as reimbursement for origination expenses paid to third parties.

During the nine-month period ended September 30, 2008 and 2007, the consolidated CDO entities that are included in the Companys consolidated financial statements incurred collateral management fees that are
payable to Cohen & Company of $12.1 million and $11.2 million, respectively. During the same periods, Cohen & Company earned origination, structuring and placement fees of $1.7 million and $16.7 million, respectively, relating to
services provided to warehouse facilities and CDOs that the Company is invested in. In addition, during the same periods, Cohen & Company received $57 thousand and $10.2 million, respectively, from warehouse facilities and consolidated CDO
entities as reimbursement for origination expenses paid to third parties.

Base management fees and incentive fees incurred, stock-based
compensation expense relating to shares of restricted common stock granted to the manager, and collateral management fees paid to Cohen & Company are included in related party management compensation on the consolidated statements of
income. Expenses incurred by the manager and reimbursed by the Company are reflected in the respective consolidated statement of income non-investment expense category based on the nature of the expense.

NOTE 10: COMMITMENTS AND CONTINGENCIES AND OTHER MATTERS

Commitments

The leveraged loan CLO vehicles consolidated by the Company are committed to purchase interests in debt
obligations of corporations, partnerships and other entities in the form of participations in leveraged loans, which obligate the CLO vehicle to acquire a predetermined interest in such leveraged loans at a specified price on a to-be determined
settlement date. As of September 30, 2008, the consolidated CLO vehicles had committed to fund approximately $15.5 million of leveraged loans. The CLO vehicles will use amounts currently included in restricted cash to fund these purchases.



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As of September 30, 2008, the consolidated CDO and CLO entities have requirements to purchase $40.1
million of additional collateral assets in order to complete the accumulation of the required amount of collateral assets. Of this amount, $29.7 million has already been advanced to consolidated CDOs and CLOs through CDO and CLO notes payable and is
included within restricted cash on the consolidated balance sheet as of September 30, 2008.

Contingencies

The Company is party to various legal proceedings which arise in the ordinary course of business. The Company is not currently involved in any litigation
nor, to our knowledge, is any litigation threatened against us, the outcome of which would, in our judgment based on information currently available to us, have a material adverse effect on our financial position or results of operations.

NOTE 11: SUBSEQUENT EVENTS

On
October 10, 2008, the Company was notified by the NYSE that it was not in compliance with an NYSE continued listing standard applicable to its common stock. The standard requires that the average closing price of any listed security not fall
below $1.00 per share for any consecutive 30 trading-day period. On October 15, 2008, the Company notified the NYSE of its intent to cure this deficiency. Under the NYSE rules, the Company has six months from the date of the NYSE notice to
comply with the NYSE minimum share price standard. If the Company is not compliant by that date, its common stock will be subject to suspension and delisting by the NYSE. The Company is currently exploring alternatives for curing the deficiency and
restoring compliance with the continued listing standards. The Companys common stock remains listed on the NYSE under the symbol AFN.



|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
|------- | --------------------------------------------------------------------------------------

Certain statements contained in this Quarterly Report on Form 10-Q, including without limitation statements regarding the objectives of management for
future operations and statements containing the words believe, may, will, estimate, continue, anticipate, intend, expect and similar expressions,
constitute forward-looking statements within the meaning of the federal securities laws. Such forward-looking statements are subject to known and unknown risks, uncertainties and assumptions which may cause actual results, performance or
achievements to differ materially from those anticipated or implied by the forward-looking statements. These risks include our failure to successfully execute our business plan, continued disruption in the U.S. credit markets generally and the
mortgage loan and CDO markets particularly, our inability to gain access to additional financing, the limited availability of additional investment portfolios for future acquisition, performance of our existing investments, our failure to maintain
REIT status, our ability to restore compliance with NYSE continued listing standards, or, in the event that we are unable to maintain our listing with the NYSE, our ability to comply with the initial listing standards of the NYSE or another
securities exchange, the cost of capital, as well as the additional risks and uncertainties detailed in our periodic reports and registration statements filed with the Securities and Exchange Commission (SEC). We disclaim any obligation
to update any such statements or publicly announce any updates or revisions to any of the forward-looking statements contained herein to reflect any change in our expectation with regard thereto or any change in events, conditions, circumstances or
assumptions underlying such statements.

Managements discussion and analysis of financial condition and results of operations is
based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities,
revenues and expenses and related disclosures of contingent assets and liabilities. On a regular basis, we evaluate these estimates, including fair value of financial instruments and provision for loan losses. These estimates are based on historical
experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.

Overview

We are a specialty finance company that invests in multiple asset classes with the objective of generating
risk-adjusted returns and predictable cash distributions for our stockholders, subject to maintaining our status as a REIT under the Internal Revenue Code and our exemption from regulation under the Investment Company Act. We seek to achieve our
investment objectives by investing primarily in the following target asset classes:



| |  |  | subordinated debt financings originated by our manager or third parties, primarily in the form of TruPS issued by banks or bank holding companies and insurance
companies, and surplus notes issued by insurance companies;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | leveraged loans made to small and mid-sized companies in a variety of industries characterized by companies with relatively low volatility and overall leverage
compared to their industry peers, including the consumer products and manufacturing industries; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | mortgage loans, other real estate-related senior and subordinated debt securities, RMBS and CMBS.
| | - |  | -------------------------------------------------------------------------------------------------



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We may also invest opportunistically from time to time in other types of investments within our
mangers areas of expertise and experience, subject to maintaining our qualification as a REIT and our exemption from regulation under the Investment Company Act. Our investment guidelines do not impose any limitations on the type of assets in
which we may invest.

We are externally managed and advised by Cohen & Company Management, LLC, whom we refer to as our manager,
pursuant to a management agreement. Our manager is a wholly-owned subsidiary of Cohen Brothers, LLC, d/b/a Cohen & Company, an alternative investment management firm, which, since 2001, has provided financing to small and mid-sized
companies in financial services, real estate and other sectors.

In general, our investment strategy is to acquire investments in our
target asset classes on a short-term basis with on and off-balance sheet warehouse facilities or other short-term financing arrangements and finance these investments on a long-term basis with securitization vehicles, including CDOs and CLOs. Our
securitization strategies generally provide for match-funding of our assets and liabilities, which typically results in predictable net investment income over the financing term. We use a substantial amount of leverage to seek to enhance our
returns. Our ability to manage the cost of borrowings to finance our investments and our ability to obtain adequate financing will have a significant impact on our net investment income and business strategy.

As we have previously disclosed, we are evaluating strategic alternatives for our company. During the second and third quarters of 2008, we were able to
repurchase a significant percentage of our outstanding convertible debt securities at a discount, thereby substantially reducing our recourse indebtedness. We have also engaged in preliminary discussions regarding potential business combination
transactions and have entered into one or more confidentiality agreements in connection with preliminary due diligence investigations of the possible transactions. As of the date of this filing, we have no agreements or understandings in place
regarding any significant transactions, and it is possible we will not enter into any significant transactions in the near future.



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Impact of Market Events on Our Business

The credit markets in the United States began suffering significant disruption in the summer of 2007. This disruption began in the subprime residential
mortgage sector and extended to the broader credit and financial markets generally. During the third quarter of 2008, it became clear that the global economy has been adversely impacted by the credit crisis. Available liquidity, particularly through
asset-backed securities (ABS) CDOs and other securitizations, declined precipitously during the second half of 2007 and remains depressed as of the date of this filing. Concerns about the capital adequacy of financial services companies, disruptions
in global credit markets, volatility in commodities prices and continued pricing declines in the U.S. housing market have led to further disruptions in the financial markets, adversely affected regional banks and have exacerbated the longevity and
severity of the credit crisis. The disruption in these markets directly impacts our business because our investment portfolio includes investments in MBS, leveraged loans and bank and insurance company debt. We typically finance our investments with
on and off-balance sheet warehouse facilities and on-balance sheet CDOs and CLOs. In an effort to seek to offset losses in our investments, we began purchasing credit defaults swaps, or CDS, in 2007. As of the date of this filing, we do not hold any
investments in CDS.

Our MBS Investments

We invest in MBS through our Kleros Real Estate CDO subsidiaries and other non-consolidated CDO investments. In 2007 and continuing in 2008, the principal U.S. rating agencies downgraded large amounts of MBS, ABS and
debt securities of CDOs collateralized by MBS, including investments that are in our portfolio. Since we finance our investments in MBS through the issuance of equity and debt securities of CDOs, our exposure to losses on our consolidated MBS
portfolios is limited to our investments in such CDOs.

Our maximum loss from investments in MBS is limited to the $90 million that we
invested into the three remaining Kleros Real Estate CDOs. The CDOs are governed by indentures that provide us with no rights to the CDOs assets and provide the CDO noteholders with no recourse to us in respect of the debt securities issued by the
CDOs. We consolidate the Kleros Real Estate CDOs in accordance with Financial Accounting Standard Board (FASB) Interpretation No. 46R, Consolidation of Variable Interest Entities (FIN 46R), which requires
that we record the financial position and results of operations of the CDOs in our consolidated financial statements, without consideration that our maximum economic exposure to loss is $90 million. We have effectively written down our remaining $90
million equity investment in the Kleros Real Estate CDOs to zero.

During the second quarter of 2007, the Company began to purchase CDS
contracts referenced to certain MBS and CDOs that trade in the public markets. In June 2008, the Company sold the subsidiary that owned the remaining $87.5 million notional of CDS positions for $70.4 million in proceeds. Following the June 2008
sale, the Company no longer holds any investments in CDS.

As previously disclosed, the Kleros Real Estate CDOs have all failed
over-collateralization tests as a result of significant ratings agency downgrade activity and are no longer making cash distributions to the Company. The net cash flows of the Kleros Real Estate CDOs are currently being used to pay down the
controlling class debtholders in each of the Kleros Real Estate CDOs. Despite the fact that each Kleros Real Estate CDO has failed over-collateralization tests, the net interest earnings of these CDOs continues to be reflected in the Companys
net investment income and taxable income. Previously, we received written notice from the trustees of Kleros Real Estate I, II, and III that each CDO experienced an event of default. On October 30, 2008, we received written notice from the
trustee of Kleros Real Estate IV that the CDO has experienced an event of default. These events of default resulted from the failure of certain additional over-collateralization tests primarily due to credit rating agency downgrades. The events of
default provide the controlling class debtholder in each CDO with the option to liquidate all of the MBS assets collateralizing the particular CDO. The proceeds of any such liquidation would be used to repay the controlling class debtholder.

On May 1, 2008, the Company received written notice from the trustee of Kleros Real Estate III that the controlling class debtholder
had submitted a notice of liquidation. The liquidation of Kleros Real Estate III occurred in June 2008 through a series of auctions of the underlying collateral and the final distribution of the liquidation proceeds was delivered to the controlling
class debtholder in the same period. Upon the commencement of the liquidation process the Company determined that it was no longer the primary beneficiary of Kleros Real Estate III, and, in accordance with FIN 46(R), deconsolidated the Kleros Real
Estate III entity from its consolidated financial statements in June 2008. Additionally, the Company is no longer able to include the liquidated assets and the related income as a component of its REIT qualifying assets.

As of the current date, the controlling class debtholders of Kleros Real Estate I, II and IV have not exercised their rights to liquidate either CDO.
Since the Company is not receiving any cash flow from its investments in any of the Kleros Real Estate CDOs, the events of default and liquidation described above do not have any further impact on the Companys cash flows. However, the assets
of the Kleros Real Estate I, II and IV CDOs and the income they generate for tax purposes are a component of the Companys REIT qualifying assets and income. If more than one of the three remaining Kleros Real Estate CDOs is liquidated, the
Company may have to deploy additional capital into REIT qualifying assets in order to continue to qualify as a REIT. If the Company is not able to invest in sufficient other REIT qualifying assets, its ability to qualify as a REIT could be
materially adversely affected.



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Our Bank and Insurance TruPS Investments

We invest in TruPS issued by banks and surplus notes issued by insurance companies through our Alesco CDO subsidiaries. As of the date of this filing, we
have experienced 25 bank deferrals and no insurance deferrals in our TruPS portfolio. As of September 30, 2008, the aggregate principal amount of investments in the 25 TruPS investments that have defaulted or are currently deferring interest
payments is $490.5 million, representing approximately 9.5% of the Companys combined TruPS portfolio. As of September 30, 2008, $162.5 million of defaulted securities, which includes securities issued by IndyMac Bancorp, have been
completely written off in the Companys consolidated financial statements. For the three-months ended September 30, 2008, investment interest income is net of a $6.2 million reserve for interest income related to the $490.5 million of
currently deferring or defaulted securities.

The TruPS deferrals and defaults described above have resulted in the over-collateralization
tests being triggered in all eight CDOs in which the Company holds equity interests. The trigger of an over-collateralization test in a TruPS CDO means that the Company, as a holder of equity securities, will no longer receive current distributions
of cash in respect of its equity interests until sufficient cash or collateral is retained in the CDOs to cure the over-collateralization tests.

Our Leveraged Loan Investments

We invest in leveraged loans through our Emporia CLO subsidiaries and through
investments held in on-balance sheet warehouse facilities. Management continues to closely monitor and actively manage the leveraged loan portfolio as a result of the continued deterioration in macro-credit conditions and the potential for
significant stress on the middle-market companies in our portfolio. As of the date of filing this report, the leveraged loans in our portfolio have not suffered material defaults or losses. However, as the economy continues to weaken, leveraged loan
borrowers may become unable to service and refinance their debt, which could cause defaults that trigger over-collateralization tests in our CLOs. In addition, the general disruption in the structured products markets has made it difficult to
securitize leveraged loans through CLOs. As a result, we are holding assets on warehouse lines longer than originally anticipated. We earn returns from the loans while they are on warehouse lines, but we must also maintain cash collateral with the
warehouse lenders during the term of the warehouse lines. The cash we maintain as collateral with our warehouse lenders is not available to us to make new investments or pay distributions until the assets are sold from the warehouse line. We have
seen warehouse lenders generally increase their cash collateral requirements as the difficult credit environment has continued. In addition, banks are generally less willing or able to provide warehouse financing in the current environment because
their capital is constrained.

NYSE Continued Listing Standard

On October 10, 2008, the Company was notified by the NYSE that it was not in compliance with an NYSE continued listing standard applicable to its
common stock. The standard requires that the average closing price of any listed security not fall below $1.00 per share for any consecutive 30 trading-day period. On October 15, 2008, the Company notified the NYSE of its intent to cure this
deficiency. Under the NYSE rules, the Company has six months from the date of the NYSE notice to comply with the NYSE minimum share price standard. If the Company is not compliant by that date, its common stock will be subject to suspension and
delisting by the NYSE. The Company is currently exploring alternatives for curing the deficiency and restoring compliance with the continued listing standards. The Companys common stock remains listed on the NYSE under the symbol
AFN. The NYSEs continued listing standards also require that our average market capitalization be at least $25 million over any 30 consecutive trading day period and that we maintain our REIT status. In addition to being delisted
due to our failure to comply with any of these continued listing standards, we will also likely be delisted if we fail to meet any other of the NYSEs listing standards.

The holders of our remaining $28.7 million aggregate principal amount of convertible debt will have the right to require us to repurchase their notes at
100% of their principal amount together with accrued but unpaid interest thereon if, among other things, our common stock ceases to be listed on the NYSE, another established national securities exchange or an automated over-the-counter trading
market in the United States. If we are unable to remedy the NYSE listing deficiency and are unable to list our common stock on another established national securities exchange or automated U.S. over-the-counter trading market, there is a risk that
some or all holders of our convertible notes will exercise their right to require us to repurchase their notes.

Liquidity

During the three-month period ended September 30, 2008, we repurchased and retired $78.8 million par value of our outstanding
convertible debt securities for $33.0 million. We realized a gain of $43.9 million on these transactions, net of a $1.9 million write-off of related deferred costs. Subsequent to September 30, 2008, we repurchased and retired an additional
$32.5 million par value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7 million principal amount of our convertible debt securities remain outstanding.



Additionally, the disruption in the credit markets has severely restricted our
ability to complete new CDOs and CLOs. Banks are capital constrained and this severely limits their ability to provide new financing commitments. We expect this situation to continue for the foreseeable future until markets stabilize, credit
concerns dissipate and capital becomes less constrained. We are fortunate that the substantial portion of our portfolio is financed with in-place, long-term financing. However, as of September 30, 2008, we had $40.8 million of cash deposited
with a warehouse lender to collateralize a warehouse facility for leverage loans. If the securitization markets remain effectively closed for an extended period, we may lose the first loss cash that we had deposited with the warehouse



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lender. In addition, our inability to maintain compliance with the over-collateralization requirements of our CDO and CLO financing arrangements can
materially adversely affect our cash flow from operations and our ability to make distributions to our stockholders for the reasons discussed above. As previously disclosed, the realized tax losses that we have experienced during 2008, including
those resulting from the failure of IndyMac Bancorp and losses on MBS in our Kleros Real Estate portfolio, are expected to eliminate our expected taxable income for the year ending December 31, 2008. Decisions regarding future dividends will
continue to consider projections regarding our taxable income and liquidity position and are subject to the review and approval of our board of directors.

Critical Accounting Policies

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared by management in accordance with GAAP. Certain
information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures
included are adequate to make the information presented not misleading. The unaudited interim consolidated financial statements should be read in conjunction with our audited financial statements for the period ended December 31, 2007, included
in our Annual Report on Form 10-K. See Item 15-Exhibits and Financial Statement Schedules included in our Annual Report on Form 10-K for the year ended December 31, 2007. In the opinion of management, all adjustments,
consisting only of normal recurring adjustments necessary to present fairly our consolidated financial position and consolidated results of operations and cash flows are included. The results of operations for the interim periods presented are not
necessarily indicative of the results for the full year.

The preparation of consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Principles of Consolidation

The consolidated
financial statements reflect the accounts of the Company and its majority-owned and/or controlled subsidiaries and those entities for which the Company is determined to be the primary beneficiary in accordance with Financial Accounting Standard
Board (FASB) Interpretation No. 46R, Consolidation of Variable Interest Entities (FIN 46R). The portions of these entities to which the Company does not have an economic interest are presented as minority
interests in the consolidated financial statements. The creditors of each variable interest entity (VIE) consolidated within the Companys consolidated financial statements have no recourse to the general credit of the Company. The
Companys maximum exposure to loss as a result of its involvement with each VIE is the capital that the Company has invested in warehouse first-loss deposits and the preference shares or debt of the CDO, CLO or other types of securitization
structures. All significant intercompany accounts and transactions have been eliminated in consolidation.

When the Company obtains an
explicit or implicit interest in an entity, the Company evaluates the entity to determine if the entity is a VIE, and, if so, whether or not the Company is deemed to be the primary beneficiary of the VIE in accordance with FIN 46R. The Company
consolidates VIEs of which the Company is deemed to be the primary beneficiary or non-VIEs which the Company controls. The primary beneficiary of a VIE is the variable interest holder that absorbs the majority of the variability in the expected
losses or potentially the residual returns of the VIE. When determining the primary beneficiary of a VIE, the Company considers its aggregate explicit and implicit variable interests as a single variable interest. If the Companys variable
interest absorbs the majority of the variability in the expected losses or the residual returns of the VIE, the Company is considered the primary beneficiary of the VIE. The Company reconsiders its determination of whether an entity is a VIE and
whether the Company is the primary beneficiary of such VIE if certain events occur. If the Company determines that it is no longer the primary beneficiary of a VIE, the deconsolidation of the VIE is accounted for as a sale of the entity for no
proceeds.

The Company has determined that certain special purpose trusts formed by third party issuers of TruPS to issue such securities
are VIEs (Trust VIEs) and that the holder of the majority of the TruPS issued by the Trust VIEs would be the primary beneficiary of the special purpose trust. In most instances, the Company is the primary beneficiary of the Trust VIEs
because it holds, either explicitly or implicitly, the majority of the TruPS issued by the Trust VIEs. The acquisition of TruPS issued by Trust VIEs may be initially financed directly by CDOs, through on-balance sheet warehouse facilities or through
off-balance sheet warehouse facilities. Under the TruPS-related off-balance sheet warehouse agreements, the Company usually deposits cash collateral with an investment bank and bears the first dollar risk of loss, up to the Companys collateral
deposit, if an investment held under the warehouse facility is liquidated at a loss. This arrangement causes the Company to hold an implicit interest in the Trust VIEs that issued TruPS held by warehouse providers. The primary assets of the Trust
VIEs are subordinated debentures issued by third party sponsors of the Trust VIEs in exchange for the TruPS proceeds and the common equity securities of the Trust VIE. These subordinated debentures have terms that mirror the TruPS issued by the
Trust VIEs. Upon consolidation of the Trust VIEs, these subordinated debentures, which are assets of the Trust VIE, are included in the Companys consolidated financial statements and the related TruPS are eliminated. Pursuant to Emerging
Issues Task Force Issue No. 85-1: Classifying Notes Received for Capital Stock, subordinated debentures issued to Trust VIEs as payment for common equity securities issued by Trust VIEs to third party sponsors are recorded net of
the common equity securities issued.



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Fair Value of Financial Instruments

Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements (SFAS No. 157), which
establishes a framework for measuring fair value by creating a three-level fair value hierarchy that ranks the quality and reliability of information used to determine fair value, and requires new disclosures of assets and liabilities measured at
fair value based on their level in the hierarchy. SFAS No. 157 also defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement
date.

SFAS No. 157 establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and
minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the financial instrument developed based on market data obtained
from sources independent of the Company. Unobservable inputs are inputs that reflect the Companys estimates about what assumptions market participants would use in pricing the financial instrument developed based on the best information
available in the circumstances. The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows:



| |  |  | Level 1: Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Since
valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Financial instruments utilizing Level 1 inputs generally include exchange-traded equity securities listed in active markets and most U.S. Government securities.



| |  |  | Level 2: Valuations based on quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not
active or for which all significant inputs are observable, either directly or indirectly.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Financial instruments utilizing Level 2 inputs
generally include certain mortgage-backed securities, or MBS, and corporate debt securities and certain financial instruments classified as derivatives, including interest rate swap contracts and credit default swaps, where fair value is based on
observable market inputs.



| |  |  | Level 3: Inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or
liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has
been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and
considers factors specific to the asset or liability.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Financial instruments utilizing Level 3 inputs generally include investments in
TruPS and TruPS security-related receivables, certain MBS, and CDO notes payable.

The fair value of the Companys financial
instruments is generally based on observable market prices or inputs or derived from such prices or inputs. When quoted market prices are not available because certain financial instruments do not actively trade in the public markets, fair value is
based on comparisons to similar instruments or from internal valuation models.

The availability of observable inputs can vary depending on
the financial instrument and is affected by a wide variety of factors, including, for example, the type of financial instrument, its age, whether the financial instrument is traded on an active exchange or in the secondary market, the current market
conditions, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment.
Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value
hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in
its entirety.

Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the
liability rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Companys own assumptions are set to reflect those that management believes market participants would use in pricing the
asset or liability at the measurement date. The Company uses prices and inputs that management believes are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of
prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3.



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Many financial instruments have bid and ask prices that can be observed in the marketplace. Bid prices
reflect the highest price that the Company and others are willing to pay for an asset. Ask prices represent the lowest price that the Company and others are willing to accept for an asset. For financial instruments whose inputs are based on bid-ask
prices, the Company does not require that fair value always be a predetermined point in the bid-ask range. The Companys policy is to allow for mid-market pricing and adjusting to the point within the bid-ask range that results in the
Companys best estimate of fair value.

Fair value for certain of the Companys Level 3 financial instruments is derived using
internal valuation models. These internal valuation models include discounted cash flow analyses developed by management using current interest rates, estimates of the term of the particular contract, specific issuer information and other market
data for securities without an active market. In accordance with SFAS No. 157, the impact of the Companys own credit and creditworthiness of consolidated CDOs is also considered when measuring the fair value of liabilities, including
derivative contracts. Where appropriate, valuation adjustments are made to account for various factors, including bid-ask spreads, credit quality and market liquidity. These adjustments are applied on a consistent basis and are based upon observable
inputs where available. Managements estimate of fair value requires significant management judgment and is subject to a high degree of variability based upon market conditions, the availability of specific issuer information and
managements assumptions.

Financial instruments that are generally classified in Level 3 of the fair value hierarchy primarily
consist of investments in TruPS and TruPS security-related receivables, certain MBS, and CDO notes payable. The valuation techniques used for those financial instruments classified in Level 3 are described below.

TruPS and TruPS Security-Related Receivables: The fair value of investments in TruPS is estimated using internal valuation models. These
investment securities generally do not trade in an active market and, therefore observable price quotations are not available. In the absence of observable price quotations, fair value is determined based on discounted cash flow models using current
interest rates, estimates of the term of the particular contract, specific issuer information, including estimates of comparable market credit spreads and other market data.

MBS:The fair value of investments in MBS is determined based on external price and spread data. When position-specific external price data are
not observable, the valuation is based on prices of comparable bonds.

CDO Notes Payable: The fair value of CDO notes payable
liabilities is estimated using external price data (where observable), or internal valuation models. In the absence of observable price quotations, fair value is determined based on prices of comparable notes payable, or discounted cash flow models
using current interest rates, estimates of the term of the particular contract, specific underlying collateral information, including estimates of credit spreads and other market data for securities without an active market.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities (SFAS No. 159). SFAS No. 159 provides entities with an irrevocable option to report most financial assets and liabilities at fair value, with subsequent changes in fair value reported in earnings.
The election can be applied on an instrument-by-instrument basis. SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar
types of assets and liabilities, and became effective for the Company on January 1, 2008. The Company elected to apply the fair value option for its investments in TruPS and TruPS security-related receivables, MBS, TruPS CDO notes payable, MBS
CDO notes payable, and TruPS obligations. The Company has elected the fair value option for these instruments to enhance the transparency of its financial condition. The transition adjustment to beginning accumulated deficit that was recorded as of
January 1, 2008 due to the adoption of SFAS No. 159 was an increase to accumulated deficit of $1.1 billion. The following table presents information about the eligible instruments for which the Company elected the fair value option and for
which transition adjustments were recorded as of January 1, 2008 (amounts in thousands):



|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|----------------------------------------------------------- |  | ---------------------------------------------------------------- | --------- | ------------------------------------------------------------- | - | --------- | --------------------------------------------------------------- |  | - | ---------
|Financial Instrument Description                            |  | Carrying Value atJanuary 1,
2008(Before Adoptionof SFAS No. 159) |           | TransitionAdjustment toAccumulated DeficitIncrease/(Decrease) |   |           | Carrying Value atJanuary 1, 2008(After
Adoptionof SFAS No. 159)
|Assets:                                                     |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|TruPS and subordinated debentures                           |  | $                                                                | 3,793,930 |                                                               | $ | (924,053  | )(1)                                                            |  | $ | 3,793,930
|TruPS security-related receivables                          |  |                                                                  | 740,342   |                                                               |   | (113,123  | )                                                               |  |   | 627,219  
|MBS                                                         |  |                                                                  | 2,091,007 |                                                               |   | (554,171  | )(1)                                                            |  |   | 2,091,007
|Liabilities:                                                |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|TruPS CDO notes payable                                     |  |                                                                  | 4,924,033 |                                                               |   | 838,109   | (2)                                                             |  |   | 4,085,924
|MBS CDO notes payable                                       |  |                                                                  | 3,852,837 |                                                               |   | 1,804,175 | (3)                                                             |  |   | 2,048,662
|TruPS obligations                                           |  |                                                                  | 382,600   |                                                               |   | 79,005    |                                                                 |  |   | 303,595  
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|Cumulative effect of the adoption                           |  |                                                                  |           |                                                               |   | 1,129,942 |                                                                 |  |   |          
|Minority interest allocation of cumulative adjustment       |  |                                                                  |           |                                                               |   | (22,737   | )                                                               |  |   |          
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|Cumulative effect of the adoption to accumulated deficit(4) |  |                                                                  |           |                                                               |   | 1,107,205 |                                                                 |  |   |          
|Adjustments related to other comprehensive income           |  |                                                                  |           |                                                               |   | 1,478,224 |                                                                 |  |   |          
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          
|Cumulative effect of the adoption to stockholders equity   |  |                                                                  |           |                                                               | $ | 2,585,429 |                                                                 |  |   |          
|                                                            |  |                                                                  |           |                                                               |   |           |                                                                 |  |   |          



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|(1) | Prior to January 1, 2008, TruPS and subordinated debentures and MBS were classified as available-for-sale and carried at fair value. Accordingly, the election of the fair value
option for these securities did not change their carrying value and resulted in a reclassification from accumulated other comprehensive loss to beginning accumulated deficit.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes write-off of deferred issuance costs of $76.9 million.
|--- | ---------------------------------------------------------------

|(3) | Includes write-off of deferred issuance costs of $21.0 million.
|--- | ---------------------------------------------------------------

|(4) | Amount includes $1.9 million of a deferred tax asset recorded upon adoption of SFAS No. 159.
|--- | --------------------------------------------------------------------------------------------

Investments

The Company invests primarily in TruPS and MBS debt securities, residential and
commercial mortgage portfolios, and leveraged loans and may invest in other types of real estate-related assets. The Company accounts for its investments in debt securities under Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity Securities, as amended and interpreted (SFAS No. 115), and designates each investment as a trading security, an available-for-sale security, or a held-to-maturity
security based on managements intent at the time of acquisition. Under SFAS No. 115, trading securities are recorded at their fair value each reporting period with fluctuations in fair value reported as a component of earnings.
Available-for-sale securities are recorded at fair value with changes in fair value reported as a component of other comprehensive income (loss). Fair value of investments is based on quoted market prices from independent pricing sources, or when
quoted market prices are not available because certain securities do not actively trade in the public markets, based on comparisons to similar instruments or from internal pricing models. These internal valuation models include discounted cash flow
analyses developed by management using current interest rates, estimates of the term of the particular contract, specific issuer information and other market data for securities without an active market. Managements estimate of fair value
requires significant management judgment and is subject to a high degree of variability based upon market conditions, the availability of specific issuer information and managements assumptions. Upon the sale of a security, the realized gain
or loss is computed on a specific identification basis and is recorded as a component of earnings in the respective period.

Effective
January 1, 2008, the Company classifies its investments in TruPS and MBS as trading securities (see Fair Value of Financial Instruments). These investments are carried at estimated fair value, with changes in fair value of these
instruments reported in income. Unamortized premiums and discounts on trading securities that are highly rated are recognized over the contractual life, adjusted for estimated prepayments using the effective interest method. For securities
representing beneficial interests in securitizations that are not highly rated (i.e., subordinate tranches of MBS), unamortized premiums and discounts are recognized over the contractual life, adjusted for estimated prepayments and estimated credit
losses of the securities using the effective interest method. Actual prepayment and credit loss experience are reviewed quarterly and effective yields are recalculated when differences arise between prepayments and credit losses originally
anticipated compared to amounts actually received plus anticipated future prepayments.

Effective January 1, 2008, the Company
accounts for its investments in subordinated debentures owned by Trust VIEs that the Company consolidates at fair value, with changes in fair value of these instruments reported in income. These Trust VIEs have no ability to sell, pledge, transfer
or otherwise encumber a company or the assets of a company until such subordinated debentures maturity. The Company accounts for investments in securities where the transfer meets the criteria as a secured financing under Statement of
Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS No. 140) as secured loans at fair value. The Companys investments in
security-related receivables represent interests in securities that were transferred to CDO securitization entities by transferors that maintain some level of continuing involvement.

As it relates to available-for-sale securities, the Company exercises judgment to determine whether an investment security has sustained an
other-than-temporary decline in fair value. If the Company determines that an investment security has sustained an other-than-temporary decline in its fair value, the investment security is written down to its fair value by a charge to earnings, and
the Company establishes a new cost basis for the investment. The Companys evaluation of an other-than-temporary decline is dependent on specific facts and circumstances relating to the particular investment. Factors that the Company considers
in determining whether an other-than-temporary decline in fair value has occurred include, but are not limited to: the estimated fair value of the investment in relation to its cost basis; the length of time the security has had a decline in
estimated fair value below its amortized cost; the financial condition of the related entity and industry events; changes in estimated cash flows from the investment; external credit ratings and recent downgrades of such credit ratings; and the
intent and ability of the Company to hold the investment for a sufficient period of time to allow for recovery in the fair value of the investment. For MBS that are not of high credit quality at acquisition, the Company performs impairment analyses
in accordance with Emerging Issues Task Force Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF No. 99-20). When
adverse changes in estimated cash flows occur as a result of actual or expected prepayment and credit loss experience, an other-than-temporary impairment is deemed to have occurred. Accordingly, the security is written down to fair value, and the
loss is recognized in current earnings. The cost basis adjustment for other-than-temporary impairment is recoverable only upon sale or maturity of the security. Effective January 1, 2008, the Company is not classifying any of its investments as
available-for-sale.



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The Company accounts for its investments in residential and commercial mortgages and leveraged loans at
amortized cost. The carrying value of these investments is adjusted for origination discounts/premiums, nonrefundable fees and direct costs for originating loans which are amortized into income over the terms of the loans using the effective yield
method adjusted for the effects of estimated prepayments based on Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases (SFAS No. 91).

The Company maintains an allowance for residential and commercial mortgages and leveraged
loan losses based on managements evaluation of known losses and inherent risks in the portfolios, including historical and industry loss experience, economic conditions and trends, estimated fair values, the quality of collateral and other
relevant quantitative and qualitative factors. Specific allowances for losses may be established for potentially impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loans expected
cash flow, the loans estimated market price or the estimated fair value of the underlying collateral. The allowance is increased by charges to operations and decreased by charge-offs (net of recoveries).

An impaired loan may be left on accrual status during the period the Company is pursuing repayment of the loan; however, the loan is placed on
non-accrual status at such time as the Company believes that scheduled debt service payments may not be paid when contractually due or the loan becomes 90 days delinquent. While on non-accrual status, interest income is recognized only upon actual
receipt.

Transfers of Financial Assets

The Company accounts for transfers of financial assets under SFAS No. 140 as either sales or financing arrangements. Transfers of financial assets that result in sale accounting are those in which (a) the transfer legally isolates
the transferred assets from the transferor, (b) the transferee has the right to pledge or exchange the transferred assets and no condition both constrains the transferees right to pledge or exchange the assets and provides more than a
trivial benefit to the transferor, and (c) the transferor does not maintain effective control over the transferred assets. If the transfer does not meet each of these criteria, the transfer is accounted for as a financing arrangement.
Dispositions of financial assets that are treated as sales are removed from the Companys accounts with any realized gain (loss) reflected in earnings during the period of sale. Dispositions of financial assets that are treated as financings
are maintained on the balance sheet with proceeds received from the legal transfer reflected as secured borrowings and no gain or loss is recognized.

Revenue Recognition

The Company recognizes interest income from investments in debt and other securities,
residential and commercial mortgages, and leveraged loans over the estimated life of the underlying financial instruments on an estimated yield to maturity basis.

In accordance with EITF No. 99-20, the Company recognizes interest income from purchased interests in certain financial assets, including certain subordinated MBS, on an estimated effective yield to maturity
basis. Management estimates the current yield on the reference amount of the investment based on estimated cash flows after considering prepayment and credit loss expectations. The adjusted yield is then applied prospectively to recognize interest
income for the next reporting period.

Derivative Instruments

The Company uses derivative financial instruments to attempt to hedge all or a portion of the interest rate risk associated with its borrowings. In accordance with Statement of Financial Accounting Standards
No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted (SFAS No. 133), the Company measures each derivative instrument (including certain derivative instruments embedded in
other contracts) at fair value and records such amounts in its consolidated balance sheet as either an asset or liability. Derivatives qualifying and designated as cash-flow hedges are evaluated at inception and at subsequent balance sheet dates in
order to determine whether they qualify for hedge accounting under SFAS No. 133. The hedge instrument must be highly effective in achieving offsetting changes in cash flows of the hedged item attributable to the risk being hedged in order to
qualify for hedge accounting. Derivative contracts are carried on the consolidated balance sheet at fair value. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in
other comprehensive income (loss). Changes in the ineffective portions of cash flow hedges are recognized in earnings. Realized gains and losses on terminated contracts that were designated as hedges are maintained in accumulated other comprehensive
income or loss and amortized into the consolidated statement of income over the contractual life of the terminated contract unless it is probable that the forecasted transaction will not occur. In that case, the gain or loss in accumulated other
comprehensive income or loss is reclassified to realized gain or loss in the consolidated statement of income.

The Company may also enter
into derivatives that do not qualify for hedge accounting or for which the Company may not elect hedge accounting, including interest rate swaps, interest rate caps and floors, credit default and total return swaps, under SFAS No. 133. These
derivatives are carried at their fair value with changes in fair value reflected in the consolidated statement of income. The fair value of credit default swaps is based on quotations from third-party brokers.



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Accounting for Off-Balance Sheet Arrangements

The Company may maintain certain warehouse financing arrangements with various investment banks that are accounted for as off-balance sheet arrangements.
The Company receives the difference between the interest earned on the investments under the warehouse facilities and the interest charged by the warehouse providers from the dates on which the respective investments were acquired. Under the
warehouse agreements, the Company is typically required to deposit cash collateral with the warehouse provider and as a result, the Company bears the first dollar risk of loss, up to the warehouse deposit, if (i) an investment funded through
the warehouse facility becomes impaired or (ii) a CDO is not completed by the end of the warehouse period, and in either case, the warehouse provider is required to liquidate the securities at a loss. These off-balance sheet arrangements are
not consolidated because the collateral assets are maintained on the balance sheet of the warehouse providers. However, since the Company holds an implicit variable interest in many entities funded under its TruPS-related warehouse facilities, the
Company often does consolidate the Trust VIEs while the TruPS they issue are held on the warehouse facilities. The Company records the cash collateral as warehouse deposits in its financial statements. The net amount earned from these warehouse
facilities and any obligation associated with the warehouse arrangement are considered free-standing derivatives and are recorded at fair value in the financial statements with changes in fair value reflected in earnings in the respective period.

Income Taxes

For tax purposes,
Sunset is deemed to have acquired Alesco Financial Trust on October 6, 2006. Sunset elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code and subsequent to the merger the Company continues to comply with
these requirements. Accordingly, the Company generally will not be subject to U.S. federal income tax to the extent of its distributions to stockholders and as long as certain asset, income, distribution and share ownership tests are met. If the
Company were to fail to meet these requirements, it would be subject to U.S. federal income tax, which could have a material adverse impact on its results of operations and amounts available for distributions to its stockholders. Management believes
that all of the criteria to maintain the Companys REIT qualification have been met for the applicable periods, but there can be no assurances that these criteria will continue to be met in subsequent periods.

The Company maintains domestic taxable REIT subsidiaries (TRSs), which may be subject to U.S. federal, state and local income taxes. Current
and deferred taxes are provided for on the portion of earnings (losses) recognized by the Company with respect to its interest in domestic TRSs. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP
consolidated financial statements and the federal and state income tax basis of assets and liabilities as of the consolidated balance sheet date. We evaluate the realizability of our deferred tax assets and recognize a valuation allowance if, based
on the weight of available evidence, it is more likely than not that some portion or all of our deferred tax assets will not be realized. When evaluating the realizability of our deferred tax assets, we consider estimates of expected future taxable
income, existing and projected book/tax differences, tax planning strategies available, and the general and industry specific economic outlook. This realizability analysis is inherently subjective, as it requires management to forecast our business
and general economic environment in future periods. Changes in estimate of deferred tax asset realizability, if any, are included in income tax expense on the consolidated statements of income.

Certain TRS entities are domiciled in the Cayman Islands and, accordingly, taxable income generated by these entities may not be subject to local income
taxation, but generally will be included in the Companys income on a current basis, whether or not distributed. Upon distribution of any previously included income to the Company, no incremental U.S. federal, state, or local income taxes would
be payable by the Company.

Recent Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment of Accounting Research Bulletin No. 51 (SFAS No. 160).
SFAS No. 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling
interests. SFAS No. 160 applies prospectively as of December 1, 2009, except for the presentation and disclosure requirements which will be applied retrospectively for all periods presented. Management is currently evaluating the impact
that this statement may have on our consolidated financial statements.

In March 2008, the FASB issued Statement of Financial Accounting
Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities  an amendment of SFAS No. 133 (SFAS No. 161). SFAS No. 161 requires enhanced disclosure related to derivatives and
hedging activities and thereby seeks to improve the transparency of financial reporting. Under SFAS No. 161, entities are required to provide enhanced disclosures relating to: (a) how and why an entity uses derivative instruments;
(b) how derivative instruments and related hedge items are accounted for under SFAS No. 133 and its related interpretations; and (c) how derivative instruments and related hedged items affect an entitys financial position,
financial performance and cash flows. The statement is effective for fiscal years beginning after November 15, 2008. Management is currently evaluating the impact that this statement may have on our consolidated financial statements.



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In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in
Share-Based Payment Transactions Are Participating Securities (FSP EITF 03-6-1). FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and,
therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method as described in SFAS No. 128, Earnings per Share. Under the guidance in FSP EITF 03-6-1, unvested share-based
payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. FSP EITF
03-6-1 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. All prior-period earnings per share data presented shall be adjusted retrospectively. Early application is not permitted. The
Company is currently evaluating the potential impact of adopting FSP EITF 03-6-1.

In June 2008, the FASB ratified the consensus reached by
the EITF on Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entitys Own Stock  (EITF No. 07-5). EITF No. 07-5 provides guidance for determining whether an
equity-linked financial instrument (or embedded feature) is indexed to an entitys own stock. EITF No. 07-5 applies to any freestanding financial instrument or embedded feature that has all of the characteristics of a derivative or
freestanding instrument that is potentially settled in an entitys own stock (with the exception of share-based payment awards within the scope of SFAS 123(R)). To meet the definition of indexed to own stock, an instruments
contingent exercise provisions must not be based on (a) an observable market, other than the market for the issuers stock (if applicable), or (b) an observable index, other than an index calculated or measured solely by reference to
the issuers own operations, and the variables that could affect the settlement amount must be inputs to the fair value of a fixed-for-fixed forward or option on equity shares. EITF No. 07-5 is effective for fiscal years
beginning after December 15, 2008, and interim periods within those fiscal years. The Company is currently evaluating the potential impact of adopting EITF No. 07-5.

In September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB
Statement 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161 (FSP FAS 133-1 and FIN 45-4). FSP FAS 133-1 and FIN 45-4 is intended to improve disclosures about credit
derivatives by requiring more information about the potential adverse effects of changes in credit risk on the financial position, financial performance, and cash flows of the sellers of credit derivatives. FSP FAS 133-1 and FIN 45-4 will be
effective for the Companys fiscal 2008 annual consolidated financial statements.

In October 2008, the FASB issued FSP FAS 157-3,
Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP FAS 157-3). FSP FAS 157-3 clarifies the application of FASB Statement No. 157, Fair Value Measurements, in a
market that is not active. FSP FAS 157-3 is effective October 10, 2008, and for prior periods for which financial statements have not been issued. The adoption of FSP FAS 157-3 did not have a material effect on our consolidated financial
statements.

In September 2008, the FASB issued for comment revisions to SFAS No. 140 and FASB Interpretation No. 46, as revised
(FIN 46R), Consolidation of Variable Interest Entities. The changes proposed include a removal of the scope exemption from FIN 46R for QSPEs, a revision of the current risks and rewards-based FIN 46R consolidation model to a
qualitative model based on control and a requirement that consolidation of VIEs be reevaluated on an ongoing basis. Although the revised standards have not yet been finalized, these changes may have a significant impact on the Companys
condensed consolidated financial statements as the Company may be required to deconsolidate certain assets and liabilities due to the ongoing evaluation of its primary beneficiary status. In addition, the Company may also be required to consolidate
other VIEs that are not currently consolidated based an analysis under the current FIN 46R consolidation model. The proposed revisions would be effective for fiscal years that begin after November 15, 2009.



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Our Investment Portfolio

The following table summarizes our allocation of capital and book value as of September 30, 2008 (amounts in thousands, except share and per share data):



|                                                  |  |                                               |          |   |             |     |   |                                    |   |            |  
|------------------------------------------------- |  | --------------------------------------------- | -------- | - | ----------- | --- | - | ---------------------------------- | - | ---------- | -
|                                                  |  | Capital Allocationas
ofSeptember 30, 2008 (A) |          |   | % ofCapital |     |   | Book Value as ofSeptember 30, 2008 |  
|TruPS investments                                 |  | $                                             | 236,234  |   |             | 37  | % |                                    | $ | 140,215    |  
|Leveraged loan investments                        |  |                                               | 88,857   |   |             | 14  | % |                                    |   | 75,744     |  
|Kleros Real Estate MBS investments                |  |                                               | 90,000   |   |             | 14  | % |                                    |   |           |  
|Residential mortgages                             |  |                                               | 79,784   |   |             | 12  | % |                                    |   | 54,523     |  
|Other investments                                 |  |                                               | 54,026   |   |             | 8   | % |                                    |   | 10,844     |  
|Total uninvested cash (B)                         |  |                                               | 95,811   |   |             | 15  | % |                                    |   | 95,811     |  
|                                                  |  |                                               |          |   |             |     |   |                                    |   |            |  
|Total investible capital                          |  |                                               | 644,712  |   |             | 100 | % |                                    |   | 377,137    |  
|Recourse indebtedness (C) (D)                     |  |                                               | (109,304 | ) |             |     |   |                                    |   | (109,304   | )
|                                                  |  |                                               |          |   |             |     |   |                                    |   |            |  
|Total                                             |  | $                                             | 535,408  |   |             |     |   |                                    | $ | 267,833    |  
|                                                  |  |                                               |          |   |             |     |   |                                    |   |            |  
|Common stock outstanding as of September 30, 2008 |  |                                               |          |   |             |     |   |                                    |   | 59,132,488 |  
|                                                  |  |                                               |          |   |             |     |   |                                    |   |            |  
|GAAP Book Value per share                         |  |                                               |          |   |             |     |   |                                    | $ | 4.53       |  
|                                                  |  |                                               |          |   |             |     |   |                                    |   |            |  



|(A) | Represents net cash invested through September 30, 2008.
|--- | --------------------------------------------------------

|(B) | Reduced for payments due to broker of $0.4 million at September 30, 2008 related to common stock repurchases that settled in October 2008.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------

|(C) | Amount is net of our $1.5 million investment in common securities of the trusts that issued our junior subordinated debentures. The $1.5 million is recorded within other assets in
our consolidated financial statements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(D) | Subsequent to September 30, 2008, we repurchased and retired an additional $32.5 million par value of convertible debt securities for $17.6 million. As of the date of this
filing, our outstanding convertible debt balance is $28.7 million.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

TruPS Portfolio. During the three-month and
nine-month period ended September 30, 2008 the Company has recorded losses of $1.0 billion and $2.2 billion, respectively, relating to changes in fair value of its investments in TruPS. The Company determined that these changes in fair value
resulted from specific issuer credit matters, widening of credit spreads, volatility in interest rates, and other qualitative factors relating to macro-credit conditions. The fair value of investments in TruPS is estimated using internal valuation
models. These investment securities generally do not trade in an active market and, therefore observable price quotations are not available. In the absence of observable price quotations, fair value is determined based on discounted cash flow models
using current interest rates, estimates of the term of the particular contract, specific issuer information, including estimates of comparable market credit spreads and other market data.

The portfolio consists of approximately 76% bank related investments and 24% insurance related investments. The terms of each of our long-term CDO
financings include limitations on specific issuer concentrations, which typically limit the par value of the underlying collateral securities included in the CDO from any single issuer to no greater than 3%. As of September 30, 2008, we had
three issuers with concentrations ranging from 2.2% to 2.4% of our total TruPS investment portfolio, which includes the defaulted investment securities of IndyMac Bancorp, and no other issuers were greater than 1.6% of our total TruPS investment
portfolio. Additionally, the banks included in our TruPS investment portfolio are concentrated in the following states as of September 30, 2008:



|           |  |       |  
|---------- |  | ----- | -
|California |  | 12.2  | %
|Texas      |  | 11.7  | %
|Illinois   |  | 9.2   | %
|Georgia    |  | 5.2   | %
|Virginia   |  | 4.4   | %
|Others     |  | 57.3  | %
|           |  |       |  
|Total      |  | 100.0 | %
|           |  |       |  

As of September 30, 2008, the aggregate principal amount of investments in the 25 TruPS
investments that have defaulted or are currently deferring interest payments is $490.5 million, representing approximately 9.5% of the Companys combined TruPS portfolio. As of September 30, 2008, $162.5 million of defaulted securities,
which includes securities issued by IndyMac Bancorp, have been completely written-off in the Companys consolidated financial statements. For the three-months ended September 30, 2008, investment interest income is net of a $6.2 million
reserve for interest income related to $490.5 million of the currently deferring or defaulted securities.

As of September 30, 2008, the
aggregate principal amount of CDO notes payable and trust preferred obligations financing our TruPS portfolio is $5.3 billion and the fair value of these instruments is $1.9 billion. During the three-month and nine-month periods ended September 30,
2008, the Company recorded gains of $1.1 billion and $2.3 billion, respectively, relating to changes in the fair value of its TruPS CDO notes payable and trust preferred obligations. The Company determined that these changes in fair value resulted
primarily from specific issuer credit matters with the assets that collateralize the liabilities, widening of credit spreads, volatility in interest rates, failure or threat of failure of overcollateralization tests in the CDO structures, general
deterioration of pricing on structured debt instruments and other qualitative factors relating to macro-credit conditions. The fair value of CDO notes payable liabilities is estimated using external price data (where observable), or internal
valuation models. In the absence of observable price quotations, fair value is determined based on prices of comparable notes payable, or discounted cash flow models using current interest rates, estimates of the term of the particular contract,
specific underlying collateral information, including estimates of credit spreads and other market data for securities without an active market.



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Leveraged Loan Portfolio. We invest in debt obligations of small and mid-sized corporations,
partnerships and other entities in the form of participations in first lien and other senior loans and mezzanine loans, which we collectively refer to as leveraged loans because of the high proportion of debt typically in the capital structure of
the borrowing entities. As of September 30, 2008, we had investments in approximately $877.1 million of leveraged loans and an allowance for loan losses related to these investments of $20.6 million.

Although the credit markets in the U.S. have experienced significant disruption and deterioration, as of the date of this filing, our leveraged loan
portfolio has not suffered material defaults or losses. During the three-months ended September 30, 2008, we increased our allowance for loan losses as a result of an increase in credit risk related to specific borrowers, continued
deterioration in macro-credit conditions and the potential impact to the middle-market companies in our portfolio. There can be no assurances that our portfolio will not be subject to material losses, defaults or rating agency downgrades, in the
event of the continued deterioration of the U.S. credit markets or overall economy.

Mortgage Loan Portfolio. As of
September 30, 2008, we owned approximately $933.0 million of residential prime mortgage loans with a weighted-average Fair Isaac Corp. (FICO) score of 734 at origination. As of September 30, 2008, we have an allowance for loan
losses of $25.8 million relating to these residential mortgage loans.

The following table summarizes the delinquency statistics of the
Companys residential mortgage loans as of September 30, 2008 (dollar amounts in thousands):



|                   |  |                |  |                 |        
|------------------ |  | -------------- |  | --------------- | -------
|Delinquency Status |  | Numberof Loans |  | PrincipalAmount
|30 to 59 days      |  | 63             |  | $               | 24,838 
|60 to 89 days      |  | 26             |  |                 | 11,354 
|90 days or more    |  | 199            |  |                 | 77,685 
|                   |  |                |  |                 |        
|Total              |  | 288            |  | $               | 113,877
|                   |  |                |  |                 |        

Additionally, the loans included in our mortgage loan portfolio are concentrated in the following
states as of September 30, 2008:



|           |  |       |  
|---------- |  | ----- | -
|California |  | 47.2  | %
|Florida    |  | 7.6   | %
|Arizona    |  | 5.7   | %
|Nevada     |  | 5.2   | %
|Washington |  | 5.0   | %
|Others     |  | 29.3  | %
|           |  |       |  
|Total      |  | 100.0 | %
|           |  |       |  

During the three and nine-month period ended September 30, 2008, the Company foreclosed on 18
and 48 residential mortgage loans with fair values of $4.8 million and $11.7 million, respectively, which are classified as real estate owned (REO). The Company records REO property at fair value within other assets in its consolidated balance
sheet. During the three and nine-month period ended September 30, 2008, the Company recorded charge-offs of $1.7 million and $7.7 million, respectively, as a result of foreclosing on these properties. As of September 30, 2008, the Company
had $12.1 million of REO property recorded within other assets in the consolidated financial statements.

MBS and Other Investment
Portfolio. As of September 30, 2008, we had investments in $744.5 million of MBS and $0.6 million in other investments. The $744.5 million of MBS collateralize the debt of the three remaining Kleros Real Estate CDOs that we have invested
in. Our maximum loss from investments in Kleros Real Estate MBS is limited to our remaining $90 million of invested capital. The CDOs are governed by indentures that provide us with no rights to the CDOs assets and provide the CDO noteholders with
no recourse to us in respect of the debt securities issued by the CDOs. We consolidate the three remaining Kleros Real Estate CDOs in accordance with FIN 46R, which requires that we record the financial position and results of operations of the CDOs
in our consolidated financial statements, without consideration that our maximum economic exposure to loss is our remaining $90 million investment. We record the investments and CDO debt at fair value.



35



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##### Table of Contents

The following table summarizes ratings of the MBS investments included in our Kleros Real Estate CDOs
(categorized based on fair value as of September 30, 2008 as rated by S&P as of October 2008):



|                    |  |                            |         |                                 |       |   |                                         |   |                                |  |       |                                        |  |                                   |       |  |       |  
|------------------- |  | -------------------------- | ------- | ------------------------------- | ----- | - | --------------------------------------- | - | ------------------------------ |  | ----- | -------------------------------------- |  | --------------------------------- | ----- |  | ----- | -
|S&P Rating Category |  | TotalMBS perRatingCategory |         | % of TotalMBS perRatingCategory |       |   | Amount ofSubprime perRatingCategory (1) |   | % ofSubprime perRatingCategory |  |       | Amount ofSecond-Lien perRatingCategory |  | % ofSecond-Lien perRatingCategory |      
|                    |  | (dollars in thousands)     |        
|AAA                 |  | $                          | 360,306 |                                 | 48.4  | % |                                         | $ | 6,252                          |  | 5.1   | %                                      |  | $                                 |      |  | 0.0   | %
|AA+                 |  |                            | 83,579  |                                 | 11.2  | % |                                         |   | 37,293                         |  | 30.3  | %                                      |  |                                   |      |  | 0.0   | %
|AA                  |  |                            | 96,206  |                                 | 12.9  | % |                                         |   | 11,215                         |  | 9.1   | %                                      |  |                                   |      |  | 0.0   | %
|AA                 |  |                            | 26,927  |                                 | 3.6   | % |                                         |   | 6,994                          |  | 5.7   | %                                      |  |                                   |      |  | 0.0   | %
|A+                  |  |                            | 20,012  |                                 | 2.7   | % |                                         |   | 9,828                          |  | 8.0   | %                                      |  |                                   | 735   |  | 19.8  | %
|A                   |  |                            | 29,334  |                                 | 3.9   | % |                                         |   | 10,005                         |  | 8.1   | %                                      |  |                                   |      |  | 0.0   | %
|A-                  |  |                            | 1,338   |                                 | 0.2   | % |                                         |   | 618                            |  | 0.5   | %                                      |  |                                   |      |  | 0.0   | %
|BBB+                |  |                            | 493     |                                 | 0.1   | % |                                         |   | 201                            |  | 0.2   | %                                      |  |                                   |      |  | 0.0   | %
|BBB                 |  |                            | 30,603  |                                 | 4.1   | % |                                         |   | 5,432                          |  | 4.4   | %                                      |  |                                   | 215   |  | 5.8   | %
|BBB                |  |                            | 124     |                                 | 0.1   | % |                                         |   |                               |  | 0.0   | %                                      |  |                                   | 124   |  | 3.4   | %
|BB+ and below       |  |                            | 95,625  |                                 | 12.8  | % |                                         |   | 35,233                         |  | 28.6  | %                                      |  |                                   | 2,632 |  | 71.0  | %
|                    |  |                            |         |                                 |       |   |                                         |   |                                |  |       |                                        |  |                                   |       |  |       |  
|Total               |  | $                          | 744,547 |                                 | 100.0 | % |                                         | $ | 123,071                        |  | 100.0 | %                                      |  | $                                 | 3,706 |  | 100.0 | %
|                    |  |                            |         |                                 |       |   |                                         |   |                                |  |       |                                        |  |                                   |       |  |       |  



|(1) | We generally consider a loan to a borrower with a FICO score of less than 625 to be a sub-prime loan.
|--- | -----------------------------------------------------------------------------------------------------

Credit Default Swaps (CDS).During June 2008, the Company sold a subsidiary that owned the remaining $87.5 million notional of CDS positions for
$70.4 million in proceeds (inclusive of the $69.3 million of counterparty margin held as of March 31, 2008). Following the June 2008 sale, the Company no longer holds any investments in CDS.

Recourse Indebtedness. As of September 30, 2008, the Companys consolidated financial statements included recourse indebtedness of
$110.8 million. During the three-month period ended September 30, 2008, we repurchased and retired $78.8 million par value of outstanding convertible debt securities for $33.0 million. We realized a gain of $43.9 million on these transactions,
net of a $1.9 million write-off of related deferred costs. Subsequent to September 30, 2008, we repurchased and retired an additional $32.5 million par value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7
million principal amount of our contingent convertible debt securities remain outstanding.

None of the Companys indebtedness
subjects the Company to potential margin calls for additional pledges of cash or other assets.

Stockholders Equity.As of
September 30, 2008 the Companys consolidated financial statements included total stockholders equity of $267.8 million. On January 1, 2008, we adopted SFAS No. 159 and elected to apply the fair value option for our
investments in TruPS and TruPS security-related receivables, MBS, TruPS CDO notes payable, MBS CDO notes payable, and TruPS obligations. The total impact to stockholders equity that was recorded as of January 1, 2008 due to the adoption
of SFAS No. 159 was a gain of $2.6 billion.



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Upon the adoption of SFAS No. 159, the match-funded nature of our MBS and TruPS assets and
liabilities resulted in changes in fair value of our assets being significantly offset by changes in the fair value of our CDO notes payable liabilities. We will continue to reflect the fair value of these financial assets and liabilities at fair
value in our balance sheet, with all corresponding changes in fair value recorded in earnings.

Results of Operations

Comparison of the Three-Month Period Ended September 30, 2008 to the Three-Month Period Ended September 30, 2007

Net income (Loss). Our net income increased $560.7 million to approximately $64.1 million for the three-month period ended
September 30, 2008 from a net loss of ($496.6) million for the three-month period ended September 30, 2007. Our net income for the three-month period ended September 30, 2008 was attributable primarily to changes in fair value of
financial instruments recorded in earnings subsequent to our adoption of SFAS No. 159, gains from the buyback and retirement of convertible debt, and net investment income generated by our investments in TruPS, MBS and leveraged loans and
investments in residential mortgages. Our net loss for the three-month period ended September 30, 2007 was primarily attributable to net investment income generated by our investments in TruPS, leveraged loans, residential mortgages and MBS,
which were offset by impairments on investments of approximately $535.1 million.

Net investment income. Our net investment
income decreased $5.0 million to $16.8 million for the three-month period ended September 30, 2008 from approximately $21.8 million for the three-month period ended September 30, 2007. The table below summarizes net investment income by
investment type for the following periods:

For the Three-Month Period Ended September 30, 2008



|                                          |  |                          |         |                           |   |         |                         |  |   |                     |   |  |   |        |  
|----------------------------------------- |  | ------------------------ | ------- | ------------------------- | - | ------- | ----------------------- |  | - | ------------------- | - |  | - | ------ | -
|Investment Type                           |  | InvestmentInterestIncome |         | InvestmentInterestExpense |   |         | Provisionfor LoanLosses |  |   | NetInvestmentIncome |  
|                                          |  | (in thousands)           |        
|Investments in TruPS                      |  | $                        | 72,667  |                           | $ | (51,384 | )                       |  | $ |                    |   |  | $ | 21,283 |  
|Investments in Leveraged Loans            |  |                          | 15,390  |                           |   | (7,615  | )                       |  |   | (6,019              | ) |  |   | 1,756  |  
|Investments in Mortgage-Backed Securities |  |                          | 23,142  |                           |   | (19,984 | )                       |  |   |                    |   |  |   | 3,158  |  
|Investments in Residential Mortgages      |  |                          | 13,800  |                           |   | (13,592 | )                       |  |   | (6,821              | ) |  |   | (6,613 | )
|Other investments                         |  |                          | 586     |                           |   |        |                         |  |   |                    |   |  |   | 586    |  
|Recourse indebtedness                     |  |                          |        |                           |   | (3,379  | )                       |  |   |                    |   |  |   | (3,379 | )
|                                          |  |                          |         |                           |   |         |                         |  |   |                     |   |  |   |        |  
|Total                                     |  | $                        | 125,585 |                           | $ | (95,954 | )                       |  | $ | (12,840             | ) |  | $ | 16,791 |  
|                                          |  |                          |         |                           |   |         |                         |  |   |                     |   |  |   |        |  

For the Three-Month Period Ended September 30, 2007



|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |        |  
|----------------------------------------- |  | ------------------------ | ------- | ------------------------- | - | -------- | ----------------------- |  | - | ------------------- | - |  | - | ------ | -
|Investment Type                           |  | InvestmentInterestIncome |         | InvestmentInterestExpense |   |          | Provisionfor LoanLosses |  |   | NetInvestmentIncome |  
|                                          |  | (in thousands)           |        
|Investments in TruPS                      |  | $                        | 96,996  |                           | $ | (80,396  | )                       |  | $ |                    |   |  | $ | 16,600 |  
|Investments in Leveraged Loans            |  |                          | 18,150  |                           |   | (11,745  | )                       |  |   | (2,877              | ) |  |   | 3,528  |  
|Investments in Mortgage-Backed Securities |  |                          | 61,272  |                           |   | (57,398  | )                       |  |   |                    |   |  |   | 3,874  |  
|Investments in Residential Mortgages      |  |                          | 16,196  |                           |   | (14,764  | )                       |  |   | (1,178              | ) |  |   | 254    |  
|Other investments                         |  |                          | 2,035   |                           |   | (405     | )                       |  |   |                    |   |  |   | 1,630  |  
|Recourse indebtedness                     |  |                          |        |                           |   | (4,086   | )                       |  |   |                    |   |  |   | (4,086 | )
|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |        |  
|Total                                     |  | $                        | 194,649 |                           | $ | (168,794 | )                       |  | $ | (4,055              | ) |  | $ | 21,800 |  
|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |        |  

Our investment interest income decreased $69.0 million to $125.6 million for the three-month
period ended September 30, 2008 from $194.6 million for the three-month period ended September 30, 2007. The decrease in investment interest income is attributable to a decrease in the weighted-average coupon rates in our target asset
classes from 6.7% for the three-month period ended September 30, 2007 to 4.8% for the three-month period ended September 30, 2008 and a decrease in the Companys average investment balances from $11.5 billion for the three months
ended September 30, 2007 to $10.5 billion for the three months ended September 30, 2008.



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Our investment interest expense decreased $72.8 million to $96.0 million for the three-month period ended
September 30, 2008 from $168.8 million for the three-month period ended September 30, 2007. Upon the adoption of SFAS No. 159, we discontinued hedge accounting for a significant portion of our derivatives and therefore, approximately $9.7 million of
periodic net interest payments on these interest rate swaps is no longer recorded within net investment income. Additionally, the decrease in investment interest expense is attributable to a decrease in the weighted-average coupon rate for CDO notes
payable from 5.8% as of September 30, 2007 to 3.3% as of September 30, 2008 as well as a decrease in the Companys average CDO notes payable from $9.0 billion for the three months ended September 30, 2007 to $8.5 billion for the three months
ended September 30, 2008.

Our provision for loan losses relates to investments in residential mortgages and leveraged loans. The provision
for loan losses increased by $8.7 million, to $12.8 million for the three-month period ended September 30, 2008 from $4.1 million for the three-month period ended September 30, 2007. The increase is primarily a result of the continued
increases in the number of delinquent residential mortgage loans experienced in 2008 as a result of the turmoil in the housing markets. The 60-plus day delinquencies in our residential mortgage portfolio increased from 2.5% as of September 30,
2007 to 9.6% as of September 30, 2008. Additionally, the increase in our leveraged loan provisioning is primarily the result of continued deterioration in macro-credit conditions and the resulting impact to the middle-market companies that we
lend to. We maintain an allowance for residential and commercial mortgages and leveraged loan losses based on managements evaluation of estimated losses and inherent risks in the portfolios. Specific allowances for losses are established for
impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loans expected cash flow, the loans estimated market price or the estimated fair value of the underlying collateral.

Expenses. Our non-investment expenses increased by $2.3 million to $10.3 million for the three-month period ended
September 30, 2008 from $8.0 million for the three-month period ended September 30, 2007. During the same periods, these non-investment expenses consisted of related party management compensation of $6.7 million and $4.9 million,
respectively, and general and administrative expenses of $3.6 million and $3.1 million, respectively. During the three-month period ended September 30, 2008 and 2007, the Company incurred base and incentive management fees, net of asset
management fee credits, of $2.7 million and $0, respectively. The $2.7 million of net fees earned by the manager were primarily the result of the $43.9 million gain on extinguishment of debt recorded during the three-month period ended
September 30, 2008. The Company recognized stock-based compensation expense related to shares of restricted common stock granted to the officers of the Company and key employees of the manager and Cohen & Company of $0.1 million and
$0.4 million during the three-month period ended September 30, 2008 and the three-month period ended September 30, 2007, respectively.

During the three-month period ended September 30, 2008 and the three-month period ended September 30, 2007, the consolidated CDO entities that are included in the Companys consolidated financial statements incurred
collateral management fees that are payable to Cohen & Company of $4.0 million and $4.5 million, respectively. The collateral management fees are expenses of consolidated CDO entities and relate to the on-going collateral management
services that Cohen & Company provides for CDOs. The $0.5 million decrease in CDO collateral management fees is due to the decrease in the value of assets used to calculate the base and subordinate fees at each CDO entity. The assets under
management are decreased by the $487.5 million of deferring and defaulted TruPS, thereby resulting in a reduction of collateral manager fee expense for the three-month period ended September 30, 2008.

Our general and administrative expenses are primarily attributable to professional service expenses, including legal services, CDO trustee compensation,
rating agency fees, audit and audit-related fees, tax compliance services, and consulting fees relating to Sarbanes-Oxley compliance.

Interest and other income. Our interest and other income decreased by $3.0 million to $1.3 million for the three-month period ended September 30, 2008 from $4.3 million for the three-month period ended September 30,
2007. This decrease is primarily attributable to reduced interest earned on cash deposits with financial institutions and interest earned on restricted cash of our consolidated CDO entities. The average total cash balance decreased from $314.4
million for the three-month period ended September 30, 2007 to $182.3 million for the three-month period ended September 30, 2008, while the average interest rate earned on cash decreased from 5.5% to 2.8% over the same period.

Net change in fair value of investments in debt securities and non-recourse indebtedness. On January 1, 2008, we adopted SFAS
No. 159 and elected to apply the fair value option for our investments in TruPS and TruPS security-related receivables, MBS, TruPS CDO notes payable, MBS CDO notes payable, and TruPS obligations. During the three-month period ended
September 30, 2008, the net change in fair value of investments in debt securities and non-recourse indebtedness was a $70.0 million gain. The net change in fair value is comprised of $1.2 billion of losses recorded on our investments in debt
securities, which was offset by $1.27 billion of gains recorded on liabilities.

Net change in fair
value of derivative contracts. During the three-month period ended September 30, 2008 and the three-month period ended September 30, 2007, we recorded change in fair value of derivative contracts of ($26.0) million and $25.3
million, respectively. Upon the adoption of FAS No. 159, we discontinued hedge accounting on a significant portion of our interest rate swaps and therefore all changes in fair value of these interest rate swaps are recorded in earnings. The net
change in fair value during the three-month period ended September 30, 2008 is attributable to a $26.0 million loss on interest rate swap contracts. The net change in fair value for the three-month period ended September 30, 2007 is
attributed to an increase in fair value of credit default swaps and partially offset by unrealized losses on interest rate swap contracts.



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Impairments on investments and intangible assets. Our impairments on investments and
intangible assets decreased by $533.6 million to $1.5 million for the three-month period ended September 30, 2008 from $535.1 million for the three-month period ended September 30, 2007. The impairments on investments and intangible assets
for the three-month period ended September 30, 2008 is attributable to $0.8 million of charge-offs on residential mortgages and a $0.7 million impairment on other non-consolidated CDO investments that are primarily collateralized by MBS. During
the three-month period ended September 30, 2007, the Company recorded other-than-temporary impairments of $521.4 million in its consolidated available-for-sale MBS portfolio and recorded a $12.2 million impairment on other non-consolidated CDO
investments that are primarily collateralized by MBS.

Gain on repurchase of debt. During the three-month period ended
September 30, 2008, we repurchased and retired $78.8 million par value of our outstanding convertible debt securities for $33.0 million. We realized a gain of $43.9 million on these transactions, net of a $1.9 million write-off of related
deferred costs. Subsequent to September 30, 2008, we repurchased and retired an additional $32.5 million par value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7 million principal amount of our contingent
convertible debt securities remain outstanding.

Net realized loss on sale of assets. During the three-month period ended
September 30, 2008 and the three-month period ended September 30, 2007, the Company recorded losses on the sale of assets of approximately $2.2 million and $11.2 million, respectively. During the three months ended September 30, 2008,
the Company sold on-balance sheet TruPS with a par value of $3.0 million for cash proceeds of $2.3 million. Additionally, the Company realized losses of $1.5 million on its residential mortgage loan portfolio. During the three months ended
September 30, 2007, the Company recognized an $11.2 million loss on the disposition of TruPS assets included in a VIE which was deconsolidated and accounted for as a sale.

Minority interests. Minority interests represent the portion of net income generated by consolidated entities that are not attributable to
our ownership interest in those entities. Minority interests increased $25.3 million to $29.8 million for the three-month period ended September 30, 2008 as compared to $4.5 million for the three-month period ended September 30, 2007. This
increase is primarily attributable to the minority interest allocation of the net change in fair value of investments in debt securities and non-recourse indebtedness.

Benefit/(Provision) for income taxes. Our domestic TRSs are subject to U.S. federal and state income and franchise taxes. An income tax benefit was recorded of $1.8 million for both the three-month
period ended September 30, 2008 and September 30, 2007, relating to net operating losses sustained by on-balance sheet warehouse arrangements.

Comparison of the Nine-Month Period Ended September 30, 2008 to the Nine-Month Period Ended September 30, 2007

Net income (Loss). Our net income increased $599.7 million to approximately $67.7 million for the nine-month period ended September 30, 2008 from a net loss of ($532.0) million for the nine-month period ended
September 30, 2007. Our net income for the nine-month period ended September 30, 2008 was attributable to changes in fair value of financial instruments recorded in earnings subsequent to our adoption of SFAS No. 159, gains from the
buyback and retirement of convertible debt, net investment income generated by our investments in TruPS, MBS and leveraged loans and investments in residential mortgages, offset by the reclassification into the income statement of MBS related cash
flow hedging losses that were previously included in accumulated other comprehensive loss . Our net income for the nine-month period ended September 30, 2007 was primarily attributable to net investment income generated by our investments in
TruPS, leveraged loans, residential mortgages and MBS, which were offset by impairments on investments of approximately $609.5 million.

Net investment income. Our net investment income increased $13.8 million to $71.4 million for the nine-month period ended September 30, 2008 from approximately $57.6 million for the nine-month period ended
September 30, 2007. The table below summarizes net investment income by investment type for the following periods:

For the
Nine-Month Period Ended September 30, 2008



|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |         |  
|----------------------------------------- |  | ------------------------ | ------- | ------------------------- | - | -------- | ----------------------- |  | - | ------------------- | - |  | - | ------- | -
|Investment Type                           |  | InvestmentInterestIncome |         | InvestmentInterestExpense |   |          | Provisionfor LoanLosses |  |   | NetInvestmentIncome |  
|                                          |  | (in thousands)           |        
|Investments in TruPS                      |  | $                        | 240,221 |                           | $ | (173,459 | )                       |  | $ |                    |   |  | $ | 66,762  |  
|Investments in Leveraged Loans            |  |                          | 47,304  |                           |   | (25,657  | )                       |  |   | (10,989             | ) |  |   | 10,658  |  
|Investments in Mortgage-Backed Securities |  |                          | 104,040 |                           |   | (84,769  | )                       |  |   |                    |   |  |   | 19,271  |  
|Investments in Residential Mortgages      |  |                          | 43,788  |                           |   | (42,152  | )                       |  |   | (17,306             | ) |  |   | (15,670 | )
|Other investments                         |  |                          | 1,646   |                           |   |         |                         |  |   |                    |   |  |   | 1,646   |  
|Recourse indebtedness                     |  |                          |        |                           |   | (11,289  | )                       |  |   |                    |   |  |   | (11,289 | )
|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |         |  
|Total                                     |  | $                        | 436,999 |                           | $ | (337,326 | )                       |  | $ | (28,295             | ) |  | $ | 71,378  |  
|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |         |  



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For the Nine-Month Period Ended September 30, 2007



|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |        |  
|----------------------------------------- |  | ------------------------ | ------- | ------------------------- | - | -------- | ----------------------- |  | - | ------------------- | - |  | - | ------ | -
|Investment Type                           |  | InvestmentInterestIncome |         | InvestmentInterestExpense |   |          | Provisionfor LoanLosses |  |   | NetInvestmentIncome |  
|                                          |  | (in thousands)           |        
|Investments in TruPS                      |  | $                        | 250,150 |                           | $ | (211,212 | )                       |  | $ |                    |   |  | $ | 38,938 |  
|Investments in Leveraged Loans            |  |                          | 43,707  |                           |   | (28,465  | )                       |  |   | (6,097              | ) |  |   | 9,145  |  
|Investments in Mortgage-Backed Securities |  |                          | 176,332 |                           |   | (165,019 | )                       |  |   |                    |   |  |   | 11,313 |  
|Investments in Residential Mortgages      |  |                          | 55,497  |                           |   | (50,716  | )                       |  |   | (3,417              | ) |  |   | 1,364  |  
|Other investments                         |  |                          | 3,613   |                           |   | (440     | )                       |  |   |                    |   |  |   | 3,173  |  
|Recourse indebtedness                     |  |                          |        |                           |   | (6,378   | )                       |  |   |                    |   |  |   | (6,378 | )
|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |        |  
|Total                                     |  | $                        | 529,299 |                           | $ | (462,230 | )                       |  | $ | (9,514              | ) |  | $ | 57,555 |  
|                                          |  |                          |         |                           |   |          |                         |  |   |                     |   |  |   |        |  

Our investment interest income decreased $92.3 million to $437.0 million for the nine-month period
ended September 30, 2008 from $529.3 million for the nine-month period ended September 30, 2007. The decrease in investment interest income is attributable to a decrease in the weighted-average coupon rates in our target asset classes from
6.4% for the nine-month period ended September 30, 2007 to 5.2% for the nine-month period ended September 30, 2008, offset by an increase in the Companys average investment balances from $11.0 billion for the nine months ended
September 30, 2007 to $11.2 billion for the nine months ended September 30, 2008.

Our investment interest expense decreased
$124.9 million to $337.3 million for the nine-month period ended September 30, 2008 from $462.2 million for the nine-month period ended September 30, 2007. Upon the adoption of SFAS No. 159, we discontinued hedge accounting for a significant portion
of our derivatives and therefore, approximately $26.0 million of periodic net interest payments on these interest rate swaps is no longer recorded within net investment income. Additionally, the decrease in investment interest expense is
attributable to a decrease in the weighted-average coupon rate for CDO notes payable from 5.8% as of September 30, 2007 to 4.2% as of September 30, 2008, offset by an increase in the Companys average CDO notes payable from $8.7 billion for the
three months ended September 30, 2007 to $8.9 billion for the three months ended September 30, 2008.

Our provision for loan losses relates
to investments in residential mortgages and leveraged loans. The provision for loan losses increased by $18.8 million, to $28.3 million for the nine-month period ended September 30, 2008 from $9.5 million for the nine-month period ended
September 30, 2007. The increase is primarily a result of the continued increases in the number of delinquent residential mortgage loans experienced in 2008 as a result of the turmoil in the housing markets. The 60-plus day delinquencies in our
residential mortgage portfolio increased from 2.5% as of September 30, 2007 to 9.6% as of September 30, 2008. Additionally, the increase in our leveraged loan provisioning is primarily the result of continued deterioration in macro-credit
conditions and the resulting impact to the middle-market companies that we lend to. We maintain an allowance for residential and commercial mortgages and leveraged loan losses based on managements evaluation of estimated losses and inherent
risks in the portfolios. Specific allowances for losses are established for impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loans expected cash flow, the loans estimated
market price or the estimated fair value of the underlying collateral.

Expenses. Our non-investment expenses increased by
$5.3 million to $26.4 million for the nine-month period ended September 30, 2008 from $21.1 million for the nine-month period ended September 30, 2007. During the same periods, these non-investment expenses consisted of related party
management compensation of $15.7 million and $12.6 million, respectively, and general and administrative expenses of $10.7 million and $8.5 million, respectively. During the nine-month period ended September 30, 2008 and 2007, the Company
incurred base and incentive management fees, net of asset management fee credits, of $2.7 million and $0, respectively. The $2.7 million of net fees earned by the manager were primarily the result of the $43.9 million gain on extinguishment of debt
recorded during the three-month period ended September 30, 2008. The Company recognized stock-based compensation expense related to shares of restricted common stock granted to the officers of the Company and key employees of the manager and
Cohen & Company of $0.9 million and $1.4 million during the nine-month period ended September 30, 2008 and the nine-month period ended September 30, 2007, respectively.

During the nine-month period ended September 30, 2008 and the nine-month period ended September 30, 2007, the consolidated CDO entities that
are included in the Companys consolidated financial statements incurred collateral management fees that are payable to Cohen & Company of $12.1 million and $11.2 million, respectively. The collateral management fees are expenses of
consolidated CDO entities and relate to the on-going collateral management services that Cohen & Company provides for CDOs. The increase in related party management compensation is primarily attributable to the increase in investments
financed through CDO transactions and the collateral manager fees incurred by these consolidated CDO entities, partially offset by the decrease in CDO collateral manager fees resulting from the $487.5 million of defaulted and deferring TruPS CDO
collateral.



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Our general and administrative expenses are primarily attributable to professional service expenses,
including legal services, CDO trustee compensation, rating agency fees, audit and audit-related fees, tax compliance services, and consulting fees relating to Sarbanes-Oxley compliance.

Interest and other income. Our interest and other income decreased by $12.1 million to $3.9 million for the nine-month period ended
September 30, 2008 from $16.0 million for the nine-month period ended September 30, 2007. This decrease is primarily attributable to $10.7 million in reduced interest earned on cash deposits with financial institutions and interest earned
on restricted cash of our consolidated CDO entities. The average total cash balance decreased from $412.0 million for the nine-month period ended September 30, 2007 to $188.9 million for the nine-month period ended September 30, 2008,
while the average interest rate earned on cash decreased from 5.2% to 2.8% over the same period. Additionally, during the nine-month period ended September 30, 2007, the Company received a one-time capital commitment fee of $1.2 million from
Cohen & Company for its services as first loss provider during the warehouse period.

Net change in fair value of
investments in debt securities and non-recourse indebtedness. On January 1, 2008, we adopted SFAS No. 159 and elected to apply the fair value option for our investments in TruPS and TruPS security-related receivables, MBS, TruPS
CDO notes payable, MBS CDO notes payable, and TruPS obligations. During the nine-month period ended September 30, 2008, the net change in fair value of investments in debt securities and non-recourse indebtedness was a $140.2 million gain. The
net change in fair value is comprised of approximately $3.21 billion of losses recorded on our investments in debt securities, which was offset by approximately $3.35 billion of gains recorded on liabilities.

Net change in fair value of derivative contracts. During the nine-month period ended September 30, 2008 and the nine-month period
ended September 30, 2007, we recorded change in fair value of derivative contracts of $(71.8) million and $44.9 million, respectively. Upon the adoption of FAS No. 159, we discontinued hedge accounting on a significant portion of our
interest rate swaps and therefore all changes in fair value of these interest rate swaps are recorded in earnings. The change in fair value during the nine- month period ended September 30, 2008 is primarily attributable to an $88.9 million
loss on interest rate swap contracts and a $17.1 million gain on our CDS positions. The interest rate swap losses described above were impacted by the reclassification to the income statement of $40.6 million of MBS related cash flow hedge losses
that were previously recorded in accumulated other comprehensive loss. The reclassifications resulted from our determination that the forecasted transactions that the instruments hedge are no longer probable of occurring due to the likelihood of or
actual liquidation of our Kleros Real Estate I, II and III portfolios. The change in fair value during the nine-month period ended September 30, 2007 is primarily attributable to a $45.2 million gain on our CDS positions.

Impairments on investments and intangible assets. Our impairments on investments and intangible assets decreased by $595.1 million to $14.4
million for the nine-month period ended September 30, 2008 from $609.5 million for the nine-month period ended September 30, 2007. The impairments on investments and intangible assets for the nine-month period ended September 30, 2008
is attributable to impairments of our goodwill of $5.0 million, $7.3 million of write-downs of REO property and $2.1 million of impairments on other investments. During the nine-month period ended September 30, 2007, the Company recorded
other-than-temporary impairments of $590.2 million in its consolidated MBS portfolio, recorded a $17.8 million impairment on other non-consolidated CDO investments that are primarily collateralized by MBS, and recorded $1.5 million of charge-offs on
residential mortgages.

Loss on disposition of consolidated entities. During June 2008, the Company sold a subsidiary that
owned the remaining $87.5 million notional of CDS positions for $70.4 million in proceeds (inclusive of the $69.3 million of counterparty margin held as of March 31, 2008). During the three-month period ended June 30, 2008, the Company
recorded a net loss upon disposition of the consolidated subsidiary of $5.6 million, which was offset by approximately $6.2 million of unrealized gains on CDS recorded during the same period. The Company records both realized and unrealized changes
in fair value on the CDS contracts within net change in fair value of derivative contracts in the consolidated statements of income (loss). Following the June 2008 sale, the Company no longer holds any investments in CDS.

Gain on repurchase of debt. During the nine-month period ended September 30, 2008, we repurchased and retired $78.8 million par value
of our outstanding convertible debt securities for $33.0 million. We realized a gain of $43.9 million on these transactions, net of a $1.9 million write-off of related deferred costs. Subsequent to September 30, 2008, we repurchased and retired
an additional $32.5 million par value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7 million principal amount of our contingent convertible debt securities remain outstanding.

Net realized loss on sale of assets. During the nine-month period ended September 30, 2008, the Company recorded losses on the sale of
assets of approximately $5.4 million. These losses are attributable to the sale of leveraged loans and TruPS during the period, for which losses were recorded of $1.4 million and $2.2 million, respectively, and a $1.8 million realized loss on the
Companys residential mortgage portfolio. During the nine-month period ended September 30, 2007, the Company recorded losses on the sale of assets of approximately $15.6 million. These losses were attributable to the sale of adjustable
rate residential mortgages and investment securities in CDO entities collateralized by MBS at a loss of $2.0 million and $2.4 million, respectively, as well as an $11.2 million loss on the disposition of TruPS assets included in a VIE which was
deconsolidated and accounted for as a sale.



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Minority interests. Minority interests represent the portion of net income generated by
consolidated entities that are not attributable to our ownership interest in those entities. Minority interests increased $56.4 million to $70.6 million for the nine-month period ended September 30, 2008 as compared to $14.2 million for the
nine-month period ended September 30, 2007. This increase is primarily attributable to the minority interest impact of the net change in fair value of financial instruments.

Benefit/(Provision) for income taxes. Our domestic TRSs are subject to U.S. federal and state income and franchise taxes. An income tax
benefit was recorded of $5.2 million relating to a $2.6 million federal tax refund and net operating loss carryforwards from on-balance sheet warehousing facilities for the nine-month period ended September 30, 2008. An income tax benefit of
$1.2 million was recorded for the nine-month period ended September 30, 2007 related to net operating losses generated at our domestic TRSs.

Liquidity and Capital Resources

Liquidity is a measure of our ability to meet potential cash requirements, including
ongoing commitments to repay borrowings, fund and maintain investments, pay dividends and other general business needs. We believe our available cash balances, other financing arrangements and cash flows from operations will be sufficient to fund
our currently anticipated liquidity requirements for the next twelve months, but our ability to grow our business will be limited by our ability to obtain future financing and our liquidity could be adversely affected by a decline in our stock
price, as discussed below. Management has evaluated our current and forecasted liquidity and continues to monitor evolving market conditions. Future investment alternatives and operating activities will continue to be evaluated against anticipated
current and longer term liquidity demands.

We are currently financing our TruPS, MBS and leveraged loan portfolio with warehouse
facilities and CDO notes payable. As of September 30, 2008, the Company is not financing any investments with short-term repurchase agreements that subject the Company to margin calls or potential recourse obligations in excess of posted first
loss deposits. Should our currently anticipated liquidity needs exceed our available sources of liquidity, we believe that certain securities in which we have invested could be sold to raise additional cash. We currently have no commitments for any
additional financings, and we may not be able to obtain any additional financing at the times required and on terms and conditions acceptable to us. If we fail to obtain needed additional financing, the pace of our growth would be adversely
affected.

On October 10, 2008, the Company was notified by the NYSE that it was not in compliance with an NYSE continued listing
standard applicable to its common stock. The standard requires that the average closing price of any listed security not fall below $1.00 per share for any consecutive 30 trading-day period. On October 15, 2008, the Company notified the NYSE of
its intent to cure this deficiency. Under the NYSE rules, the Company has six months from the date of the NYSE notice to comply with the NYSE minimum share price standard. If the Company is not compliant by that date, its common stock will be
subject to suspension and delisting by the NYSE. The Company is currently exploring alternatives for curing the deficiency and restoring compliance with the continued listing standards. The Companys common stock remains listed on the NYSE
under the symbol AFN. The NYSEs continued listing standards also require that our average market capitalization be at least $25 million over any 30 consecutive trading day period and that we maintain our REIT status. In addition to
being delisted due to our failure to comply with any of these continued listing standards, we will also likely be delisted if we fail to meet any other of the NYSEs listing standards.

During the three-month period ended September 30, 2008, we repurchased and retired $78.8 million par value of our outstanding convertible debt
securities for $33.0 million. We realized a gain of $43.9 million on these transactions, net of a $1.9 million write-off of related deferred costs. Subsequent to September 30, 2008, we repurchased and retired an additional $32.5 million par
value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7 million principal amount of our contingent convertible debt securities remain outstanding.

The holders of our remaining $28.7 million aggregate principal amount of convertible debt will have the right to require us to repurchase their notes at
100% of their principal amount together with accrued but unpaid interest thereon if, among other things, our common stock ceases to be listed on the NYSE, another established national securities exchange or an automated over-the-counter trading
market in the United States. If we are unable to remedy the deficiency described above and remain listed on the NYSE and if we are unable to list our common stock on another established national securities exchange or automated U.S. over-the-counter
trading market, there is a risk that some or all holders of our convertible notes will exercise their right to require us to repurchase their notes. There can be no assurance that we would be able to satisfy such repurchase requests.

As of September 30, 2008, the Companys consolidated financial statements include $96.2 million of cash and cash equivalents and total
indebtedness of $4.4 billion. Total indebtedness includes recourse indebtedness of $110.8 million and $4.3 billion of non-recourse debt relating to consolidated VIEs. As mentioned above, as of the date of this filing total recourse indebtedness has
been reduced to $78.3 million as a result of additional convertible debt repurchases. The creditors of each consolidated VIE have no recourse to the general credit of the Company. The Companys maximum exposure to loss as a result of its
involvement with each consolidated VIE is the equity that the Company has invested in warehouse first-loss deposits and the preference shares or debt of the CDO, CLO or other types of securitization structures.

Our primary cash needs include the ability to:



| |  |  | distribute earnings to maintain our qualification as a REIT;
| | - |  | ------------------------------------------------------------



| |  |  | pay costs of borrowings, including interest on such borrowings and expected CDO, CLO and other securitization debt;
| | - |  | -------------------------------------------------------------------------------------------------------------------



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| |  |  | pay base and incentive fees to our manager and pay other operating expenses;
| | - |  | ----------------------------------------------------------------------------



| |  |  | fund investments and discretionary repurchases of our debt and equity securities; and
| | - |  | -------------------------------------------------------------------------------------



| |  |  | pay federal, state and local taxes of our domestic TRSs.
| | - |  | --------------------------------------------------------

We intend to meet these short-term requirements through the following:



| |  |  | revenue from operations, including interest income from our investment portfolio;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | interest income from temporary investments and cash equivalents;
| | - |  | ----------------------------------------------------------------



| |  |  | borrowings under warehouse facilities; and
| | - |  | ------------------------------------------



| |  |  | proceeds from future borrowings or offerings of our common stock.
| | - |  | -----------------------------------------------------------------

From our inception through the beginning of the credit crisis in August 2007, we sought to finance our assets on a long-term basis through CDOs and CLOs. The disruption in the credit markets has substantially
forestalled our ability to execute new CDOs and CLOs. If the securitization markets re-open in the future, the costs of securitizing assets may be higher than what we experienced in the past. Increased securitization costs may cause us to realize
lower returns on our equity for investments in future CDOs as compared with the returns that we have realized to date on completed CDOs that have lower financing costs. If securitization costs become unacceptably high, or if securitization financing
remains unavailable, we may not be willing or able to complete a securitization for assets that have been purchased using short-term warehouse lines. In that event, we may potentially lose the first loss cash that we had deposited with the warehouse
lender. If we are unable to deploy our capital in high-yielding CDO investments quickly or at all, we would need to find alternative investments which may be lower yielding.

CDO Over-collateralization Tests

The terms of the CDO and CLO vehicles that we use to finance
our investments generally provide that the principal amount of assets must exceed the principal balance of the related securities to be issued by the CDO or CLO by a certain amount, commonly referred to as over-collateralization. The CDO
and CLO terms generally provide that, if certain delinquencies and/or losses exceed the specified levels based on the analysis by the rating agencies (or any financial guaranty insurer) of the characteristics of the assets collateralizing the CDO or
CLO securities, the required level of over-collateralization may be increased or may be prevented from decreasing as would otherwise be permitted if losses or delinquencies did not exceed those levels. Other tests, based on delinquency levels or
other criteria including downgrades by the rating agencies of the underlying portfolio securities of the CDO, may restrict our ability to receive cash distributions from assets collateralizing the CDO or CLO securities. The performance tests may not
be satisfied. In addition, collateral management agreements typically provide that if certain over-collateralization ratio tests are failed and an event of default occurs, the collateral management agreement may be terminated by a vote of the
security holders and the security holders have the option to liquidate the underlying collateral securities. If the assets held by CDOs and CLOs fail to perform as anticipated, our liquidity may be adversely affected.

The following summarizes certain key over-collateralization test matters for each of our respective target asset classes:



| |  |  | MBS and Other InvestmentsAs previously disclosed, the Kleros Real Estate CDOs have all failed over-collateralization tests as a result of
significant ratings agency downgrade activity and are no longer making cash distributions to the Company. The net cash flows of the Kleros Real Estate CDOs are currently being used to pay down the controlling class debtholders in each of the Kleros
Real Estate CDOs. Despite the fact that each Kleros Real Estate CDO has failed over-collateralization tests, the net interest earnings of the three remaining CDOs will continue to be reflected in the Companys net investment income and taxable
income. Previously, we received written notice from the trustees of Kleros Real Estate I, II, and III that each CDO experienced an event of default. On October 30, 2008, we received written notice from the trustee of Kleros Real Estate IV that
the CDO has experienced an event of default. These events of default resulted from the failure of certain additional over-collateralization tests primarily due to credit rating agency downgrades. The events of default provide the controlling class
debtholder in each CDO with the option to liquidate all of the MBS assets collateralizing the particular CDO. The proceeds of any such liquidation would be used to repay the controlling class debtholder.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

On May 1, 2008, the Company received written notice from the trustee of Kleros Real Estate III that the controlling class debtholder had submitted a
notice of liquidation. The liquidation of Kleros Real Estate III occurred in June 2008 through a series of auctions of the underlying collateral and the final distribution of the liquidation proceeds was delivered to the controlling class debtholder
in the same period. Additionally, the Company is no longer able to include the liquidated assets and the related income as a component of its REIT qualifying assets. As of the current date, the controlling class debtholders of Kleros Real Estate I,
II and IV have not exercised their rights to liquidate either CDO.



| |  |  | TruPSOur investments in TruPS are also financed with CDOs that are subject to over-collateralization requirements. The over-collateralization
requirements in the TruPS CDOs are typically triggered in the event that more than three percent of the par value of collateral securities that collateralize the CDO debt defer on a principal or interest payment or are otherwise determined to be
defaulted in accordance with the indenture for the particular CDO. As of the date of this filing, we have experienced 25 bank deferrals or defaults and no insurance deferrals in our TruPS portfolio. As of September 30, 2008, the aggregate
principal amount of investments in the 25 TruPS that have defaulted or are currently deferring interest
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | payments is $490.5 million, representing approximately 9.5% of the Companys consolidated trust preferred securities portfolio. The TruPS deferrals and
defaults described above have resulted in the over-collateralization tests being triggered in all eight CDOs in which the Company holds equity interests. The trigger of an over-collateralization test in a TruPS CDO means that the Company, as a
holder of equity securities, will no longer receive current distributions of cash in respect of its equity interests until sufficient cash or collateral is retained in the CDOs to cure the over-collateralization tests. The Company currently projects
that the affected CDOs may cure the over-collateralization failures and recommence making equity distributions from 2010 to 2023. These cash flow projections assume zero recovery of principal or interest on any of the currently deferring or
defaulted securities and no additional deferrals. There can be no assurance that we will not experience additional deferrals or defaults that will result in further over-collateralization test failures or extend the expected cure periods of the
deals currently failing over-collateralization tests.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Leveraged LoansThe over-collateralization requirements in the leveraged loan CLOs are typically triggered in the event that we experience
significant losses on the sale of assets below par, as well as unrealized fair value adjustments on certain assets as mandated by the indentures which govern our leveraged loan CLOs. The primary cause for such fair value adjustments are default
activity, and credit downgrades in the underlying asset pool. In the event that an over-collateralization failure occurs in a leveraged loan CLO, changes to the priority of payments will result in the equity holders, including us, of the CLO not
receiving any cash flows until such time as the over-collateralization failure is cured. Management continues to closely monitor and actively manage the leveraged loan portfolio as a result of the continued deterioration in macro-credit conditions
and the potential for significant stress on the middle-market companies in our portfolio. As of the date of this filing, we have not experienced an over-collateralization failure in any of our leveraged loan CLOs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Warehouse Financing Arrangements

As of
September 30, 2008, we were party to the following agreement which is collateralized by the assets shown below:



|                                                        |  |                  |  |                       |              
|------------------------------------------------------- |  | ---------------- |  | --------------------- | -------------
|Financing Facilities (and Aggregate Borrowing Capacity) |  | Termination Date |  | Assets Being Financed
|Leveraged loan related warehouse facility               |  | May 2009         |  | $                     | 174.0 million

As of September 30, 2008, the Companys consolidated financial statements included
$133.2 million of warehouse credit facility debt in the form of short term notes payable. Warehouse credit facility debt relates to on-balance sheet warehouse facilities entered into by a subsidiary of the Company utilized to finance the acquisition
of leveraged loans on a short-term basis until longer-term financing is available. The Companys maximum economic exposure to loss on the warehouse credit facility is limited to the amount of capital that the Company has invested pursuant to
the terms of the arrangement. As of September 30, 2008, the Company has invested $40.8 million of capital in this financing arrangement, which provides for $200 million of total borrowing capacity and bears interest of 125 basis points over the
daily commercial paper rate.

Inflation

We believe that the principal risk to us from inflation is the effect that market interest rates may have on our floating rate debt instruments as a result of future increases caused by inflation. We mitigate against this risk through our
financing strategy to match the terms of our investment assets with the terms of our liabilities and, to the extent necessary, through the use of hedging instruments.

Fair Values

For certain of the financial instruments that we own, fair values will not be readily
available since there are no active trading markets for these instruments as characterized by currency exchanges between willing parties. Accordingly, fair values can only be derived or estimated for these investments using various valuation
techniques, such as computing the present value of estimated future cash flows using discount rates commensurate with the risks involved. However, the determination of estimated future cash flows is inherently subjective and imprecise. Minor changes
in assumptions or estimation methodologies can have a material effect on these derived or estimated fair values. These estimates and assumptions are indicative of the interest rate environments as of September 30, 2008 and do not take into
consideration the effects of subsequent interest rate fluctuations.

We note that the values of our investments in MBS, residential
mortgages, TruPS, and derivative instruments will be sensitive to changes in market interest rates, interest rate spreads, credit spreads and other market factors. The value of these investments can vary materially from period to period.

Securities Repurchases

In August 2007, our board
of directors authorized us to repurchase up to $50 million of our common stock from time to time in open market purchases or privately negotiated transactions. During the three-month period ended September 30, 2008, we repurchased 629,596
shares of common stock for $0.6 million, at a weighted-average price of $0.99 per share. Additionally, during October 2008, we repurchased 112,800 shares of common stock for $0.1 million, at a weighted-average price of $1.02 per share. We may also
repurchase convertible debt securities from time to time in open market purchases or privately negotiated transactions. During the three-month period ended September 30, 2008, the Company repurchased and retired $78.8 million par value of its
outstanding convertible debt securities for $33.0 million. The Company realized a gain of $43.9 million on these transactions, net of a $1.9 million write-off of related deferred costs. Subsequent to September 30, 2008, the Company repurchased
and retired an additional $32.5 million par value of convertible debt securities for $17.6 million. As of the date of this filing, $28.7 million principal amount of the Companys contingent convertible debt securities remains outstanding. There
can be no assurance as to the timing or amount of any future securities repurchases we may complete.

Off-Balance Sheet Arrangements and Commitments

We may maintain arrangements with various investment banks regarding CDO securitizations and off-balance sheet warehouse facilities.
Prior to the completion of a CDO securitization, historically our off-balance sheet warehouse providers have acquired investments in accordance with the terms of the warehouse facility agreements. Pursuant to the terms of the warehouse agreements,



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we receive all or a portion of the difference between the interest earned on the investments acquired under the warehouse facilities and the interest accrued
on the warehouse facilities from the date of the respective acquisitions. Under the warehouse agreements, we are required to deposit cash collateral with the warehouse providers, and as a result, we bear the first dollar risk of loss up to our
warehouse deposit if an investment held under the warehouse facility is liquidated at a loss. Upon the completion of a CDO securitization, the cash collateral held by the warehouse provider is returned to us. In the event that we are unable to
obtain long-term CDO financing for the accumulated warehouse collateral, our cash collateral is at risk and may not be returned to the Company. The duration of a warehouse facility is generally at least nine months. These arrangements are deemed to
be derivative financial instruments and are recorded by us at fair value in each accounting period with the change in fair value recorded in earnings.



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|ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
|------- | -----------------------------------------------------------

Our exposure to market risk pertains to losses resulting from changes in interest rates and equity security prices. We are exposed to credit risk and interest rate risk related to our investments in assets in our target asset classes.

Market Risk

The credit markets
in the United States began suffering significant disruption in the summer of 2007. This disruption began in the subprime residential mortgage sector and extended to the broader credit and financial markets generally. During the third quarter of
2008, it became clear that the global economy has been adversely impacted by the credit crisis. Available liquidity, particularly through asset-backed securities (ABS) CDOs and other securitizations, declined precipitously during the second half of
2007 and remains depressed as of the date of this filing. Concerns about the capital adequacy of financial services companies, disruption in global credit markets, volatility in commodities prices and continued pricing declines in the U.S. housing
market have led to further disruptions in the financial markets, adversely affected regional banks and have exacerbated the longevity and severity of the credit crisis. The disruption in these markets directly impacts our business because our
investment portfolio includes investments in mortgage-backed securities, or MBS, mortgage loans, leveraged loans and bank and insurance company debt.

The disruption in the credit markets has severely restricted our ability to complete new CDOs and CLOs. In addition, banks are capital constrained and this severely limits their ability to provide new financing
commitments. We expect this situation to continue for the foreseeable future until markets stabilize, credit concerns dissipate and capital becomes less constrained. We are fortunate that the substantial portion of our portfolio is financed with
in-place, long-term financing. However, as of September 30, 2008, we had $40.8 million of cash deposited with warehouse lenders to collateralize a warehouse facility for leveraged loans. If the securitization markets remain effectively closed
for an extended period, we may lose the first loss cash that we had deposited with the warehouse lender.

Interest Rate Risk

Interest rates may be affected by economic, geopolitical, monetary and fiscal policy, market supply and demand and other factors generally outside our
control, and such factors may be highly volatile. Our interest rate risk sensitive assets and liabilities and financial derivatives typically will be held for long-term investment and not held for sale purposes. Our intent in structuring CDO and CLO
transactions and other securitizations will be to limit interest rate risk with a financing strategy that matches the terms of our investment assets with the terms of our liabilities and, to the extent necessary, through the use of hedging
instruments. Although we have had only limited operations, we do not believe an increase or decrease in interest rates will have a material impact on our net equity in our overall portfolio.

We generally make investments that are either floating rate or fixed rate. Our floating rate investments will generally be priced at a fixed spread over
an index such as LIBOR that reprices either quarterly or every 30 days based upon movements in effect at each measurement date. Given the frequency of future price changes in our floating rate investments, changes in interest rates are not expected
to have a material effect on the value of these investments. Increases or decreases in LIBOR will have a corresponding increase or decrease in our interest income and the match funded interest expense, thereby mitigating the net earnings impact on
our overall portfolio. In the event that long-term interest rates increase, the value of our fixed-rate investments would be diminished. We have hedged this risk where the benefit outweighs the cost of the hedging strategy. Such changes in interest
rates would not have a material effect on the income of these investments, which generally will be held to maturity.

Through
September 30, 2008, we entered into various interest rate swap agreements to hedge variable cash flows associated with CDO notes payable and repurchase agreements. These interest rate swap contracts have an aggregate notional value of $2.2
billion and are used to swap the variable cash flows associated with variable rate CDO notes payable and repurchase agreements into fixed-rate payments. As of September 30, 2008, the interest rate swaps had an aggregate liability fair value of
$115.7 million. Changes in the fair value of interest rate swaps that were not designated as hedges under SFAS No. 133 are recorded in earnings.

There have been no material changes in Quantitative and Qualitative disclosures in 2008 from the disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2007. See discussion of
quantitative and qualitative disclosures about market risk under Item 7A-Quantitative and Qualitative Disclosures About Market Risk included in our Annual Report on Form 10-K for the year ended December 31, 2007.



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|ITEM 4. | CONTROLS AND PROCEDURES.
|------- | ------------------------

Evaluation of Disclosure Controls and
Procedures

We have established disclosure controls and procedures to ensure that material information relating to the Company,
including our consolidated subsidiaries, is made known to the officers who certify our financial reports and to other members of senior management and the board of directors. Under the supervision, and with the participation of our Chief Executive
Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934 (Exchange
Act) as of September 30, 2008. Based on that evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures were effective at September 30, 2008, to ensure that
information required to be disclosed by us in the reports we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial
reporting.

PART II. OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------

On June 8, 2006, our loan to
Beech Thicket Spring, Inc., Communities of Penland, LLC, COP Preservation Partners, LLC, F.W., Inc., The Penland Reserve Tract, LLC, and Triad Apartment Group, LLC in the original principal amount of $16.7 million (the Penland Loan)
matured. The outstanding balance at maturity was $11,745,589.50. The Penland Loan was guaranteed by five individuals, Anthony R. Porter, Dorothy M. Porter, Frank A. Amelung, Eugenia Amelung and Richard L. Amelung (collectively
Guarantors). On March 29, 2007, we obtained a judgment against the Guarantors for $13,060,614.63in the case is styled Alesco Financial Inc. v. Anthony R. Porter, Dorothy M. Porter, Frank Amelung, Eugenia Amelung and Richard
Amelung, in the United States District Court in the Middle District of Florida, Case No.: 3:07-cv-00032-HWM-HTS. Frank A. Amelung, Eugenia Amelung and Richard L. Amelung sought protection in the United States Bankruptcy Court in the Southern
District of Florida, West Palm Beach Division, In Re: Frank A. Amelung, Jr. and Eugenia Marie Amelung, Chapter 7 Debtors, Case No.: 07-15492-BKC-PGH, and In Re: Richard L. Amelung, Debtor Chapter 7, Case No.: 07-15493-BKC-PGH,
respectively. Alesco has made a claim in both cases for the amount of the Judgment, reduced as the Peerless Loan otherwise is collected. At least two parties, including the Trustee in each case, have filed pleadings objecting to the discharge of
Frank A. Amelung and Richard L. Amelung. The ability to collect a material amount of the Judgment in the bankruptcy proceedings is slight, and we do not belive the other Guarantors have significant assets for levy. We are considering all options to
pursue collection of the Judgment in the various jurisdictions, subject to limitations imposed by law. We also retain our primary collateral consisting of real property in the Mountains of North Carolina.

The Attorney General of North Carolina on June 6, 2007, filed suit against one or more of the Borrowers and Guarantors of the Penland Loan described
above, among others, in the case styled State of North Carolina ex rel, Roy Cooper, Attorney General vs. Peerless Real Estate Services, Inc., Village of Penland, L.L.C., MFSL Landholdings, L.L.C., Communities of Penland, L.L.C., COP Land
Holdings, L.L.C., PG Capital Holdings, L.L.C., Anthony Porter, Frank Amelung, Richard Amelung, J. Kevin Foster, Neil ORourke, Michael Yeomans, and A. Greg Anderson, General Court of Justice, Superior Court Division, State of North
Carolina, Wake County, Case No.: 07-CVS-9006. The North Carolina Attorney General alleged that the defendants in the case obtained monies from consumers in violation of North Carolina law relating to unfair or deceptive practices affecting commerce.
The court in this case has issued an order appointing a receiver for the assets of the corporate defendants in the case, Peerless Real Estate Services, Inc., Village of Penland, L.L.C., MFSL Landholdings, L.L.C., Communities of Penland, L.L.C., COP
Land Holdings, L.L.C., PG Capital Holdings, L.L.C., and has since added the rest of our Borrowers not originally named as defendants for receivership. We are not a named party in this action, but the receivership includes all of the North Carolina
real property collateral held by us to secure the Penland Loan. The complaint filed by the North Carolina Attorney General seeks to void all contracts between the named defendants and consumers in the alleged deceptive scheme identified in the
complaint, the return of all monies obtained by the named defendants in the alleged deceptive scheme, civil penalties against the named defendants and attorney fees from the named defendants. The Order Appointing Receiver authorizes the Receiver,
among other things, to sell and dispose of property of the Borrowers in the receivership free and clear of all liens and other collateral interests, which liens or other collateral interests will then attach to the proceeds. We have not received
notice of any such sale or disposition of our collateral, and we plan to protect vigorously any and all liens and other collateral interests in the collateral for the Penland Loan. In the pleadings in this case, we have learned that two of the
Guarantors and other officers of our Borrowers have pled guilty to one or more felony counts relating to fraud involving the sale of real property in and around our remaining collateral in North Carolina and that the Receiver also has been appointed
Special Master in the restitution proceedings in the criminal cases. We intend to continue to foreclose some or all our collateral, which may require this courts approval, and pursue collection by all other available means.



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##### Table of Contents

|Item 1A. | Risk Factors
|-------- | ------------

The risks described under
Item 1A  Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2007, could materially and adversely affect our business, financial condition and results of operations. The risk factors
discussed in that Form 10-K and in this Quarterly Report on Form 10-Q do not identify all risks that we face because our business operations could also be affected by additional factors that are not presently known to us or that we currently
consider to be immaterial to our operations.



|Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds
|------- | -----------------------------------------------------------

On August 3, 2007, our board of directors authorized us to repurchase up to $50.0 million of our outstanding common stock, such repurchases to be effected from time to time in the open market or through privately negotiated
transactions. Below in tabular format is information pertaining to the repurchases of the Companys shares of common stock during the three-month period ended September 30, 2008:



|                                             |  |                                    |  |                                 |      |                                                                                 |           |                                                                                                           |   |           
|-------------------------------------------- |  | ---------------------------------- |  | ------------------------------- | ---- | ------------------------------------------------------------------------------- | --------- | --------------------------------------------------------------------------------------------------------- | - | ----------
|Period                                       |  | (a) Total Numberof SharesPurchased |  | (b) Average PricePaid per Share |      | (c) Total Numberof SharesPurchased as Partof PubliclyAnnounced Plansor
Programs |           | (d) MaximumNumber (orApproximateDollar Value) ofShares that MayYet Be PurchasedUnder the Plans orPrograms
|July 1, 2008 through July 31, 2008           |  |                                   |  | $                               |     |                                                                                 | 420,800   |                                                                                                           | $ | 48,045,578
|August 1, 2008 through August 31, 2008       |  |                                   |  | $                               |     |                                                                                 | 420,800   |                                                                                                           | $ | 48,045,578
|September 1, 2008 through September 30, 2008 |  | 629,596                            |  | $                               | 0.99 |                                                                                 | 1,050,396 |                                                                                                           | $ | 47,419,420

Additionally, during October 2008, we repurchased 112,800 shares of common stock for $0.1 million,
at a weighted-average price of $1.02 per share. As of the date of this filing, we have repurchased a total 1,163,196 shares at a weighted-average price of $2.32 per share.



|Item 3. | Defaults Upon Senior Securities
|------- | -------------------------------

None.



|Item 4. | Submission of Matters to a Vote of Security Holders
|------- | ---------------------------------------------------

None.



|Item 5. | Other Information
|------- | -----------------

None.



|Item 6. | Exhibits
|------- | --------

(a) Exhibits  see Exhibit
Index.



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##### Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                       |  |                       |  |                          
|---------------------- |  | --------------------- |  | -------------------------
|                       |  | ALESCO FINANCIAL INC.
|                       |  |                      
|                       |  | By:                   |  | /s/ James J. McEntee, III
|                       |  |                       |  | James J. McEntee, III    
|Date: November 5, 2008 |  |                       |  | Chief Executive Officer  
|                       | 
|                       |  | ALESCO FINANCIAL INC.
|                       |  |                      
|                       |  | By:                   |  | /s/ John J. Longino      
|                       |  |                       |  | John J. Longino          
|Date: November 5, 2008 |  |                       |  | Chief Financial Officer  



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EXHIBIT INDEX



|            |  |                                                                                                                                                                                                                                                                                                                            
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                
|2.1         |  | Amended and Restated Agreement and Plan of Merger, dated as of July 20, 2006, by and among Alesco Financial Inc., Alesco Financial Trust and Jaguar Acquisition Inc. (incorporated by reference to
Annex A to our Proxy Statement on Schedule 14A filed with the SEC on September 8, 2006).                                
|            | 
|2.2         |  | Letter Agreement dated September 5, 2006 by and among Alesco Financial Inc., Alesco Financial Trust and Jaguar Acquisition Inc. and the attached Registration Rights Provisions (incorporated by
reference to Exhibit 2.1 to our Current Report on Form 8-K filed with the SEC on September 5, 2006).                      
|            | 
|2.3         |  | Letter Agreement dated September 29, 2006 by and among Alesco Financial Inc., Alesco Financial Trust and Jaguar Acquisition Inc. (incorporated by reference to Exhibit 3.1 to our Current Report
on Form 8-K filed with the SEC on September 29, 2006).                                                                    
|            | 
|3.1         |  | Second Articles of Amendment and Restatement (incorporated by reference to Exhibit 3.1 to Amendment No. 1 to our Registration Statement on Form S-11 (Registration No. 333-111018) filed with the
SEC on February 6, 2004).                                                                                                
|            | 
|3.2         |  | Articles of Amendment changing our name to Alesco Financial Inc. (incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-3 (Registration No. 333-138136) filed with the
SEC on October 20, 2006).                                                                                                
|            | 
|3.3         |  | By-laws, as amended (incorporated by reference to Exhibit 3.1 to our Current Report on Form 8-K filed with the SEC on October 11, 2005).                                                                                                                                                                                   
|            | 
|4.1         |  | Form of Specimen Stock Certificate (incorporated by reference to Exhibit 4.1 to our Quarterly Report on Form 10-Q filed with the SEC on August 9, 2007).                                                                                                                                                                   
|            | 
|4.2         |  | Form of 7.625% Contingent Convertible Senior Notes due 2027 (incorporated by reference to Exhibit 4.2 to our Current Report on Form 8-K filed with the SEC on May 21, 2007).                                                                                                                                               
|            | 
|4.3         |  | Registration Rights Agreement, dated as of May 15, 2007, by and between Alesco Financial Inc. and RBC Capital Markets Corporation (incorporated by reference to Exhibit 4.3 to our Current Report
on Form 8-K filed with the SEC on May 21, 2007).                                                                         
|            | 
|4.4         |  | Indenture, dated as of May 15, 2007, by and between Alesco Financial Inc. and U.S. Bank National Association (incorporated by reference to Exhibit 4.1 to our Current Report on Form 8-K filed
with the SEC on May 21, 2007).                                                                                              
|            | 
|4.5         |  | Junior Subordinated Indenture, dated as of June 25, 2007, by and between Alesco Financial Inc. and Wells Fargo Bank, N.A. (incorporated by reference to Exhibit 4.1 to our Current Report on Form
8-K filed with the SEC on June 29, 2007).                                                                                
|            | 
|4.6         |  | Indenture, dated as of June 29, 2007, by and among Bear Stearns ARM Trust 2007-2, Citibank, N.A. and Wells Fargo Bank, N.A. (incorporated by reference to Exhibit 4.6 to our Quarterly Report on
Form 10-Q filed with the SEC on August 9, 2007).                                                                          
|            | 
|10.1        |  | Management Agreement, dated as of January 31, 2006, by and between Alesco Financial Trust and Cohen Brothers Management, LLC (incorporated by reference to Annex E to our Proxy Statement on
Schedule 14A filed with the SEC on September 8, 2006).                                                                        
|            | 
|10.2        |  | Shared Facilities and Services Agreement, dated as of January 31, 2006, by and between Cohen Brothers Management, LLC and Cohen Brothers, LLC (incorporated by reference to Exhibit 10.3 to
Amendment No. 1 to our Registration Statement on Form S-3 (Registration No. 333-137219) filed with the SEC on October 5, 2006).



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|            |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.3        |  | Letter Agreement, dated January 31, 2006, by and between Alesco Financial Trust and Cohen Brothers, LLC, relating to certain rights of first refusal and non-competition arrangements between the
parties (incorporated by reference to Exhibit 10.4 to Amendment No. 1 to our Registration Statement on Form S-3 (Registration No. 333-137219) filed with the SEC on October 5, 2006).                                                                                                                            
|            | 
|10.4        |  | Master Repurchase Agreement, dated as of February 28, 2006, by and between Bear Stearns Mortgage Capital Corporation and Alesco Loan Holdings Trust (incorporated by reference to Exhibit 10.10 to
our Annual Report on Form 10-K filed with the SEC on March 16, 2007).                                                                                                                                                                                                                                           
|            | 
|10.5        |  | Separation Agreement and General Release, dated July 14, 2006, by and between Sunset Financial Resources, Inc. and George Deehan (incorporated by reference to Exhibit 10.1 to our Current Report
on Form 8-K filed with the SEC on July 26, 2006).                                                                                                                                                                                                                                                                
|            | 
|10.6        |  | Assignment and Assumption Agreement, dated as of October 6, 2006, by and between Alesco Financial Inc. and Cohen Brothers Management, LLC, transferring the agreement referred to in Exhibit 10.1
hereto to Alesco Financial Inc. (incorporated by reference to Exhibit 10.2 to our Registration Statement on Form S-3 (Registration No. 333-138136) filed with the SEC on October 20, 2006).                                                                                                                      
|            | 
|10.7        |  | Letter Agreement, dated October 18, 2006, by and between Alesco Financial Inc. and Cohen & Company, LLC, transferring the agreement referred to in Exhibit 10.1 hereto to Alesco Financial
Inc. (incorporated by reference to Exhibit 10.5 to our Registration Statement on Form S-3 (Registration No. 333-138136) filed with the SEC on October 20, 2006).                                                                                                                                                        
|            | 
|10.8        |  | Credit Agreement, dated as of September 29, 2006, by and among Alesco Financial Holdings, LLC, Alesco Financial Trust and Royal Bank of Canada (incorporated by reference to Exhibit 10.9 to our
Annual Report on Form 10-K filed with the SEC on March 16, 2007).                                                                                                                                                                                                                                                 
|            | 
|10.9        |  | Credit Agreement, dated as of March 27, 2007, by and among Alesco Financial Holdings, LLC, Alesco Financial Inc., Royal Bank of Canada, U.S. Bank National Association and Royal Bank of Canada
(incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on April 3, 2007).                                                                                                                                                                                                 
|            | 
|10.10       |  | Letter Agreement, dated April 10, 2007, by and among Alesco Financial Inc., Alesco Warehouse Conduit, LLC, Cohen & Company Financial Management, LLC and Cohen & Company, in relation to
the Note Purchase Agreement, dated December 5, 2006, by and among PFW III, Ltd., the investors party thereto, Alesco Warehouse Conduit LLC, as initial subordinated noteholder and ABN Amro Bank N.V. (incorporated by reference to Exhibit 10.2 to our
Quarterly Report on Form 10-Q filed with the SEC on May 10, 2007).
|            | 
|10.11       |  | Letter Agreement, dated April 23, 2007, by and among Alesco Financial Inc., Alesco Holdings, Ltd., Strategos Capital Management, LLC and Cohen & Company, in relation to the Warehouse Risk
Sharing Agreement, dated as of February 7, 2007, between Merrill Lynch and Alesco Holdings, Ltd. (incorporated by reference to Exhibit 10.3 to our Quarterly Report on Form 10-Q filed with the SEC on May 10, 2007).                                                                                                  
|            | 
|10.12       |  | Purchase Agreement, dated as of May 9, 2007, by and between Alesco Financial Inc. and RBC Capital Markets Corporation) (incorporated by reference to Exhibit 1.1 to our Current Report on Form 8-K
filed with the SEC on May 10, 2007).                                                                                                                                                                                                                                                                            
|            | 
|10.13       |  | Underwriting Agreement, dated June 20, 2007, by and between Alesco Financial Inc. and RBC Capital Markets Corporation (incorporated by reference to Exhibit 1.1 to our Current Report on Form 8-K
filed with the SEC on June 22, 2007).                                                                                                                                                                                                                                                                            
|            | 
|10.14       |  | Amended and Restated Trust Agreement, dated as of June 25, 2007, by and among Alesco Financial Inc., Wells Fargo Bank, N.A., Wells Fargo Delaware Trust Company and the administrative trustees
named therein (incorporated by reference to Exhibit 4.2 to our Current Report on Form 8-K filed with the SEC on June 29, 2007).                                                                                                                                                                                    



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|            |  |                                                                                                                                                                                                                                                                                                                                                                                              
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                  
|10.15       |  | Amended and Restated Trust Agreement, dated as of June 29, 2007, by and among Structured Asset Mortgage Investments II Inc., Wilmington Trust Company, Wells Fargo Bank, N.A. and acknowledged by
Alesco Financial Inc. (incorporated by reference to Exhibit 10.13 to our Quarterly Report on Form 10-Q filed with the SEC on August 9, 2007).                                              
|            | 
|10.16       |  | Mortgage Loan Purchase Agreement, dated as of June 29, 2007, by and between Alesco Financial Inc. and Structured Asset Mortgage Investments II Inc. (incorporated by reference to Exhibit 10.14 to
our Quarterly Report on Form 10-Q filed with the SEC on August 9, 2007).                                                                                                                  
|            | 
|10.17       |  | Sale and Servicing Agreement, dated as of June 29, 2007, by and among Structured Asset Mortgage Investments II Inc., Bear Stearns ARM Trust 2007-2, Alesco Financial Inc., Citibank, N.A. and
Wells Fargo Bank, N.A., as securities administrator and master servicer (incorporated by reference to Exhibit 10.15 to our Quarterly Report on Form 10-Q filed with the SEC on August 9, 2007).
|            | 
|10.18       |  | Guarantee Agreement, dated as of June 29, 2007, by and between Alesco Financial Inc. and Alesco Loan Holdings Trust (incorporated by reference to Exhibit 10.16 to our Quarterly Report on Form
10-Q filed with the SEC on August 9, 2007).                                                                                                                                                  
|            | 
|10.19       |  | 2006 Long-Term Incentive Plan, as amended (incorporated by reference to Annex A to our Proxy Statement on Schedule 14A filed with the SEC on April 30, 2007).                                                                                                                                                                                                                                
|            | 
|10.20       |  | Form of Restricted Share Award Agreement (incorporated by reference to Exhibit 10.7 to our Annual Report on Form 10-K filed with the SEC on March 16, 2007).                                                                                                                                                                                                                                 
|            | 
|10.21       |  | Form of Indemnification Agreement by and between Alesco Financial Inc. and each of its directors and officers (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed
with the SEC on October 20, 2006).                                                                                                                                                          
|            | 
|11.1        |  | Statement Regarding Computation of Per Share Earnings.***                                                                                                                                                                                                                                                                                                                                    
|            | 
|31.1        |  | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, as amended.*                                                                                                                                                                                                                                                                         
|            | 
|31.2        |  | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, as amended.*                                                                                                                                                                                                                                                                         
|            | 
|32          |  | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, as amended.**                                                                                                                                                                                                                                            



|* | Filed herewith.
|- | ---------------

|** | Furnished herewith.
|-- | -------------------

|*** | Data required by Statement of Financial Accounting Standard No. 128, Earnings per Share, is provided in Note 8 to the consolidated financial statements included in this
report.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

All other schedules have been omitted because the required information of such other schedules is not present, or is
not present in amount sufficient to require submission of the schedule.



53