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**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 March 31,2009**

 

**OR**

 

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

 

**For the transition period from          to           **

 

**Commissionfile number: 1-32551**

 

**DEERFIELD CAPITAL CORP.**

(Exact name ofregistrant as specified in its charter)

 

| **Maryland**              | ** ** | **20-2008622**       |
|---------------------------|------------|----------------------|
| (State of  incorporation) |       | (I.R.S. Employer     |
|                      |       | Identification  No.) |

 

**6250North River Road, 9th Floor, Rosemont, Illinois 60018**

**(773) 380-1600**

 (Address, including zip code, and telephonenumber,

 including area code, of registrant’s principalexecutive offices)

* *

**n/a**

(Former name,former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days.     Yes x No o

 

Indicate by checkmark whether the registrant has submitted electronically and posted on itscorporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).     Yes o No o

 

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

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

(Do not check if  a smaller reporting company) |   | Smaller  reporting company o |

 

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

 

There were 6,454,924 shares of the registrant’s CommonStock outstanding as of May 8, 2009.

 

 

 

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**DEERFIELDCAPITAL CORP.**

**QUARTERLYREPORT ON FORM 10-Q**

**FORTHE QUARTER ENDED MARCH 31, 2009**

**INDEX**

 
| ** **                                                                                                    | **Page** |
|---------------------------------------------------------------------------------------------------------------|----------|
|                                                                                                          |     |
| Part I. Financial  Information                                                                           |     |
|                                                                                                          |     |
| Item 1. Condensed  Consolidated Financial Statements and Notes (Unaudited)                               | 6        |
|                                                                                                          |     |
| Condensed Consolidated Balance Sheets — March 31,  2009 and December 31, 2008                  | 6        |
|                                                                                                          |     |
| Condensed Consolidated Statements of Operations —  Three Months Ended March 31, 2009 and 2008       | 7        |
|                                                                                                          |     |
| Condensed Consolidated Statement of Stockholders’  Deficit — Three Months Ended March 31, 2009 | 8        |
|                                                                                                          |     |
| Condensed Consolidated Statements of Cash Flows —  Three Months Ended March 31, 2009 and 2008       | 9        |
|                                                                                                          |     |
| Notes to Condensed Consolidated Financial Statements                                                          | 10       |
|                                                                                                          |     |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations     | 26       |
|                                                                                                          |     |
| Item 3. Quantitative and Qualitative Disclosures  About Market Risk                                      | 54       |
|                                                                                                          |     |
| Item 4. Controls and Procedures                                                                          | 57       |
|                                                                                                          |     |
| Part II.  Other Information                                                                              |     |
|                                                                                                          |     |
| Item 1A.  Risk Factors                                                                                   | 57       |
|                                                                                                          |     |
| Item  5. Other Information                                                                                    | 58       |
|                                                                                                          |     |
| Item 6. Exhibits                                                                                         | 59       |
|                                                                                                          |     |
| Signatures                                                                                                    | 60       |

 

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**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Certain statements inthis quarterly report on Form 10-Q, or Quarterly Report, and theinformation incorporated by reference into this Quarterly Report areforward-looking as permitted by the Private Securities Litigation Reform Act of1995. These include statements regarding future results or expectations.Forward-looking statements can be identified by forward-looking language,including words such as “believes,” “anticipates,” “expects,” “estimates,” “intends,”“may,” “plans,” “projects,” “will” and similar expressions, or the negative ofthese words. Such forward-looking statements are based on facts and conditionsas they exist at the time such statements are made. Forward-looking statementsare also based on predictions as to future facts and conditions, the accurateprediction of which may be difficult and involve the assessment of eventsbeyond our control. Forward-looking statements are further based on variousoperating assumptions. Caution must be exercised in relying on forward-lookingstatements. Due to known and unknown risks, actual results may differmaterially from expectations or projections. We do not undertake any obligationto update any forward-looking statement, whether written or oral, relating tomatters discussed in this Quarterly Report, except as may be required byapplicable securities laws. All future written and oral forward-looking statementsattributable to us or any person acting on our behalf are expressly qualifiedin their entirety by the cautionary statements contained or referenced above.In addition, it is our policy generally not to make any specific projections asto future earnings, and we do not endorse any projections regarding futureperformance that may be made by third parties.

 

The following factors,among others, could cause actual results to differ materially from thosedescribed in the forward-looking statements:

 

**Relatingto our business generally:**

 
| · | effects of the current  dislocation and weakness in the mortgage market and credit markets generally;                                                                                                                                                                                                                                                                                                                                                               |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | effects of the current  global economic crisis and recession;                                                                                                                                                                                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | failure to comply with  covenants contained in the agreements governing our indebtedness, and failure  to obtain waivers for future non-compliance, including with respect to the  net worth covenant in the agreements governing our trust preferred securities  and our ability to extend the current waiver for non-compliance beyond  April 1, 2010;                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | limitations and  restrictions contained in instruments and agreements governing our  indebtedness;                                                                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | our ability to maintain  adequate liquidity, including ability to raise additional capital and secure  additional financing;                                                                                                                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | our ability to develop  and submit an acceptable plan to the NYSE Amex LLC (the “NYSE Amex”) that  adequately addresses how we will regain compliance, and our ability to  generally regain and maintain compliance, with the continued listing  standards of the NYSE Amex to maintain the listing of our securities on a  national securities exchange;                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | our ability to generate  earnings or raise capital to achieve positive stockholders’ equity;                                                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | internal policy  decisions at the NYSE Amex that may impact our ability to maintain our  listing;                                                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | our ability to satisfy  the conditions to the capital commitments in our new investment venture with  Pegasus Capital Advisors L.P. (“Pegasus”), whether Pegasus ultimately invests  all or a portion of its $75.0 million capital commitment and whether such  investment venture is successful;                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | rapid changes in the  fair values of our assets, making it difficult for us to comply with our  exemption from registration under the Investment Company Act of 1940, as  amended (the “1940 Act”);                                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | our ability to forecast  our tax attributes, which are based upon various facts and assumptions, and  our ability to protect and use our net operating losses and net capital  losses to offset future taxable income and gains, including whether our  recently adopted stockholder rights plan or our current proposed charter  amendment will be effective in preventing an ownership change that would  significantly limit our ability to utilize such losses; |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | increases in borrowing  costs relative to interest received on our assets;                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | the costs and effects  of the current Securities and Exchange Commission (“SEC”) investigation into  certain mortgage securities trading procedures in connection with which the  SEC has requested information from Deerfield Capital Corp. (“DFR”) and  Deerfield Capital Management LLC (“DCM”) regarding certain mortgage  securities trades of ours;                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| · | changes in strategy,  including investment strategy;                                                                                                                                                                                                                                                                                                                                                                                                                |

 

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| · | our inability, due to  market conditions, to launch collateralized debt obligation (“CDO”) or other  investment vehicles, which provide us with investment management fee revenue; |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                         |
| · | effect of the current  market conditions on management fees and equity cash flows from CDOs;                                                                                                 |
|   |                                                                                                                                                                                         |
| · | loss of key personnel,  most of whom are not bound by employment agreements;                                                                                                                 |
|   |                                                                                                                                                                                         |
| · | our ability to enter  into, and the effects of, any potential strategic transaction:                                                                                                         |
|   |                                                                                                                                                                                         |
| · | adverse changes in  accounting principles, tax law or legal or regulatory requirements;                                                                                                      |
|   |                                                                                                                                                                                         |
| · | failure to comply with  applicable laws and regulations;                                                                                                                                     |
|   |                                                                                                                                                                                         |
| · | liability resulting  from actual or potential future litigation;                                                                                                                             |
|   |                                                                                                                                                                                         |
| · | the costs,  uncertainties and other effects of legal and administrative proceedings;                                                                                                         |
|   |                                                                                                                                                                                         |
| · | the costs of obtaining,  and the potential inability to obtain, necessary or prudent insurance to  cover our business operations;                                                            |
|   |                                                                                                                                                                                         |
| · | the impact of  competition; and                                                                                                                                                         |
|   |                                                                                                                                                                                         |
| · | actions of domestic and  foreign governments and the effect of war or terrorist activity.                                                                                                    |

 

**Relatingto our investment management segment:**

 
| · | continued significant  reductions in assets under management (“AUM”) and related reductions in our  investment advisory fee revenue, due to such factors as weak investment  performance, substantial illiquidity or price volatility in the fixed income  instruments in which we invest, loss of key portfolio management or other  personnel (or lack of availability of additional key personnel if needed for  expansion), withdrawal of investors from the funds that we manage, reduced  investor demand for the types of investment products that we offer or loss of  investor confidence due to weak investment performance, volatility of  returns, general declines in economic conditions and adverse publicity; |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | non-renewal or early  termination of investment management agreements or removal of DCM as  investment manager pursuant to the terms of such investment management  agreements;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | pricing pressure on the  advisory fees that we can charge for our investment advisory services;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | our ability to assume  or otherwise acquire additional CDO management contracts on favorable terms,  or at all;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | difficulty in  increasing AUM, or efficiently managing existing AUM, due to market-related  constraints on trading capacity, inability to hire the necessary additional  or replacement personnel or lack of potentially profitable trading  opportunities;                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | the reduction in CDO  management fees or AUM resulting from payment defaults by issuers of the  underlying collateral, downgrades of the underlying collateral by the rating  agencies or depressed market values of the underlying collateral, all of  which may contribute to the triggering of certain structural protections  and/or events of default built into CDOs;                                                                                                                                                                                                                                                                                                                                                             |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | changes in CDO asset  and liability spreads making it difficult or impossible to launch new CDOs or  negatively impacting our investment advisory fees;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | our ability to launch  new investment products, make investments in such products and realize growth  from fee-based income;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | liability relating to  our failure to comply with investment guidelines set by our clients or the  provisions of the management and other agreements; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | changes in laws,  regulations or government policies affecting our business, including  investment management regulations and accounting standards.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |

 

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**Relatingto our principal investing segment:**

 
| · | impact of changes in  our strategy surrounding the composition and decreased size of our investment  portfolio;                                                                                                                                                                                                                                                                                         |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | a decrease in the value  of our mortgage portfolio resulting in higher counterparty margin calls and  decreased liquidity;                                                                                                                                                                                                                                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | effects of leverage and  indebtedness on portfolio performance;                                                                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | effects of defaults or  terminations under repurchase transactions, interest rate swaps and long term  debt obligations, including our revolving warehouse funding agreement with  Wachovia Capital Markets, LLC;                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | the impact on our  investments and business strategy resulting from conservatorship of the  Federal National Mortgage Association (“Fannie Mae”) and the Federal  Home Loan Mortgage Corporation (“Freddie Mac”), and related efforts, along  with any changes in laws and regulations affecting the relationship between  Fannie Mae and Freddie Mac and the U.S. government; |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | effects of having the  majority of our repurchase transactions concentrated with one counterparty;                                                                                                                                                                                                                                                                                                      |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | higher or lower than  expected prepayment rates on the mortgages underlying our residential  mortgage backed securities (“RMBS”) portfolio;                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | illiquid nature of  certain of the assets in our investment portfolio;                                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | increased rates of  default on our investment portfolio (which risk rises as the portfolio  seasons) and decreased recovery rates on defaulted loans;                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | our inability to obtain  the financing needed to leverage our RMBS and other portfolios and our  inability to obtain favorable interest rates, margin or other terms on any  such financing;                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | flattening or inversion  of the yield curve (a decreased differential between long and short term  interest rates) reducing our net interest income on our financed mortgage  securities positions;                                                                                                                                                                                                     |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | our inability to  adequately hedge our holdings that are sensitive to changes in interest  rates;                                                                                                                                                                                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | narrowing of credit  spreads, thus decreasing our net interest income on future credit investments  (such as bank loans);                                                                                                                                                                                                                                                                               |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | concentration of  investment portfolio in adjustable-rate RMBS;                                                                                                                                                                                                                                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | effects of investing in  equity and mezzanine securities of CDOs; and                                                                                                                                                                                                                                                                                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| · | effects of investing in  the debt of middle market companies.                                                                                                                                                                                                                                                                                                                                           |

 

These and other factors that could cause our actualresults to differ materially from those described in the forward-lookingstatements are set forth in our annual report on Form 10-K for the yearended December 31, 2008, including those factors set forth in our annualreport under the heading *“Risk Factors”*as well as other factors set forth in this Quarterly Report and our otherpublic filings with the SEC and public statements. Readers of this QuarterlyReport are cautioned to consider these risks and uncertainties and not to placeundue reliance on any forward-looking statements.

 

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**PART I. FINANCIAL INFORMATION**

** **

**ITEM 1. FINANCIAL STATEMENTS**

 

**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS(UNAUDITED)**

 
| ** **                                                                                                                                             | ** ** | **March 31,**              | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                             | ** ** | **2009**                        | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                             | ** ** | **(In thousands, except share** | ** ** |
| ** **                                                                                                                                             | ** ** | **and per share amounts)**      | ** ** |
| **ASSETS**                                                                                                                                             | ** ** | ** **                      | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                                                             |       | $                               | 42,354     |                  | $          | 32,791 |   |
| Due from broker                                                                                                                                        |       | 23,939                          |       | 15,065                |       |
| Restricted cash  and cash equivalents                                                                                                                  |       | 23,905                          |       | 76,892                |       |
| Available-for-sale  securities—at fair value                                                                                                      |       | 2,619                           |       | 2,338                 |       |
| Trading  securities, including $335,252 and $340,866 pledged—at fair value                                                                        |       | 339,436                         |       | 347,977               |       |
| Other  investments                                                                                                                                     |       | 4,764                           |       | 4,764                 |       |
| Derivative  assets                                                                                                                                     |       | 21                              |       | 132                   |       |
| Loans held for  sale                                                                                                                                   |       | 210,616                         |       | 218,137               |       |
| Loans held for  investment                                                                                                                             |       | 304,438                         |       | 255,351               |       |
| Allowance for  loan losses                                                                                                                             |       | (22,171                         | )          | (19,979               | )          |
| Loans held for  investment, net of allowance for loan losses                                                                                           |       | 282,267                         |       | 235,372               |       |
| Investment  advisory fee receivables                                                                                                                   |       | 2,030                           |       | 4,012                 |       |
| Interest receivable                                                                                                                                    |       | 4,360                           |       | 5,843                 |       |
| Other receivable                                                                                                                                       |       | 2,513                           |       | 4,249                 |       |
| Prepaid and  other assets                                                                                                                              |       | 11,678                          |       | 11,831                |       |
| Fixed assets,  net                                                                                                                                     |       | 8,820                           |       | 9,143                 |       |
| Intangible  assets, net                                                                                                                                |       | 26,997                          |       | 28,310                |       |
| TOTAL ASSETS                                                                                                                                           |       | $                               | 986,319    |                  | $          | 996,856 |   |
|                                                                                                                                                   |       |                            |       |                  |       |
| **LIABILITIES**                                                                                                                                        |       |                            |       |                  |       |
| Repurchase  agreements, including $53 and $407 of accrued interest                                                                                     |       | $                               | 318,641    |                  | $          | 326,112 |   |
| Due to broker                                                                                                                                          |       | —                          |       | 1,514                 |       |
| Derivative  liabilities                                                                                                                                |       | 13,817                          |       | 13,529                |       |
| Interest payable                                                                                                                                       |       | 2,575                           |       | 6,606                 |       |
| Accrued and  other liabilities                                                                                                                         |       | 7,190                           |       | 15,112                |       |
| Long term debt                                                                                                                                         |       | 714,622                         |       | 716,417               |       |
| TOTAL  LIABILITIES                                                                                                                                     |       | 1,056,845                       |       | 1,079,290             |       |
|                                                                                                                                                   |       |                            |       |                  |       |
| **STOCKHOLDERS’  DEFICIT**                                                                                                                        |       |                            |       |                  |       |
| Preferred stock,  par value $0.001:  100,000,000 shares authorized; 14,999,992 shares issued and zero outstanding                                      |       | —                          |       | —                |       |
| Common stock,  par value $0.001:  500,000,000 shares authorized; 6,455,466 and 6,455,466 shares issued and 6,454,383  and 6,449,102 shares outstanding |       | 6                               |       | 6                     |       |
| Additional  paid-in capital                                                                                                                            |       | 865,910                         |       | 865,869               |       |
| Accumulated  other comprehensive loss                                                                                                                  |       | (3,928                          | )          | (4,256                | )          |
| Accumulated  deficit                                                                                                                                   |       | (932,514                        | )          | (944,053              | )          |
| TOTAL  STOCKHOLDERS’ DEFICIT                                                                                                                      |       | (70,526                         | )          | (82,434               | )          |
|                                                                                                                                                   |       |                            |       |                  |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                      |       | $                               | 986,319    |                  | $          | 996,856 |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS (UNAUDITED)**

** **
| ** **                                                            |   | **Three months ended March 31,**                  |   |
|-----------------------------------------------------------------------|--------|--------------------------------------------------------|--------|
| ** **                                                            |   | **2009**                                               |   | **2008** |   |
| ** **                                                            |   | **(In thousands, except share and per share amounts)** |   |
| **Revenues**                                                          |   |                                                   |   |   |   |
| Interest income                                                       |   | $                                                      | 13,782 |   | $ | 61,350 |   |
| Interest expense                                                      |   | 6,999                                                  |   | 47,600 |   |
| Net interest  income                                                  |   | 6,783                                                  |   | 13,750 |   |
| Provision for  loan losses                                            |   | 2,107                                                  |   | 2,200 |   |
| Net interest  income after provision for loan losses                  |   | 4,676                                                  |   | 11,550 |   |
| Investment  advisory fees                                             |   | 4,737                                                  |   | 12,119 |   |
| Total net  revenues                                                   |   | 9,413                                                  |   | 23,669 |   |
|                                                                  |   |                                                   |   |   |   |
| **Expenses**                                                          |   |                                                   |   |   |   |
| Compensation and  benefits                                            |   | 3,354                                                  |   | 9,101 |   |
| Professional  services                                                |   | 790                                                    |   | 1,387 |   |
| Insurance  expense                                                    |   | 764                                                    |   | 734 |   |
| Other general  and administrative expenses                            |   | 946                                                    |   | 1,430 |   |
| Depreciation and  amortization                                        |   | 1,635                                                  |   | 2,687 |   |
| Occupancy                                                             |   | 639                                                    |   | 621 |   |
| Cost savings  initiatives                                             |   | 197                                                    |   | 257 |   |
| Impairment of  intangible assets and goodwill                         |   | —                                                 |   | 27,906 |   |
| Total expenses                                                        |   | 8,325                                                  |   | 44,123 |   |
|                                                                  |   |                                                   |   |   |   |
| **Other  Income and Gain (Loss)**                                     |   |                                                   |   |   |   |
| Net loss on  available-for-sale securities                            |   | (31                                                    | )      | — |   |
| Net gain (loss)  on trading securities                                |   | 5,138                                                  |   | (200,719 | ) |
| Net gain (loss)  on loans                                             |   | 5,815                                                  |   | (26,542 | ) |
| Net loss on  derivatives                                              |   | (404                                                   | )      | (223,215 | ) |
| Dividend income  and other net (loss) gain                            |   | (49                                                    | )      | 118 |   |
| Net other income  and gain (loss)                                     |   | 10,469                                                 |   | (450,358 | ) |
| Income (loss)  before income tax expense                              |   | 11,557                                                 |   | (470,812 | ) |
| Income tax  expense (benefit)                                         |   | 18                                                     |   | (7,202 | ) |
|                                                                  |   |                                                   |   |   |   |
| **Net  income (loss)**                                                |   | 11,539                                                 |   | (463,610 | ) |
| Less: Cumulative  convertible preferred stock dividends and accretion |   | —                                                 |   | 2,393 |   |
| **Net  income (loss) attributable to common stockholders**            |   | $                                                      | 11,539 |   | $ | (466,003 | ) |
|                                                                  |   |                                                   |   |   |   |
| NET INCOME  (LOSS) PER SHARE - BASIC                                  |   | $                                                      | 1.72   |   | $ | (84.78 | ) |
| NET INCOME  (LOSS) PER SHARE - DILUTED                                |   | $                                                      | 1.72   |   | $ | (84.78 | ) |
|                                                                  |   |                                                   |   |   |   |
| WEIGHTED-AVERAGE  NUMBER OF SHARES OUTSTANDING - BASIC                |   | 6,702,329                                              |   | 5,496,522 |   |
| WEIGHTED-AVERAGE  NUMBER OF SHARES OUTSTANDING - DILUTED              |   | 6,702,329                                              |   | 5,496,522 |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ DEFICIT (UNAUDITED)**

** **
| ** **                                                    | ** ** | ** **              | ** ** | ** **     | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** **      | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|----------------|------------|-------------|------------|-------------------|------------|-----------------|------------|------------|------------|-------------------|------------|
| ** **                                                    | ** ** | **Common Stock**   | ** ** | **Additional** | ** ** | **Other**   | ** ** | ** **        | ** ** | ** **      | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **              | ** ** | **Par**        | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                    | ** ** | **Shares**              | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Loss**          | ** ** | **Deficit**     | ** ** | **Total**  | ** ** | **Income**        | ** ** |
| ** **                                                    | ** ** | **(In thousands)** | ** ** |
| **Balance  - January 1, 2009**                                |       | 6,449                   |       | $              | 6          |        | $          | 865,869           |       | $               | (4,256     | )          | $          | (944,053          | )          | $ | (82,434 | ) |   |   |
| **Net  income**                                               |       |                    |       |           |       |        |       |              |       | 11,539          |       | 11,539     |       | $                 | 11,539     |   |
| Available-for-sale  securities - fair value adjustment        |       |                    |       |           |       |        |       | 308               |       |            |       | 308        |       | 308               |       |
| Previously  designated derivatives - amortization of net loss |       |                    |       |           |       |        |       | 49                |       |            |       | 49         |       | 49                |       |
| Foreign currency  translation loss                            |       |                    |       |           |       |        |       | (29)              |       |            |       | (29        | )          | (29               | )          |
| Comprehensive  income                                         |       |                    |       |           |       |        |       |              |       |            |       |       |       | $                 | 11,867     |   |
| Share-based  compensation                                     |       | 5                       |       |           |       | 41          |       |              |       |            |       | 41         |       |              |       |
| **Balance  - March 31, 2009**                            |       | 6,454                   |       | $              | 6          |        | $          | 865,910           |       | $               | (3,928     | )          | $          | (932,514          | )          | $ | (70,526 | ) |   |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

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

 
| ** **                                                                                | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| ** **                                                                                | ** ** | **(In thousands)**                    | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                |       |                                  |       |   |   |
| Net income  (loss)                                                                        |       | $                                     | 11,539     |   | $ | (463,610 | ) |
| **Adjustments  to reconcile net income (loss) to net cash used in operating activities:** |       |                                  |       |   |   |
| Net premium and  discount amortization on investments, loans and debt issuance            |       | (59                                   | )          | 393 |   |
| Share-based  compensation                                                                 |       | 41                                    |       | 115 |   |
| Net purchases of  trading securities                                                      |       | (582                                  | )          | (341,181 | ) |
| Net (gain) loss  from trading securities                                                  |       | (5,138                                | )          | 200,720 |   |
| Other-than-temporary  impairment on available-for-sale securities                         |       | 31                                    |       | — |   |
| Net proceeds  (purchases) of loans held for sale                                          |       | 967                                   |       | (1,919 | ) |
| Net (gain) loss  on loans                                                                 |       | (5,815                                | )          | 26,550 |   |
| Provision for  loan losses                                                                |       | 2,107                                 |       | 2,200 |   |
| Net changes in  undesignated derivatives                                                  |       | 137                                   |       | (148,727 | ) |
| Amortization of  net loss on previously designated derivatives                            |       | 49                                    |       | 96,904 |   |
| Depreciation and  amortization                                                            |       | 1,635                                 |       | 2,687 |   |
| Impairment of  intangible assets and goodwill                                             |       | —                                |       | 27,906 |   |
| Non-cash rental  expense                                                                  |       | 141                                   |       | 50 |   |
| Provision for  income tax                                                                 |       | 18                                    |       | — |   |
| Deferred tax  expense (benefit)                                                           |       | 49                                    |       | (11,814 | ) |
| **Changes  in operating assets and liabilities:**                                         |       |                                  |       |   |   |
| Due from broker                                                                           |       | 1,921                                 |       | 78,982 |   |
| Interest  receivable                                                                      |       | 530                                   |       | 25,670 |   |
| Other receivable                                                                          |       | 3,464                                 |       | 904 |   |
| Prepaid and  other assets                                                                 |       | (200                                  | )          | (2,803 | ) |
| Accrued interest  on repurchase agreements                                                |       | (354                                  | )          | (19,464 | ) |
| Due to broker                                                                             |       | (1,253                                | )          | (621 | ) |
| Interest payable                                                                          |       | (4,030                                | )          | (7,221 | ) |
| Accrued and  other liabilities                                                            |       | (8,076                                | )          | (4,242 | ) |
| **Net  cash used in operating activities**                                                |       | (2,878                                | )          | (538,521 | ) |
|                                                                                      |       |                                  |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                |       |                                  |       |   |   |
| Change in  restricted cash and cash equivalents                                           |       | 52,987                                |       | (10,016 | ) |
| Purchase of  available-for-sale securities                                                |       | —                                |       | (1,750 | ) |
| Principal  payments on available-for-sale securities                                      |       | —                                |       | 22,824 |   |
| Proceeds from  the sale of trading securities previously classified as available-for-sale |       | —                                |       | 4,138,198 |   |
| Principal  payments on trading securities previously classified as available-for-sale     |       | 14,423                                |       | 144,017 |   |
| Origination and  purchase of loans held for investment                                    |       | (67,978                               | )          | (1,512 | ) |
| Principal  payments on loans held for investment                                          |       | 10,021                                |       | 18,104 |   |
| Proceeds from sale  of loans held for investment                                          |       | 10,956                                |       | 18,707 |   |
| Proceeds from  sale of loans held for sale previously classified as held for investment   |       | 1,165                                 |       | — |   |
| Purchases of  fixed assets                                                                |       | —                                |       | (8 | ) |
| **Net  cash provided by investing activities**                                            |       | 21,574                                |       | 4,328,564 |   |
|                                                                                      |       |                                  |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                |       |                                  |       |   |   |
| Net payments  under repurchase agreements                                                 |       | (7,117                                | )          | (3,860,528 | ) |
| Proceeds from  Wachovia Facility                                                          |       | —                                |       | 3,000 |   |
| Payments made on  Wachovia Facility                                                       |       | (1,932                                | )          | — |   |
| Payment of debt  issuance costs                                                           |       | (83                                   | )          | (267 | ) |
| Dividends paid                                                                            |       | —                                |       | (21,736 | ) |
| Payments made on  short term debt                                                         |       | —                                |       | (648 | ) |
| **Net  cash used in financing activities**                                                |       | (9,132                                | )          | (3,880,179 | ) |
|                                                                                      |       |                                  |       |   |   |
| Foreign currency  translation                                                             |       | (1                                    | )          | (20 | ) |
| Net increase  (decrease) in cash and cash equivalents                                     |       | 9,563                                 |       | (90,156 | ) |
| Cash and cash  equivalents at beginning of period                                         |       | 32,791                                |       | 113,733 |   |
| **Cash  and cash equivalents at end of period**                                           |       | $                                     | 42,354     |   | $ | 23,577 |   |
| ** **                                                                                |       |                                  |       |   |   |
| **SUPPLEMENTAL  DISCLOSURE:**                                                             |       |                                  |       |   |   |
| Cash paid for  interest                                                                   |       | $                                     | 10,412     |   | $ | 81,881 |   |
| Cash (received)  paid for income taxes                                                    |       | (175                                  | )          | 1,299 |   |
|                                                                                      |       |                                  |       |   |   |
| **NONCASH  INVESTING AND FINANCING ACTIVITIES:**                                          |       |                                  |       |   |   |
| Unsettled loan  sales - due to broker                                                     |       | 10,795                                |       | — |   |
| Settlement of  interest income as an addition to principal balance of loans               |       | 955                                   |       | 1,684 |   |
| Receipt of  warrants                                                                      |       | —                                |       | 1,092 |   |
| Share-based  compensation                                                                 |       | —                                |       | 2,789 |   |
| Series A  cumulative convertible preferred stock dividend and accretion              |       | —                                |       | 2,393 |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**1.****        ****ORGANIZATION**

 

Deerfield Capital Corp. (“DFR”and, together with its subsidiaries, the “Company”) is a Maryland corporation.The Company, through its wholly-owned subsidiary, Deerfield Capital ManagementLLC (“DCM”), manages client assets, including bank loans and other corporatedebt, residential mortgage backed securities (“RMBS”), government securitiesand asset-backed securities (“ABS”). In addition, its Principal Investingsegment has an investment portfolio comprised of fixed income investments,including bank loans and other corporate debt and RMBS. Historically, theCompany had elected to be taxed as a real estate investment trust (“REIT”)under the Internal Revenue Code of 1986, as amended (the “Code”). However, theCompany’s REIT status terminated in 2008 when, in an effort to increasestockholder value, the Company converted to a C corporation to maximize use ofsignificant potential tax benefits and provide more flexibility with respect tofuture capital investment.

 

DFR was externallymanaged by DCM from the commencement of its operations in December 2004 untilDecember 21, 2007 when the Company acquired Deerfield & CompanyLLC (“Deerfield”), the parent company of DCM (the “Merger”). As a result of theMerger, Deerfield and its subsidiaries became indirect wholly-ownedsubsidiaries, and DFR became internally managed.

 

The Company intends to operate, and to cause each ofits subsidiaries to operate, in such a way as to be excluded from registrationunder the Investment Company Act of 1940, as amended (the “1940 Act”).  DFR and Deerfield Capital LLC (“DC LLC”) areexcluded from registration under the 1940 Act because no more than 40% of theirrespective assets, on an unconsolidated basis, excluding cash and governmentsecurities, are investment securities. The Company intends to continue toqualify for this exclusion by monitoring the value of all its subsidiaries andany investment securities it owns to ensure that at all times, no more than 40%of its assets, on an unconsolidated basis, excluding certain items, will beinvestment securities under the 1940 Act.

 

After the close ofbusiness on October 16, 2008, the Company effected a 1-for-10 reversestock split of its common stock. All share and per share amounts reflectedthroughout the condensed consolidated financial statements and notes theretohave been retroactively restated to reflect the reverse stock split.

 

***Business Segments***

 

The Company operateswithin two business segments:

 

*InvestmentManagement* —The Company manages assets within a variety of investment vehicles, includingcollateralized debt obligations (“CDOs”), separately managed accounts andinvestment funds, and earns investment advisory fees for providing itsservices. The Company specializes in managing corporate debt, RMBS, governmentsecurities, commercial real estate and ABS.

 

*PrincipalInvesting* —The Company has a portfolio of investments comprised primarily of fixed incomeinvestments, including bank loans and other corporate debt and RMBS. Incomefrom this business segment is influenced by three factors: (i) the netspread, or difference, between the interest income the Company earns on itsinvestment portfolio and the cost of its borrowings net of hedging derivatives,(ii) the net recognized gains and losses, if any, on the Company’sinvestment portfolio and (iii) provision for loan losses, if any.Investments in senior secured loans (first lien and second lien term loans),senior subordinated debt facilities and other junior securities, typically inmiddle market companies across a range of industries, are referred to as “CorporateLoans.”

 

***Liquidity and Capital Resources***

 

The Company believes thatits current cash and cash equivalents, unencumbered liquid assets, net equityin financed RMBS portfolio along with cash flows from operations, among otherthings, are adequate to meet anticipated liquidity requirements through April 1,2010. Unencumbered RMBS and unrestricted cash and cash equivalents aggregated$47.3 million at March 31, 2009. In addition, net equity in thefinanced RMBS portfolio (including associated interest rate swaps), excludingthe unencumbered RMBS included above, totaled $17.8 million at March 31,2009. In total, the Company had unrestricted cash and cash equivalents,unencumbered RMBS and net equity in the financed RMBS portfolio of$65.1 million as of March 31, 2009. As of March 31, 2009, thefair value of the Company’s Agency RMBS (as defined below) and non-Agency RMBSportfolios were $333.9 million and $4.8 million, respectively. The Company’slargest repurchase agreement counterparty has required that it maintain a minimumof $20.0 million of cash in their custody in order to maintain its currentrepurchase agreement margin percentages on the Company’s Agency RMBS. If theCompany fails to satisfy this requirement, the counterparty will have the rightto increase the margin percentage under the repurchase agreements and exerciseother remedies.

 

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On November 7, 2008,the Company entered into a letter agreement (the “November LetterAgreement”) with the representative of the holders of its trust preferredsecurities (the “Trust Preferred Securities”). The November LetterAgreement provided a waiver of any prior noncompliance by DC LLC with the networth covenant contained in the indentures governing the Trust PreferredSecurities and waived any further noncompliance with such covenant through April 1,2010. The Company does not expect to be in compliance with the net worth covenanton April 1, 2010 and, therefore, expects to discuss a potential longer termsolution with the holders of the Trust Preferred Securities.  No assurances can be provided that theCompany will have any success in obtaining such a longer term solution withrespect to the Trust Preferred Securities.

 

Agency-issued RMBS arebacked by mortgage loans and are guaranteed as to principal and interest byfederally chartered entities such as the Federal National Mortgage Association(“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”),and, in the case of the Government National Mortgage Association (“Ginnie Mae”),the U.S. government. The Company refers to these entities as “Agencies”and to RMBS guaranteed or issued by the Agencies as “Agency RMBS.” The Company’sAgency RMBS portfolio at March 31, 2009 consists of Fannie Mae and FreddieMac securities. The Company’s non-Agency RMBS portfolio consists of twosecurities with estimated fair values of $3.9 and $0.9 million that arecurrently rated “A-” and “B-”, respectively, by Standard & Poor’s.

 

**2.****        ****ACCOUNTING POLICIES AND RECENTACCOUNTING PRONOUNCEMENTS**

 

*Basisof Presentation* —The accompanying unaudited condensed consolidated financial statements havebeen prepared by the Company in accordance with accounting principles generallyaccepted in the United States of America (“GAAP”) for interim financialinformation and are in the form prescribed by the Securities and ExchangeCommission (“SEC”) pursuant to Regulation S-X and the instructions to Form 10-Q.Accordingly, the Company does not include all of the information and footnotesfor complete financial statements as required by GAAP. The interim unauditedcondensed consolidated financial statements should be read in conjunction withthe Company’s audited financial statements as of and for the year ended December 31,2008, which are included in the Company’s Annual Report on Form 10-K filedwith the SEC on March 16, 2009. In the opinion of the Company’smanagement, all adjustments, consisting of only normal recurring accruals,necessary for a fair presentation of the Company’s financial position, resultsof operations and cash flows have been included. The nature of the Company’sbusiness is such that the results of any interim period information are notnecessarily indicative of results for a full year.

 

*Principlesof Consolidation* —The condensed consolidated financial statements include the financialstatements of DFR and its subsidiaries which are wholly-owned and entitieswhich are variable interest entities (“VIEs”) in which the Company is theprimary beneficiary under Financial Accounting Standards Board (“FASB”)Interpretation No. 46 (revised 2004), *Consolidationof Variable Interest Entities*(“FIN 46(R)”). An enterprise isthe primary beneficiary if it absorbs a majority of the VIE’s expected lossesor receives a majority of the VIE’s expected residual returns, or both. Allintercompany balances and transactions have been eliminated in consolidation.

 

The Company consolidatedMarket Square CLO Ltd. (“Market Square CLO”) and DFR Middle Market CLO Ltd. (“DFRMM CLO”) for the three months ended March 31, 2009 and 2008 as it isdeemed to be the primary beneficiary of these VIEs.   Although the Company consolidates 100% ofthe assets and liabilities of Market Square CLO and DFR MM CLO, the Company’smaximum exposure to loss on its investments in these entities is limited to itsinitial investments of $24.0 million in Market Square CLO and$69.0 million DFR MM CLO. As of March 31, 2009, the Company hadrecorded losses in excess of its economic risk for Market Square CLO of$64.3 million, which losses are consolidated in its total equity. Theeconomic impact of the Company’s investments in the DFR MM CLO and MarketSquare CLO is determined by the cash flows received from these investments,subject to deferral or elimination, as set forth in their respectiveindentures. These economic impacts may diverge from results recorded inconformity with GAAP. The debt holders of Market Square CLO and DFR MM CLO haverecourse only to the assets of those entities and not to the general assets ofthe Company. The Company consolidated assets of $212.6 million and $305.5million and liabilities of $276.9 million and $231.5 million, relatedto Market Square CLO and DFR MM CLO, respectively, as of March 31, 2009.

 

*Reclassifications* — Certain amounts in the condensedconsolidated financial statements and notes as of December 31, 2008 andfor the three months ended March 31, 2008 have been reclassified toconform to the presentation as of and for the three months ended March 31,2009. Occupancy and Cost savings initiative, which were included in Othergeneral and administrative expenses and Compensation and benefits,respectively, in the March 31, 2008 condensed consolidated statements ofoperations, are presented as separate line items in the current quartercondensed consolidated statements of operations.

 

*SignificantAccounting Policies*— The Company’s significant accounting policies are discussed in the Notes tothe Consolidated Financial Statements included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2008.

 

*RecentAccounting Pronouncements* — In December 2007, the FASB issued Statement of FinancialAccounting Standards (“SFAS”) No. 160, *Noncontrolling Interestsin Consolidated Financial Statements — an amendment of ARB No. 51*(“SFAS No. 160”), which established accounting and reporting standards forthe noncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary.  The Company adopted SFAS No. 160,and the adoption had no impact on the Company’s condensed consolidatedfinancial statements.

 

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In February 2008,the FASB issued Staff Position (“FSP”) FAS 140-3*Accounting for Transfers of Financial Assets and Repurchase FinancingTransactions* (“FSP FAS 140-3”), which relates to SFAS No. 140,*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities* (“SFAS No. 140”)*,* in order to address certain situationswhere assets purchased from a particular counterparty and financed through arepurchase agreement with the same counterparty can be considered and accountedfor as separate transactions. Historically, the Company recorded such assetsand the related financing on a gross basis as separate transactions in thecondensed consolidated balance sheet and the corresponding interest income andinterest expense in the Company’s condensed consolidated statements ofoperations. FSP FAS 140-3 assumes that an initial transfer of a financialasset and a repurchase financing are considered part of the same arrangement,or a linked transaction. However, if certain criteria are met, the initialtransfer and repurchase financing are not treated as a linked transaction, butrather are evaluated separately under SFAS No. 140. The Companyadopted FSP No. 140-3 on January 1, 2009, and the adoption has had noimpact on the Company’s condensed consolidated financial statements as nolinked transactions have occurred since adoption.

 

In March 2008, theFASB issued SFAS No. 161,*Disclosures about Derivative Instruments and Hedging Activities* (“SFAS No. 161”),which amends and expands the disclosure requirements of SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities* (“SFAS No. 133”). SFAS No. 161 requiresqualitative disclosures regarding objectives and strategies for usingderivatives, quantitative disclosures regarding fair value amounts of gains andlosses on derivative instruments and disclosures regarding credit-risk-relatedcontingent features in derivative contracts. The Company adopted SFAS No. 161and included the required additional disclosures in Note 7 below.

 

In June 2008, theFASB issued FSP EITF 03-6-1,*Determining Whether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities* (“FSP EITF 03-6-1”). FSPEITF 03-6-1 addresses whether instruments granted in share-based paymenttransactions are participating securities prior to vesting and, therefore, needto be included in the earnings allocation in computing earnings per share underthe two-class method described in FASB Statement No. 128,*Earnings per Share*. The Company adoptedFSP EITF 03-6-1 on January 1, 2009, and the adoption had no impact onthe Company’s condensed consolidated financial statements.

 

In April 2009, theFASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures aboutFair Value of Financial Instruments* (“FSP FAS 107-1 and APB 28-1”).   FSP FAS 107-1 and APB 28-1 requiresdisclosures regarding fair value of financial instruments for interim reportingperiods of publicly traded companies as well as in annual financial statements.  FSP FAS 107-1 and APB 28-1 is effective forthe Company for interim reporting periods ending after June 15, 2009.  Management is currently evaluating theeffects that FSP FAS 107-1 and APB 28-1 will have on the disclosures includedin the Company’s condensed consolidated financial statements.

 

In April 2009, theFASB issued FSP FAS 157-4, *Determining Fair ValueWhen the Volume and Level of Activity for the Asset or Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly*(“FSP FAS 157-4”).  FSP 157-4 was issuedto provide additional guidance for estimating fair value when the volume andlevel of activity have significantly decreased and to provide guidance onidentifying circumstances that indicate a transaction is not orderly.  In addition, FSP FAS 157-4 requires an entityto disclose, in interim and annual periods, the inputs and valuation techniquesused to measure fair value and provide a discussion of changes in valuationtechniques and related inputs, if any, during the period.  FSP FAS 157-4 is effective for the Company’sinterim reporting periods ending after June 15, 2009.  Management is currently evaluating theeffects that FSP FAS 157-4 will have on the Company’s condensed consolidatedfinancial statements.

 

In April 2009, theFASB issued FSP FAS 115-2 and FAS 124-2, *Recognition andPresentation of Other-Than-Temporary Impairments*(“FSP FAS 115-2 andFAS 124-2”).  This statement was issuedto amend the other-than-temporary impairment guidance in GAAP for debtsecurities to make the guidance more operational and to improve thepresentation and disclosure of other-than-temporary impairments on debt andequity securities in the financial statements. FSP FAS 115-2 and FAS 124-2 does not amend existing recognition andmeasurement guidance related to other-than-temporary impairments of equitysecurities.  FSP FAS 115-2 and FAS 124-2is effective for the Company’s interim and annual reporting periods endingafter June 15, 2009.  Management iscurrently evaluating the effects that FSP FAS 115-2 and FAS 124-2 will have onthe Company’s condensed consolidated financial statements and disclosuresincluded in those condensed consolidated financial statements.

 

**3.****        ****FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

Effective January 1,2008, the Company adopted Statement of Financial Accounting Standards No. 157,*Fair Value Measurements* (“SFAS No. 157”).SFAS No. 157 defines fair value, establishes a framework used tomeasure fair value and enhances disclosure requirements for fair valuemeasurements. In accordance with SFAS No. 157, the Company hascategorized its financial instruments carried at fair value, based on thepriority of the valuation technique, into a three-level fair value hierarchy.The valuation hierarchy is based upon the transparency of the inputs to thevaluation of the asset or liability as of the measurement date. A financialinstrument’s categorization within the valuation hierarchy is based on thelowest level of input that is significant to the fair value measurement. Thethree levels are defined as follows:

 

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*Level 1* — inputs to the valuationmethodology are quoted prices (unadjusted) for identical assets or liabilitiesin active markets.

 

The types of assetscarried at Level 1 generally are equity securities listed on an activeexchange. The Company held no Level 1 securities as of March 31,2009.

 

*Level 2* — inputs to the valuationmethodology include quoted prices for similar assets and liabilities in activemarkets and inputs that are observable for the asset or liability, eitherdirectly or indirectly, for substantially the full term of the financialinstrument.

 

The Company’s assets andliabilities that are generally included in this category are Agency RMBS andinterest rate derivatives.

 

*Level 3* — inputs to the valuation methodologyinclude significant unobservable inputs to the fair value measurement. Thisincludes situations where there is little, if any, market activity for theasset or liability. However, a substantial number of the Level 3 assetvaluations are provided by independent third parties.

 

The Company’s assets andliabilities that are generally included in this category are non-Agency RMBS,commercial mortgage-backed securities (“CMBS”), corporate bonds, preferredshares of CDOs and certain loans held for investment and loans held for sale.

 

The Company’s fullvaluation methodology and SFAS No. 157 accounting policy are discussed inthe Notes to the Consolidated Financial Statements included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2008.  There were no significant changes in theCompany’s valuation methodologies during the three months ended March 31,2009.

 

***Assets and liabilities measured at fair value on a recurringbasis***

 

The following tablepresents the financial instruments carried at fair value on a recurring basisas of March 31, 2009, by caption in the condensed consolidated balancesheet and by level within the SFAS No. 157 valuation hierarchy:

 
| ** **                         | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|------------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **(In thousands)** | ** ** |
| Available-for-sale  securities     |       | $                       | —     |             | $          | —           |       | $                       | 2,619      |   | $ | 2,619 |   |
| Trading  securities                |       | —                  |       | 333,888          |       | 5,548            |       | 339,436                 |       |
| Derivative  assets                 |       | —                  |       | —           |       | 21               |       | 21                      |       |
| Total financial  instrument assets |       | $                       | —     |             | $          | 333,888          |       | $                       | 8,188      |   | $ | 342,076 |   |
|                               |       |                    |       |             |       |             |       |                    |       |
| Derivative  liabilities            |       | $                       | —     |             | $          | 13,817           |       | $                       | —     |   | $ | 13,817 |   |

 

***Changes in Level 3 recurring fair value measurements***

 

The table below includesa rollforward of the balance sheet amounts for the three months ended March 31,2009 (including the change in fair value) for financial instruments classifiedby the Company within Level 3 of the valuation hierarchy.

 
| ** **                         | ** ** | ** **                                                                                      | ** ** | **Changes in Unrealized** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains (Losses)**   | ** ** |
| ** **                         | ** ** | **Estimated**                                                                                   | ** ** | **Net Realized/**    | ** ** | **Purchases, (Sales),** | ** ** | **Net Transfers** | ** ** | **Estimated** | ** ** | **Related to Financial** | ** ** |
| ** **                         | ** ** | **Fair Value**                                                                             | ** ** | **Unrealized**            | ** ** | **Issuances and** | ** ** | **In/Out** | ** ** | **Fair Value** | ** ** | **Instruments Held** | ** ** |
| ** **                         | ** ** | **January 1, 2009**                                                                   | ** ** | **Losses**                | ** ** | **(Settlements), Net** | ** ** | **of Level 3** | ** ** | **March 31, 2009** | ** ** | **at March 31, 2009** | ** ** |
| ** **                         | ** ** | **(In thousands)**                                                                         | ** ** |
| Available-for-sale  securities     |       | $                                                                                               | 2,338      |                      | $          | 281 |  (1) | $ | — |   | $ | — |   | $ | 2,619 |   | $ | 277 |  (1) |
| Trading  securities                |       | 5,554                                                                                           |       | (496                      | )(2)       | 490 |   | — |   | 5,548 |   | (523 | )(2) |
| Derivative  assets                 |       | 132                                                                                             |       | (111                      | )(3)       | — |   | — |   | 21 |   | (111 | )(3) |
| Total financial  instrument assets |       | $                                                                                               | 8,024      |                      | $          | (326 | ) | $ | 490 |   | $ | — |   | $ | 8,188 |   | $ | (357 | ) |
|                               |       |                                                                                            |       |                      |       |   |   |   |   |   |   |   |   |
| Derivative  liabilities            |       | $                                                                                               | 402        |                      | $          | 120 |  (3) | $ | (522 | ) | $ | — |   | $ | — |   | $ | 402 |  (3) |

 

----

| (1) | Net unrealized changes  in fair value for available-for-sale securities are reported as an adjustment  to accumulated other comprehensive loss on the condensed consolidated  statement of stockholders’ deficit. Impairment charges on available-for-sale  securities are reported within net loss on available-for-sale securities in  the condensed consolidated statements of operations. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Net realized and  unrealized gains (losses) on trading securities are reported within net gain  (loss) on trading securities in the condensed consolidated statements of  operations.                                                                                                                                                                                                              |
| (3) | Net realized and  unrealized gains (losses) on derivative assets and derivative liabilities are  recorded in net loss on derivatives in the condensed consolidated statements  of operations.                                                                                                                                                                                                      |

 

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***Assets measured at fair value on a nonrecurring basis***

 

Certain assets aremeasured at fair value on a nonrecurring basis, meaning that the instrumentsare measured at fair value only in certain circumstances (for example, whenheld at the lower of cost or market). The following table presents the assetscarried on the condensed consolidated balance sheet by caption and by levelwithin the SFAS No. 157 valuation hierarchy, as of March 31,2009, for which a nonrecurring change in fair value has been recorded duringthe three months ended March 31, 2009:

 
| ** **                                          | ** ** | ** **              | ** ** | ** **       | ** ** | ** **       | ** ** | **Carrying** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|--------------|------------|
| ** **                                          | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Value**    | ** ** |
| ** **                                          | ** ** | **(In thousands)** | ** ** |
| Loans held for sale                                 |       | $                       | —     |             | $          | —           |       | $            | 201,542    |   | $ | 201,542 |   |
| Loans held for  investment                          |       | —                  |       | —           |       | 5,926            |       | 5,926        |       |
| Total assets at  fair value on a nonrecurring basis |       | $                       | —     |             | $          | —           |       | $            | 207,468    |   | $ | 207,468 |   |

 

In the table above, “Loansheld for sale” includes changes in fair value of loans which are carried on thebalance sheet at the lower of cost or fair value. “Loans held for investment”represents loans which are measured at fair value as a result of theestablishment or subsequent change in the allowance for loan losses as of March 31,2009.

 

The following tablepresents the total change in value of financial assets for which a fair valueadjustment has been included in the condensed consolidated financialstatements:

 
| ** **                                    | ** ** | **Three months ended  March 31, 2009** | ** **  |
|-----------------------------------------------|------------|------------------------------------------------------------|-------------|
| ** **                                    | ** ** | **(In thousands)**                                    | ** **  |
| Loans held for sale            |       | $                                                          |  8,032 |  (1) |
| Loans held for  investment                    |       | (2,107                                                     | )(2)        |
| Total  nonrecurring fair value gains (losses) |       | $                                                          | 5,925       |   |

 

----

| (1) | Changes  in the fair value on loans held for sale are reported within net gain (loss)  on loans in the condensed consolidated statements of operations.                     |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Impairment  charges to mark loans held for investment to fair value are reported within  provision for loan losses in the condensed consolidated statements of  operations. |

 

**4.****        ****AVAILABLE-FOR-SALE SECURITIES**

 

The following tablesummarizes the Company’s available-for-sale securities as of March 31,2009, which are carried at fair value:

 
| ** **                                            | ** ** | **Amortized**           | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Estimated**       | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| **Security Description**                         | ** ** | **Cost**                | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| ** **                                            | ** ** | **(In thousands)** | ** ** |
| High-yield corporate  bonds held in Market Square CLO |       | $                       | 3,983      |           | $          | —         |       | $                   | (2,129     | ) | $ | 1,854 |   |
| ABS held in  Market Square CLO                        |       | 2,383                   |       | —         |       | (1,618         | )          | 765                 |       |
| Total                                                 |       | $                       | 6,366      |           | $          | —         |       | $                   | (3,747     | ) | $ | 2,619 |   |

 

The following tablesummarizes the Company’s securities classified as available-for-sale as of March 31,2009 according to their weighted average lives, which are based uponcontractual maturity:

 
| ** **                                       | ** ** | ** **              | ** ** | ** **          | ** ** | **Weighted** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|---------------------|------------|--------------|------------|
| ** **                                       | ** ** | **Amortized**           | ** ** | **Estimated**       | ** ** | **Average**  | ** ** |
| **Weighted Average Life**              | ** ** | **Cost**                | ** ** | **Fair Value** | ** ** | **Coupon**   | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** |
| Greater than one  year and less than five years  |       | $                       | 961        |                | $          | 504          |       | 3.82 | % |
| Greater than  five years and less than ten years |       | 4,771                   |       | 1,927               |       | 5.17         | %          |
| Greater than ten  years                          |       | 634                     |       | 188                 |       | 4.59         | %          |
| Total                                            |       | $                       | 6,366      |                | $          | 2,619        |       | 4.89 | % |

 

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The weighted averagelives for high-yield corporate bonds and ABS are based upon contractualmaturity. Weighted average life is an estimate of how many years it will taketo receive half of the outstanding principal, which for the high-yieldcorporate bonds and ABS is maturity.

 

The following table showsthe fair value of and gross unrealized losses on available-for-sale securitieswith respect to which amortized cost exceeds fair value, aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position as of March 31, 2009:

 
| ** **                                            | ** ** | **12 Months or less** | ** ** | **More than 12 Months** | ** ** | **Total**      | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|----------------------------------------|------------|----------------|------------|
| ** **                                            | ** ** | **Number**                           | ** ** | **Estimated**                          | ** ** | **Gross**      | ** ** | **Number** | ** ** | **Estimated** | ** ** | **Gross** | ** ** | **Number** | ** ** | **Estimated** | ** ** | **Gross** | ** ** |
| ** **                                            | ** ** | **of**                               | ** ** | **Fair**                               | ** ** | **Unrealized** | ** ** | **of** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **of** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                                            | ** ** | **Securities**                       | ** ** | **Value**                              | ** ** | **Losses**     | ** ** | **Securities** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Securities** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| High-yield corporate  bonds held in Market Square CLO |       | —                               |       | $                                      | —     |           | $          | — |   | 2 |   | $ | 1,854 |   | $ | (2,129 | ) | 2 |   | $ | 1,854 |   | $ | (2,129 | ) |
| ABS held in  Market Square CLO                        |       | —                               |       | —                                 |       | —         |       | 6 |   | 765 |   | (1,618 | ) | 6 |   | 765 |   | (1,618 | ) |
| Total  temporarily impaired securities                |       | —                               |       | $                                      | —     |           | $          | — |   | 8 |   | $ | 2,619 |   | $ | (3,747 | ) | 8 |   | $ | 2,619 |   | $ | (3,747 | ) |

 

Temporary impairment ofavailable-for-sale securities results from the fair value of securities fallingbelow their amortized cost basis, primarily due to changes in the interest rateenvironment and in credit spreads. When the fair value of an available-for-salesecurity is less than its amortized cost for an extended period, the Companyconsiders whether there is an other-than-temporary impairment in the value ofthe security. If, in the Company’s judgment, an other-than-temporary impairmentexists, the cost basis of the security is written down to the then-current fairvalue, and the unrealized loss is transferred from accumulated othercomprehensive loss to an immediate reduction of current earnings (as if theloss had been realized in the period of other-than-temporary impairment) and nolonger included in the above table. The cost basis adjustment is recoverableonly upon sale or maturity of the security. The determination ofother-than-temporary impairment is a subjective process, and differentjudgments and assumptions could affect the timing of loss realization, if any.The determination of other-than-temporary impairment is made at leastquarterly.

 

The Company considers thefollowing factors when determining an other-than-temporary impairment for asecurity or investment:

 

·                                          severity of the impairment;

·                                          the length of time and the extent towhich the fair value has been less than the amortized cost;

·                                          whether the security has been downgradedby a rating agency;

·                                          the financial condition of the investeeand the prospect for future recovery; and

·                                          the Company’s intent and ability to holdthe security for a period of time sufficient to allow for any anticipatedrecovery in fair value.

 

The Company intends andbelieves it has the ability to hold the high-yield corporate bonds and ABS heldin Market Square CLO, categorized as available-for-sale securities in anunrealized loss position as of March 31, 2009, until the fair value of thesecurities is recovered, which may be to maturity if necessary.

 

For the three monthsended March 31, 2009, the Company recognized $31,000 ofother-than-temporary impairment related to certain CMBS which the Company nolonger has the intent to hold to recovery in value or maturity. For the threemonths ended March 31, 2008, the Company recognized no net realized gainor loss or other-than-temporary impairments on available-for-sale securities.

 

**5.****        ****TRADING SECURITIES**

 

The following tablesummarizes the Company’s securities classified as trading securities as of March 31,2009:

 
| ** **                    | ** ** | **Estimated**           | ** ** |
|-------------------------------|------------|-------------------------|------------|
| **Security Description** | ** ** | **Fair Value**     | ** ** |
| ** **                    | ** ** | **(In thousands)** | ** ** |
| RMBS:                         |       |                    |       |
| Agency RMBS                   |       | $                       | 333,888    |   |
| Non-Agency RMBS               |       | 4,841                   |       |
| Other  investments            |       | 707                     |       |
| Total                         |       | $                       | 339,436    |   |

 

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The Company recordschanges in fair value of trading securities in its condensed consolidatedstatements of operations. The following table summarizes the Company’ssecurities classified as trading securities as of March 31, 2009,according to their weighted average life:

 
| ** **                                       | ** ** | ** **              | ** ** | ** **          | ** ** | **Weighted** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|---------------------|------------|--------------|------------|
| ** **                                       | ** ** | **Amortized**           | ** ** | **Estimated**       | ** ** | **Average**  | ** ** |
| **Weighted Average Life**              | ** ** | **Cost**                | ** ** | **Fair Value** | ** ** | **Coupon**   | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** | ** **          | ** ** |
| Greater than one  year and less than five years  |       | $                       | 106,982    |                | $          | 92,728       |       | 5.58 | % |
| Greater than  five years and less than ten years |       | 235,724                 |       | 239,784             |       | 4.69         | %          |
| Greater than ten  years                          |       | 6,840                   |       | 6,924               |       | 4.72         | %          |
| Total                                            |       | $                       | 349,546    |                | $          | 339,436      |       | 4.93 | % |

 

The weighted averagelives in the table above are based upon contractual maturity for otherinvestments and primarily based on a prepayment model that considers currentyield, forward yield, slope of the yield curve, mortgage rates, contractualrate of the outstanding loans, loan age, margin and volatility for RMBS.Weighted average life is an estimate of how many years it will take to receivehalf of the outstanding principal. Actual lives of RMBS are generally shorterthan stated contractual maturities, are affected by the contractual maturitiesof the underlying mortgages, periodic payments of principal and prepayments ofprincipal and may differ materially from those set forth above.

 

For the three monthsended March 31, 2009, the Company had no RMBS sales and received RMBSprincipal paydowns of $14.5 million. During the three months ended March 31,2009, the Company recorded unrealized gains of $5.3 million in net gain (loss)on trading securities on the condensed consolidated statements of operations. Duringthe three months ended March 31, 2008, the RMBS portfolio experienced asignificant decrease in value, fueled by the ongoing credit crisis. Thisnegative environment had several impacts on the Company’s ability tosuccessfully finance and hedge its RMBS portfolio. As a result during the threemonths ended March 31, 2008, the Company sold a significant portion of itsRMBS portfolio to improve liquidity. During the three months endedMarch 31, 2008, the Company recorded realized and unrealized losses of$169.1 million and $31.6 million, respectively, in net gain (loss) on tradingsecurities on the condensed consolidated statements of operations.

 

**6.****        ****LOANS HELD FOR SALE AND LOANS HELDFOR INVESTMENT**

 

The following summarizesthe Company’s loans held for sale and loans held for investment as of March 31,2009:

 
| ** **                        | ** ** | **Carrying Value**    | ** ** |
|-----------------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **Loans Held**        | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Type of Loan**        | ** ** | **for Sale (1)** | ** ** | **for Investment** | ** ** | **Total** | ** ** |
| ** **                        | ** ** | **(In thousands)**    | ** ** |
| Loans held in  Market Square CLO  |       | $                          | 197,515    |   | $ | — |   | $ | 197,515 |   |
| Corporate  leveraged loans:       |       |                       |       |   |   |   |   |
| Loans held in  DFR MM CLO (2)     |       | —                     |       | 292,108 |   | 292,108 |   |
| Loans held in  Wachovia Facility  |       | 4,831                      |       | — |   | 4,831 |   |
| Other corporate  leveraged loans  |       | 8,270                      |       | — |   | 8,270 |   |
| Commercial real  estate loans (3) |       | —                     |       | 12,330 |   | 12,330 |   |
|                              |       | $                          | 210,616    |   | 304,438 |   | 515,054 |   |
| Allowance for  loan losses        |       |                       |       | (22,171 | ) | (22,171 | ) |
|                              |       |                       |       | $ | 282,267 |   | $ | 492,883 |   |

 

----

(1)             Carrying valueof loans held for sale is lower of cost or estimated fair value.

(2)             Loans held inDFR MM CLO classified as loans held for investment reported gross of$15.6 million allowance for loan losses.

(3)             Commercial realestate loans classified as loans held for investment reported gross of$6.5 million allowance for loan losses.

 

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The following summarizesthe Company’s allowance for loan losses as of March 31, 2009:

 
| ** **                    | ** ** | **Number**        | ** ** | **Par**                 | ** ** | **Allowance**                 | ** ** |
|-------------------------------|------------|-------------------|------------|-------------------------|------------|-------------------------------|------------|
| **Type of Loan**    | ** ** | **of Loans** | ** ** | **Value**               | ** ** | **for Loan Losses** | ** ** |
|                          |       |              |       | **(In thousands)** |       |
|                          |       |              |       |                    |       |                          |       |
| Loans held in  DFR MM CLO     |       | 2                 |       | $                       | 17,704     |                          | $          | 15,637 |   |
| Commercial real  estate loans |       | 4                 |       | 11,118                  |       | 6,534                         |       |
| Total                         |       | 6                 |       | $                       | 28,822     |                          | $          | 22,171 |   |

 

As of March 31,2009, the Company’s loans held for sale and loans held for investment totaled$492.9 million, net of allowance for loan losses. Loans classified as heldfor sale and carried at the lower of cost or estimated fair value totaled$210.6 million, net of a valuation allowance of $88.7 million, as of March 31,2009. Loans classified as held for investment and carried at amortized costtotaled $304.4 million, less an allowance for loan losses of$22.2 million, as of March 31, 2009. As of March 31, 2009, therewere $10.8 million of unsettled sales of loans held for sale, net of interestof $0.2 million. As of March 31, 2009, the Company held certain loans thatsettle interest accruals by increasing the principal balance of the loanoutstanding. For the three months ended March 31, 2009, the Companysettled interest receivables through increases to the loans’ outstandingprincipal balance in the amount of $1.0 million.

 

Loans held in MarketSquare CLO consist of syndicated bank loans. This portfolio is classified asheld for sale and is managed within the parameters specified in the governingindenture. Loans held in DFR MM CLO consist of loans which are not broadlysyndicated and are, therefore, less liquid. These loans are primarilyconsidered to be held for investment and are reported at amortized cost with anallowance for loan losses, if necessary, unless the Company decides to sell oneof these loans, in which case the loan is transferred to loans held for sale.

 

Loans held in the Company’s alternative assetrevolving warehouse funding facility with Wachovia Capital Markets, LLC (the “WachoviaFacility”) and loans classified as other corporate leveraged loans consist ofloans that are not broadly syndicated and are, therefore, less liquid. Theseloans had historically been primarily considered to be held for investment andwere reported at amortized cost with an allowance for loan losses, ifnecessary, unless the Company decided to sell one of these loans, in which casethe loan was transferred to loans held for sale. During the year ended December 31,2008, the Company began actively seeking to sell all loans in the WachoviaFacility as the Company triggered an acknowledged termination event thereunderon November 30, 2008. The Company sold a significant portion of the loansheld within the Wachovia Facility during the year ended December 31, 2008and transferred all loans held within the Wachovia Facility to loans held forsale.  During the three months ended March 31,2009, the Company entered into an agreement to sell loans held within theWachovia Facility with a par value of $31.5 million for $10.8 million, net ofinterest of $0.2 million.  The Companyrealized a loss of $6.2 million reported in net gain (loss) on loans held forinvestment and loans held for sale in the condensed consolidated statements ofoperations during the three months ended March 31, 2009 as a result ofthese sales.  In addition, during theyear ended December 31, 2008, the Company began to opportunistically sellthe other corporate leveraged loans in connection with its strategy ofincreasing liquidity in the Principal Investing segment and focusing on growingthe Investment Management segment. As a result, during the year ended December 31,2008, the Company transferred all other corporate leveraged loans to loans heldfor sale.

 

As of March 31,2009, the Company’s commercial real estate loans consisted of five loansclassified as held for investment totaling $12.3 million less an allowancefor loan losses of $6.5 million. The Company did not recognize interestincome on these loans for the three months ended March 31, 2009.

 

The following summarizesthe activity within the allowance for loan losses for the three months ended March 31,2009 and 2008:

 
| ** **                                   | ** ** | **Allowance for Loan Losses** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                   | ** ** | **2009**                                     | ** ** | **2008** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                      | ** ** |
| Allowance for  loan losses at January 1 |       | $                                            | 19,979     |   | $ | 5,300 |   |
| Provision for  loan losses                   |       | 2,107                                        |       | 2,200 |   |
| Recoveries                                   |       | 85                                           |       | — |   |
| Allowance for loan  losses at March 31  |       | $                                            | 22,171     |   | $ | 7,500 |   |

 

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The Company recordedrealized losses on loans held for sale and loans held for investment of $5.2million and $4.9 million in net gain (loss) on loans on the condensedconsolidated statements of operations for the three months ended March 31,2009 and 2008, respectively.  The Companyrecorded unrealized gains on loans held for sale and loans held for investmentof $11.0 million and unrealized losses of $21.6 million in net gain (loss) onloans on the condensed consolidated statements of operations for the threemonths ended March 31, 2009 and 2008, respectively.  Unrealized gains on loans held for saleinclude recoveries up to original cost or value on the date the loan wastransferred from loans held for investment to loans held for sale.

 

The Company did notrecognize $0.8 million of interest income earned, but not yet received, onimpaired loans held for investment for the three months ended March 31,2009. In addition, the Company did not recognize $1.9 million of interestincome earned, but not yet received, on loans held for sale for the threemonths ended March 31, 2009.

 

**7.****        ****DERIVATIVE INSTRUMENTS AND HEDGINGACTIVITIES**

 

The Company seeks tomanage its exposure to the effects of interest rate changes. Such exposure mayarise from the issuance and forecasted rollover of short term liabilities orfrom liabilities with a contractual variable rate based on the London InterbankOffered Rate (“LIBOR”). The Company does not have any derivative instrumentsdesignated as hedging instruments, and all derivative instruments are carriedat fair value.

 

The following table is a summaryof the Company’s derivative instruments as of March 31, 2009:

 
| ** **           | ** ** | ** ** | ** ** | **Notional**            | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|----------------------|------------|------------|------------|-------------------------|------------|------------|------------|-----------------|------------|------------------------|------------|
| ** **           | ** ** | **Count**  | ** ** | **Amount**              | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **           | ** ** | ** ** | ** ** | **(In thousands)** | ** ** |
| Interest rate  swaps |       | 5          |       | $                       | 165,000    |       | $          | —          |       | $                      | (13,708    | ) | $ | (13,708 | ) |
| Interest rate  cap   |       | 1          |       | 40,000                  |       | —     |       | (109            | )          | (109                   | )          |
| Warrants             |       | 3          |       | n/a                     |       | 21         |       | —          |       | 21                     |       |
|                 |       | 9          |       | $                       | 205,000    |       | $          | 21              |       | $                      | (13,817    | ) | $ | (13,796 | ) |

 

----

n/a —not applicable

 

The following table is a summary of the net loss onderivatives included in the statements of operations:

 
| ** **                     | ** ** | **Three months ended March 31,** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|
| ** **                     | ** ** | **2009**                                             | ** ** | **2008** | ** ** |
| ** **                     | ** ** | **(In thousands)**                              | ** ** |
| Interest rate  swaps           |       | $                                                    | (173       | ) | $ | (219,238 | ) |
| Credit default  swaps          |       | (120                                                 | )          | (2,145 | ) |
| Total return  swaps            |       | —                                               |       | (1,225 | ) |
| Interest rate  floors and caps |       | —                                               |       | (557 | ) |
| Warrants                       |       | (111                                                 | )          | (50 | ) |
| Net loss on  derivatives       |       | $                                                    | (404       | ) | $ | (223,215 | ) |

 

***Interest Rate Swaps***

 

In general, when a fixed-rate or hybridadjustable-rate RMBS is funded by a short term borrowing, the Company may enterinto an interest rate swap agreement that effectively fixes a portion of theborrowing costs for a period close to the anticipated weighted-average life ofthe fixed-rate portion of the related RMBS. This strategy is designed toprotect a portion of the Company’s portfolio from increased funding costs dueto rising interest rates because the borrowing costs are not fixed for theduration of the fixed-rate period of the related residential mortgage-backedsecurity.  The Company has structured itsinterest rate swaps to roll off or expire in conjunction with the estimatedweighted average life of the fixed period of the mortgage portfolio.  The Company did not enter into or terminateany interest rate swaps during the three months ended March 31, 2009.

 

The weighted averagefixed rate payable on the interest rate swaps as of March 31, 2009 was5.07%.  The Company is currently inviolation of substantially all of its International Swap Dealers Association (“ISDA”)agreements with its interest rate swap counterparties. Each of these ISDAagreements contains an equity decline trigger that the Company breached duringthe first quarter of 2008. This violation generally gives the counterpartiesthe right to terminate the ISDA agreements and the related interest rate swaps.The Company has notified its active counterparties of the breach, and none ofthose counterparties has expressed an intention to terminate the ISDAagreements. To date, the violations of the Company’s ISDA agreements have nothad a material adverse effect on its operations.

 

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As of January 1,2008, in conjunction with the adoption of SFAS No. 159, *The Fair Value Option for Financial Assets and Liabilities*(“SFASNo. 159”) the Company de-designated $3.8 billion (notional) ofinterest rate swaps previously designated as a hedge with a net negative fairvalue of $85.9 million at de-designation, including accrued interest.Prior to the de-designation, designated interest rate swaps were carried atfair value with changes in value recorded directly into equity through othercomprehensive loss, to the extent they were effective as a hedge, in accordancewith the guidance under SFAS No. 133*,Accounting for Derivatives and Hedging Activities,* as amended andinterpreted. As of the adoption date, the other comprehensive loss related tothe de-designation of interest rate hedges was $69.9 million. To theextent that the forecasted rolls on repurchase agreement transactions continuedas anticipated, the Company would have amortized this loss and the$27.3 million in other comprehensive loss related to previouslyde-designated swaps from other comprehensive loss into interest expense overthe remaining original hedge period, and all future changes in fair value ofthe interest rate swaps would be reflected in the consolidated statements ofoperations. However, due to the significant RMBS sales activity andcorresponding repurchase agreement repayment during the three months ended March 31,2008, forecasted rolls on the repaid repurchase agreements did not continue asanticipated. As a result, a loss of $91.7 million was recognized duringthe three months ended March 31, 2008 in the consolidated statements ofoperations in net loss on derivatives, and a corresponding cumulative net lossrelating to newly and previously de-designated interest rate swaps in othercomprehensive loss was removed. The remaining $0.2 million in othercomprehensive loss related to the terminated and de-designated swaps as of March 31,2009 and will be amortized over the remaining original hedge period.Additionally, the Company recorded a net increase to interest expense of$49,000 and $5.3 million during the three months ended March 31, 2009and 2008, respectively, related to the amortization of de-designated andterminated interest rate swaps.

 

***Interest Rate Cap***

 

The Company’s interestrate cap is structured such that the Company will receive payments based on thespread in rates, if the three-month LIBOR rate increases above certain agreedupon contractual rate, and the Company will make payments based on a nominalfixed interest rate.  This interest ratecap was entered into to manage interest rate exposure in DFR Middle Market CLO.

 

***Credit Default Swaps***

 

A credit default swap (“CDS”), is a financialinstrument used to transfer the credit risk of a reference entity from oneparty to another for a specified period of time. In a standard CDS contract,one party, referred to as the protection buyer, purchases credit default protectionfrom another party, referred to as the protection seller, for a specificnotional amount of obligations of a reference entity. In these transactions,the protection buyer pays a premium to the protection seller. The premium isgenerally paid quarterly in arrears, but may be paid in full, up front, in thecase of a CDS with a short maturity. If a pre-defined credit event occursduring the term of the CDS, the protection seller pays the protection buyer thenotional amount and takes delivery of the reference entity’s obligation.  The CDS were entered into because managementbelieved that they provided an attractive method of taking credit risk on thereference entity thereof. The Company analyzed the current status of the referenceentity through private financial information provided by the reference entity.The last CDS to which the Company was a party was terminated during the threemonths ended March 31, 2009.

 

***Warrants***

 

The Company holdswarrants to purchase shares of companies with respect to which the Company isalso a debt holder. These warrants were issued in connection withrenegotiations of the loan agreements.

 

***Total Return Swaps***

 

Total return swaps arefinancial instruments which provide the holder with the total return on one ormore underlying assets (for example, a syndicated bank loan or bond) offset bythe cost of financing. The Company’s total return swaps were entered intobecause management determined that such swaps provided a better risk adjustedreturn of capital than owning the underlying loans outright.  As of March 31, 2009, the Company heldno total return swaps.

 

**8.****        ****REPURCHASE AGREEMENTS**

 

Repurchase agreements areshort term borrowings from financial institutions that bear interest rates thathave historically moved in close relationship to the one-month, two-month orthree-month LIBOR. As of March 31, 2009, the Company had repurchaseagreements outstanding in the amount of $318.6 million (including $53,000of accrued interest). The repurchase agreements had remaining maturitiesbetween 2 and 30 days and a weighted-average borrowing rate of 0.75%.

 

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As of March 31, 2009, theCompany had amounts at risk with the following repurchase agreementcounterparties:

 
| ** **                                | ** ** | ** **             | ** ** | **Weighted-Average**       | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | ** **             | ** ** | **Maturity of Repurchase** | ** ** |
| ** **                                | ** ** | **Amount at Risk (1)** | ** ** | **Agreements**             | ** ** |
| ** **                                | ** ** | **(In thousands)**     | ** ** | **(In days)**              | ** ** |
| **Repurchase  Agreement Counterparties:** | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Deutsche Bank  Securities Inc.            |       | 4,990                  |       | 7                          |       |
| Fortis  Securities LLC                    |       | 11,620                 |       | 6                          |       |
| Total                                     |       | $                      | 16,610     |                       | 6          |   |
|                                           |            |                        |            |                            |            |  |

 

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(1)        Equal to the fair value ofsecurities pledged, minus repurchase agreement liabilities and related accruedinterest payable.

 

During the three monthsended March 31, 2009, repurchase agreement liabilities declined by $7.5 million,as a result of RMBS principal paydowns, which resulted in associated repaymentsof repurchase agreement liabilities. The Company’s repurchase agreementliabilities are significantly concentrated with one counterparty that providesfinancing totaling 84.6% of the $318.6 million of repurchase agreementliabilities as of March 31, 2009. See Note 9 for additional discussionconcerning securities received and pledged as collateral.

 

**9.      SECURITIES RECEIVED AND PLEDGED ASCOLLATERAL**

 

To the extent that theCompany receives collateral in connection with derivative and repurchase agreementtransactions, it is generally permitted to sell or repledge these securities.As of March 31, 2009, the Company did not have any securities held ascollateral.

 

The Company also pledgesits own assets to collateralize its repurchase agreements and in connectionwith derivative transactions. These securities owned and pledged, where thecounterparty has the right by contract or custom to sell or repledge thefinancial instruments, were approximately $335.3 million as of March 31, 2009and consisted of RMBS pledged as initial collateral on repurchase agreements.In addition, as of March 31, 2009, the Company sent $13.1 million of cash tocounterparties as collateral on derivatives, which is included in due frombroker on the condensed consolidated balance sheet.

 

**10.    LONG TERM DEBT**

 

The following tablesummarizes the Company’s long term debt as of March 31, 2009:

 
| ** **                             | ** ** | ** **         | ** ** | **Weighted** | ** ** |
|----------------------------------------|------------|--------------------|------------|--------------|------------|
| ** **                             | ** ** | **Carrying**       | ** ** | **Average**  | ** ** |
| ** **                             | ** ** | **Value**          | ** ** | **Rate**     | ** ** |
| ** **                             | ** ** | **(In thousands)** | ** ** | ** **   | ** ** |
| **Recourse:**                          | ** ** | ** **         | ** ** | ** **   | ** ** |
| Trust Preferred  Securities            |       | $                  | 123,717    |         | 3.95       | % |
| Series A  and Series B Notes |       | 71,905             |       | 6.44         | %          |
| Total Recourse                         |       | 195,622            |       | 4.87         | %          |
| **Non-Recourse:**                      |       |               |       |         |       |
| Wachovia  Facility (1)                 |       | 12,000             |       | 3.00         | %          |
| Market Square  CLO                     |       | 276,000            |       | 1.64         | %          |
| DFR MM CLO (2)                         |       | 231,000            |       | 1.83         | %          |
| Total  Non-Recourse                    |       | 519,000            |       | 1.76         | %          |
| Total long term  debt                  |       | $                  | 714,622    |         | 2.61       | % |

 

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| (1) |   | On November 30, 2008,  the Company triggered an acknowledged termination event under the Wachovia  Facility. The Company has entered into a forbearance agreement with respect  to such acknowledged termination event that extends through July 7, 2009. See  Note 18 for subsequent events related to the Wachovia Facility. |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Excludes $19.0 million  of DFR MM CLO debt that is owned by the Company and eliminated upon  consolidation. Had this debt been included, the weighted-average borrowing  rate would be 2.08%.                                                                                                                                  |

 

Recourse debt refers todebt that is a general obligation of the Company.  Non-recourse debt refers to debt withrecourse only to specific assets pledged as collateral to the lenders, such aswarehouse facilities and the debt issued by CDOs that are consolidated as VIEs.The creditors of the non-recourse debt have no recourse to the other assets ofthe Company. None of the long term debt is subject to potential margin callsfor additional pledges of cash or assets. The carrying value of the collateral of the entities which thenon-recourse debt holders have recourse for the repayment of outstanding debtare $16.1 million, $209.8 million and $291.8 million for the Wachovia Facility,Market Square CLO and DFR MM CLO, respectively.

 

During the three monthsended March 31, 2009, the Company entered into an agreement to sell loans heldwithin the Wachovia Facility with a par value of $31.5 million for $10.8million, net of interest of $0.2 million. Proceeds from the settlement of this trade reduced the outstanding debtassociated with the Wachovia Facility. See Note 18 for subsequent eventsrelated to the Wachovia Facility.

 

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**11.STOCKHOLDERS’ EQUITY**

 

***Performance Shares***

 

During 2008, theCompany granted restricted stock units (the “Performance Shares”) to each ofthe five independent members of the Company’s board of directors (the “Board”)as a component of their compensation and to certain of its employees as partialpayment of their 2007 bonus. Each of the Performance Shares represents theright to receive one share of the Company’s common stock on March 3, 2011,subject to forfeiture and acceleration upon the occurrence of certain specifiedevents. The number of Performance Shares granted to each employee is subject toadjustment for dividends or other distributions paid between March 3, 2008 and March3, 2011 and may also be adjusted, as determined by the Board, in connectionwith any stock dividends, stock splits, subdivisions or consolidations ofshares (including reverse stock splits) or similar changes in the Company’scapitalization. There was no Performance Share activity during the three monthsended March 31, 2009.  As of March 31,2009, there were 248,069 Performance Shares outstanding.

 

***Restricted Stock Grants***

 

During the three monthsended March 31, 2009, vesting was accelerated on an additional 541 shares ofcommon stock for an employee terminated in 2009 as a result of the November 2008Plan. See Note 15 for further information regarding the November 2008Plan.  In addition, during the threemonths ended March 31, 2009, 541 shares of common stock vested under the termsof the grant.  The unamortized amount ofthe share-based payments totaled $0.1 million as of March 31, 2009, and isbeing recognized on a straight-line basis over the remaining vesting period asan expense to compensation and benefits in the condensed consolidatedstatements of operations and an off-setting credit to additional paid-incapital.

 

The following tablesummarizes changes in restricted stock grants (number of shares) granted byDeerfield and obtained as a result of the Merger for the three months ended March31, 2009:

 
| ** **                           | ** ** | **Number of Shares** | ** ** |
|--------------------------------------|------------|----------------------|------------|
| Nonvested,  January 1, 2009     |       | 1,623                |       |
| Vested                               |       | (1,082               | )          |
| Nonvested as of  March 31, 2009 |       | 541                  |       |

 

**12.    COMPUTATION OF EARNINGS (LOSS) PER SHARE**

 

The following tablepresents the calculation of basic and diluted earnings (loss) per share:

 
| ** **                                                            | ** ** | **Three months ended March 31,**     | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                            | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| ** **                                                            | ** ** | **(In thousands, except per share data)** | ** ** |
|                                                                  |       |                                      |       |   |   |
| Net income  (loss)                                                    |       | $                                         | 11,539     |   | $ | (463,610 | ) |
| Less: Cumulative  convertible preferred stock dividends and accretion |       | —                                    |       | 2,393 |   |
| Net income  (loss) attributable to common stockholders                |       | $                                         | 11,539     |   | $ | (466,003 | ) |
|                                                                  |       |                                      |       |   |   |
| Weighted average  shares used in basic and diluted calculations       |       | 6,702                                     |       | 5,497 |   |
|                                                                  |       |                                      |       |   |   |
| Net income  (loss) per share - basic                                  |       | $                                         | 1.72       |   | $ | (84.78 | ) |
|                                                                  |       |                                      |       |   |   |
| Net income  (loss) per share - diluted                                |       | $                                         | 1.72       |   | $ | (84.78 | ) |

 

For the three monthsended March 31, 2009 and 2008, restricted stock grants of 541 and 6,429,respectively, are not included in the calculation of diluted net income (loss)per share because their effect was anti-dilutive. For the three months ended March31, 2008, the 14,999,992 shares of Series A Preferred Stock (not adjusted toreflect the 1-for-10 reverse stock split effected on October 16, 2008) are notincluded in calculation of diluted net loss per share because their effect was anti-dilutive.On March 11, 2008, the Series A Preferred Stock converted into 14,999,992 sharesof common stock (not adjusted to reflect the 1-for-10 reverse stock spliteffected on October 16, 2008), which are included in the calculation of basicearnings per share.

 

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**13.    ACCUMULATED OTHER COMPREHENSIVE LOSS**

 

The following is asummary of the components of accumulated other comprehensive loss:

 
| ** **                                   | ** ** | **For the three months ended March 31, 2009** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                   | ** ** | **Available-for-**                                 | ** ** | **Cash Flow** | ** ** | **Foreign Currency** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Sale Securities**                                | ** ** | **Hedges** | ** ** | **Translation** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                 | ** ** |
| Beginning  balance - January 1, 2009    |       | $                                                  | (4,055     | ) | $ | (199 | ) | $ | (2 | ) | $ | (4,256 | ) |
| Unrealized net  gain for the period          |       | 308                                                |       | — |   | — |   | 308 |   |
| Foreign currency  translation loss           |       | —                                             |       | — |   | (29 | ) | (29 | ) |
| Reclassification  adjustments:               |       |                                               |       |   |   |   |   |   |   |
| Hedging  amortization recognized in earnings |       | —                                             |       | 49 |   | — |   | 49 |   |
| Ending balance -  March 31, 2009        |       | $                                                  | (3,747     | ) | $ | (150 | ) | $ | (31 | ) | $ | (3,928 | ) |

 

**14.    INCOME TAXES**

 

The Company has recordeddeferred income taxes as of March 31, 2009 in accordance with SFAS No. 109,*Accounting for Income Taxes*(“SFAS No. 109”). The Company recordsdeferred tax assets and liabilities for the future tax consequencesattributable to differences between the GAAP carrying amounts and theirrespective income tax bases.  As requiredby SFAS No. 109, DFR evaluated the likelihood of realizing tax benefits infuture periods, which requires the recognition of a valuation allowance toreduce any deferred tax assets to an amount that is more likely than not to berealized.

 

As of March 31, 2009, theCompany concluded that, due to the ongoing disruption and uncertainty in thecredit markets, a full valuation allowance on the deferred tax asset would berecorded. Accordingly, as of March 31, 2009, the Company has recognized a grossdeferred tax asset of $376.4 million, a deferred tax liability of $1.6 millionand a valuation allowance for deferred tax assets in the amount of $374.8 million.As such, the Company recognized no net deferred tax asset as of March 31, 2009.In future reporting periods, the Company will continue to reassess its abilityto recognize additional deferred tax assets, which will impact the Company’srecorded income tax expense or benefit on the condensed consolidated statementof operations at that time.

 

As of March 31, 2009, theCompany had a federal net operating loss (“NOL”) of approximately $197.4 million,which will be available to offset future taxable income, subject to thelimitations described below. If not used, this NOL will begin to expire in2028. The Company also had net capital losses (“NCLs”) in excess of capitalgains of $387.9 million as of March 31, 2009, which can be carried forward tooffset future capital gains, subject to the limitations described below. If notused, this carryforward will begin to expire in 2012. No assurance can beprovided that the Company will have future taxable income or future capitalgains to benefit from its NOL and NCL carryovers. In addition, the Company’sNOL and NCL carryovers may be limited by Sections 382 and 383 of the InternalRevenue Code of 1986, as amended (the “Code”), if the Company undergoes anownership change as defined in those sections (“Ownership Change”).  If an Ownership Change occurs, the Company’sability to use its NOLs, NCLs and certain recognized built-in losses to reduceits taxable income in a future year would generally be limited to an annualamount (the “Section 382 Limitation”) equal to the fair value of the Companyimmediately prior to the Ownership Change multiplied by the “long termtax-exempt interest rate.” In the event of an Ownership Change, NOLs and NCLsthat exceed the Section 382 Limitation in any year will continue to be allowedas carryforwards for the remainder of the carryforward period, and such NOLsand NCLs can be used to offset taxable income for years within the carryforwardperiod subject to the Section 382 Limitation in each year. However, if thecarryforward period for any NOL or NCL were to expire before that loss is fullyutilized, the unused portion of that loss would be lost.

 

For the three monthsended March 31, 2009, the Company recognized income tax expense of $18,000relating to its London subsidiary.

 

On March 11, 2009, theBoard adopted a stockholder rights plan (the “Rights Plan”) to dissuadeinvestors from engaging in certain transactions that could trigger an OwnershipChange, and declared a dividend of one right (“Right”) for each outstandingshare of our common stock to stockholders of record at the close of business onMarch 11, 2009. The Rights will also attach to any additional shares of theCompany’s common stock issued after March 11, 2009. The Rights Plan was notadopted in response to any effort to acquire control of the Company, but as ameans to protect the use of previously accumulated NOLs, NCLs and certain othertax attributes by dissuading investors from aggregating ownership in theCompany and triggering an Ownership Change.

 

Initially, the Rightswill not be exercisable and will be attached to and automatically trade withthe Company’s common stock. The Rights will separate from the Company’s commonstock and a “distribution date” will occur, with certain exceptions, upon theearlier of (i) ten business days following a public announcement that a personor group of affiliated or associated persons has acquired beneficial ownershipof 4.9% or more of the Company’s outstanding common stock, which person or groupwould then qualify as an “acquiring person,” or (ii) ten business daysfollowing the first public announcement of a person’s intention to commence orthe commencement of a tender offer or exchange offer that would result in aperson becoming an acquiring person. If at the time of the adoption of theRights Plan, any person or group of affiliated or associated persons was thebeneficial owner of 4.9% or more of the

 

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outstanding shares of theCompany’s common stock, such person shall not become an acquiring person unlessand until such person acquires any additional shares of the Company’s commonstock. In addition to other exceptions, a person will not become an acquiringperson if such person acquired the shares of the Company’s common stock,directly or indirectly, as the result of a warrant, the exercise thereof, thetransfer or acquisition of such warrant or common stock acquired thereby, wheresuch warrant had first been issued upon approval by the Board unless and untilsuch person and its affiliates and associates acquire any additional shares ofthe Company’s common stock then outstanding that are unrelated to the warrant.If the Rights become exercisable, each Right will entitle its holder topurchase one one-thousandth of a share of the Company’s Series A JuniorParticipating Preferred Stock at a purchase price of $16.00 per fractionalshare, subject to adjustment. The Rights have no voting privileges and willexpire at the close of business on March 10, 2019, unless earlier expired,redeemed or exchanged by the Company. The Rights will expire at such time asthe State Department of Assessments and Taxation of Maryland accepts for recorda charter amendment providing for (as determined in good faith by the Board)restrictions on the transfer of our securities in order to preserve thebenefits of the Company’s NOLs, NCLs or other tax attributes.

 

The Rights Plan containscustomary “flip-in” and “flip-over” provisions such that if a person or groupacquires beneficial ownership of 4.9% or more of the Company’s common stock andis determined by the Board to be an acquiring person, each Right (other thanRights held by the acquiring person) will entitle the holder to purchase commonstock having a value of two times the exercise price of the Right.  There was no impact on our financial resultsas a result of the adoption of the Rights Plan.

 

**15.          COST SAVINGS INITIATIVES**

 

On March 1, 2008, inresponse to the adverse credit markets the Company implemented an initial costsaving initiative (the “March 2008 Plan”) and reduced the Company’s headcountby 13 employees, or approximately 10% of the then current workforce, across abroad range of functions. This resulted in severance expense of $0.3 millionduring the three months ended March 31, 2008. In November 2008, in response tothe continued deterioration in market conditions, the Company implemented asecond cost saving initiative (the “November 2008 Plan”). The November 2008Plan involved reducing headcount by 24 employees, or approximately 26% of thethen current workforce, reducing bonus compensation and instituting a salaryfreeze. The compensation payable to those 24 employees accounted forapproximately 37% of the Company’s annual compensation expense in 2008. The November2008 Plan headcount reductions were largely related to the fixed incomearbitrage trading business and the associated back-office infrastructure.

 

The following tableprovides a rollforward of the activity included within the accrued and otherliabilities line item in the condensed consolidated balance sheets related tothe March 2008 Plan and the November 2008 Plan:

 
| ** **                      | ** ** | **Employee Severance  Accrual** | ** **  | **Exit Costs  Accrual** | ** ** | **Total** | ** ** |
|---------------------------------|------------|---------------------------------|-------------|-------------------------|------------|-----------|------------|
| ** **                      | ** ** | **(In thousands)**              | ** **  |
| Balance -  January 1, 2009 |       | $                               |  1,083 |                    | $          |  175 |       | $ |  1,258 |   |
| Provisions                      |       | 159                             |        | 38                      |       | 197       |       |
| Distributions                   |       | (929                            | )           | (71                     | )          | (1,000    | )          |
| Balance -  March 31, 2009  |       | $                               | 313         |                    | $          | 142       |       | $ | 455 |   |

 

**16.    SEGMENT REPORTING**

 

The Company operates intwo reportable segments, Investment Management and Principal Investing.Management evaluates the performance of each business unit based on segmentresults, expenses and revenues. It is also important to understand when viewingsegment results that they include direct and allocated expenses and revenues.

 

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The following summarizesthe financial information concerning the Company’s reportable segments (asdescribed in Note 1):

 
| ** **                                                     | ** ** | **For the three months ended March 31, 2009**                               | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                                                               | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                                                       | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                                                             |       |   |   |   |   |   |   |
| Interest income                                                |       | $                                                                                | 46         |   | $ | 13,736 |   | $ | — |   | $ | 13,782 |   |
| Interest expense                                               |       | 1,344                                                                            |       | 5,655 |   | — |   | 6,999 |   |
| Net interest  (expense) income                                 |       | (1,298                                                                           | )          | 8,081 |   | — |   | 6,783 |   |
| Provision for  loan losses                                     |       | —                                                                           |       | 2,107 |   | — |   | 2,107 |   |
| Net interest  (expense) income after provision for loan losses |       | (1,298                                                                           | )          | 5,974 |   | — |   | 4,676 |   |
| Investment  advisory fees                                      |       | 6,201                                                                            |       | — |   | (1,464 | )(1) | 4,737 |   |
| Total net  revenues                                            |       | $                                                                                | 4,903      |   | $ | 5,974 |   | $ | (1,464 | ) | $ | 9,413 |   |
| Depreciation and  amortization                                 |       | $                                                                                | 1,635      |   | $ | — |   | $ | — |   | $ | 1,635 |   |
| Income tax  expense                                            |       | $                                                                                | 18         |   | $ | — |   | $ | — |   | $ | 18 |   |
| Net (loss)  income                                             |       | $                                                                                | (1,923     | ) | $ | 13,462 |   | $ | — |   | $ | 11,539 |   |
|                                                           |       |                                                                             |       |   |   |   |   |   |   |
| ** **                                                     | ** ** | **As of March 31, 2009**                                     | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                          | ** ** |
| Identifiable  assets                                           |       | $                                                                                | 55,288     |   | $ | 933,734 |   | $ | (2,703 | )(2) | $ | 986,319 |   |
|                                                           |       |                                                                             |       |   |   |   |   |   |   |
| ** **                                                     | ** ** | **For the three months ended March 31, 2008** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                          | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                                                       | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                                                             |       |   |   |   |   |   |   |
| Interest income                                                |       | $                                                                                | 342        |   | $ | 61,008 |   | $ | — |   | $ | 61,350 |   |
| Interest expense                                               |       | 1,971                                                                            |       | 45,629 |   | — |   | 47,600 |   |
| Net interest  (expense) income                                 |       | (1,629                                                                           | )          | 15,379 |   | — |   | 13,750 |   |
| Provision for  loan losses                                     |       | —                                                                           |       | 2,200 |   | — |   | 2,200 |   |
| Net interest  (expense) income after provision for loan losses |       | (1,629                                                                           | )          | 13,179 |   | — |   | 11,550 |   |
| Investment  advisory fees                                      |       | 16,078                                                                           |       | — |   | (3,959 | )(1) | 12,119 |   |
| Total net  revenues                                            |       | $                                                                                | 14,449     |   | $ | 13,179 |   | $ | (3,959 | ) | $ | 23,669 |   |
| Depreciation and  amortization                                 |       | $                                                                                | 2,687      |   | $ | — |   | $ | — |   | $ | 2,687 |   |
| Income tax  (benefit) expense                                  |       | $                                                                                | (8,670     | ) | $ | 1,468 |   | $ | — |   | $ | (7,202 | ) |
| Net loss                                                       |       | $                                                                                | (20,773    | ) | $ | (442,837 | ) | $ | — |   | $ | (463,610 | ) |
|                                                           |       |                                                                             |       |   |   |   |   |   |   |
| ** **                                                     | ** ** | **As of March 31, 2008**                                     | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                          | ** ** |
| Identifiable  assets                                           |       | $                                                                                | 197,366    |   | $ | 2,280,464 |   | $ | (1,528 | )(2) | $ | 2,476,302 |   |
|                                                                |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

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| (1) |   | Represents  the fees charged to the Principal Investing segment by the Investment  Management segment on a cost plus basis for investment advisory, management  and operational services.                                                                                                                               |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Represents  the payable for fees charged to the Principal Investing segment by the  Investment Management segment and the intercompany receivable from the  Principal Investing segment for expenses paid by the Investment Management  segment which have not yet been reimbursed by the Principal Investing  segment. |

 

**17.    COMMITMENTS AND CONTINGENCIES**

 

***Legal Proceedings***

 

As previously reported,the SEC is conducting an investigation relating to certain practices associatedwith the offer, purchase or sale of collateralized mortgage obligations andreal estate mortgage investment conduits (“REMICs”) and the creation ofre-REMICs. The investigation concerns certain mortgage securities transactionseffected by DCM for the Company in 2005 and 2006. The Company cannot predictthe outcome of this investigation.

 

In the ordinary course ofbusiness, the Company may be subject to legal and regulatory proceedings thatare generally incidental to its ongoing operations. While there can be noassurance of the ultimate disposition of such proceedings, the Company does notbelieve their disposition will have a material adverse effect on the Company’scondensed consolidated financial statements.

 

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***2009 Interim Chairman Compensation Agreement***

 

On March 5, 2009, theCompany entered into a letter agreement (the “2009 Rothschild CompensationAgreement”) with Peter H. Rothschild setting forth the fees payable to him forhis services as Interim Chairman of the Board for the year ended December 31,2009. The 2009 Rothschild Compensation Agreement provides for two discretionaryfees, a “Capital Transaction Success Fee” not to exceed $1,000,000 and a “Non-CapitalTransaction Success Fee” not to exceed $500,000, which may be paid if certainspecified conditions are met.   Inaddition, the 2009 Rothschild Compensation Agreement provides for a “Fund SuccessFee” of $250,000 relating to a new investment vehicle, provided the closing ofinitial capital commitments to the investment vehicle occurred on or before June30, 2009 and the total amount of such commitments exceeded $50.0 million.  The Fund Success Fee was paid on April 17,2009 as a result of the new investment venture with Pegasus Capital AdvisorsL.P (“Pegasus”) announced on April 14, 2009. See Note 18 for further discussion concerning the new investmentventure.

 

***Other Commitments***

 

The Company had unfundedinvestment commitments on bank loans of $5.0 million as of March 31, 2009. Thetiming and amount of additional funding on these bank loans are at thediscretion of the borrower, to the extent the borrower satisfies certainrequirements in the loan documentation.

 

**18.SUBSEQUENT EVENTS**

 

***New Investment Venture***

 

On April 14, 2009, theCompany announced Deerfield Pegasus Loan Capital LP (“DPLC”), its newinvestment venture with Pegasus.  Pegasusis a U.S. based private equity firm. Pegasus and the Company have committed to invest $75.0 million and $15.0million, respectively, in DPLC with such amounts to be invested primarily incorporate bank loans and other senior secured corporate loans.  DPLC will be managed by DCM.  The commitments of each of Pegasus and theCompany are subject to numerous conditions, any or all of which may not besatisfied.

 

In connection with thelaunch of DPLC, the Company issued to Pegasus Deerfield (AIV), LLC, anaffiliate of Pegasus (“Pegasus Deerfield”), (i) a five-year warrant to purchase2,500,000 shares of its common stock at an exercise price of $4.25 per share (“WarrantA”) and (ii) a five-year warrant to purchase 500,000 shares of its common stockat an exercise price of $10.00 per share (“Warrant B” and, together withWarrant A, the “Warrants”).  The Warrantsare subject to certain vesting conditions, including that none of the Warrantsvest prior to April 9, 2011 and that the Warrants will vest only if Pegasusmaintains a certain minimum investment in DPLC. In addition, Pegasus will be required by a certain specified date tomake an election to either retain the Warrants or receive a share of theincentive allocations and investment advisory fees paid to the Company and DCMin respect of certain future investment funds and separately managed accountsmanaged by DCM that invest primarily in syndicated bank loans to and bonds issuedby non-investment grade borrowers.  In the event that Pegasus elects toreceive these subsequent fund economics, they will forfeit the Warrants.  Simultaneously with the execution of theWarrants, the Company entered into a registration rights agreement, dated as ofApril 9, 2009, with Pegasus Deerfield that provides registration rights withrespect to the shares of the Company’s common stock underlying the Warrants.

 

***Notice of Non-Compliance with NYSE Amex Continued ListingStandard***

 

On April 15, 2009,the Company was notified by the NYSE Amex LLC (the “NYSE Amex”), that it is notin compliance with a NYSE Amex continued listing standard applicable to itscommon stock. Specifically, the letter from the NYSE Amex states that a reviewof the Company’s public filings indicates that the Company is not in compliancewith Section 1003(a)(i) of the NYSE Amex Company Guide (the “Company Guide”)because the Company has stockholders’ equity of less than $2,000,000 and hassustained losses from continuing operations and/or net losses in two of itsthree most recent fiscal years.

 

Under the NYSEAmex rules, the Company must submit a plan to the NYSE Amex by May 15, 2009addressing how it intends to regain compliance with Section 1003(a)(i) of theCompany Guide by October 15, 2010, and that plan must be accepted by the NYSEAmex in order for the Company to maintain its listing. If the Company’s plan isaccepted by the NYSE Amex, but the Company is not in compliance with allcontinued listing standards set forth in the Company Guide by October 15, 2010or does not make progress consistent with its plan, the NYSE Amex stated thatit will initiate delisting proceedings as it deems appropriate.

 

***SecondAmended and Restated Forbearance Agreement under Wachovia Facility***

 

On May 8, 2009, the Company entered into a secondamended and restated forbearance agreement related to the Wachovia Facilityextending the period through which no action will be taken in respect of anyprior noncompliance with the covenant requiring the Company to maintainstockholders’ equity of at least $240.0 million as well as certain othercovenants under the Wachovia Facility through the earlier of July 7, 2009and the date of any breach of the forbearance agreement by the Company.  The outstanding balance under the WachoviaFacility as of May 8, 2009 was approximately $0.9 million.

 

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**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

The statements in thisdiscussion regarding the industry outlook and our expectations regarding thefuture performance of our business and the other non-historical statements inthis discussion are forward-looking statements. These forward-lookingstatements are subject to numerous risks and uncertainties, including, but notlimited to, the risks and uncertainties described in this quarterly report on Form10-Q, or Quarterly Report,  beginning on page3 under the title “Special Note Regarding Forward Looking Statements” and “*Part II — Item 1A. Risk Factors”* and inour Annual Report on Form 10-K for the fiscal year ended December 31, 2008, asfiled with the Securities and Exchange Commission filed on March 16, 2009, orour Annual Report,  in “*Part I — Item 1A. Risk Factors.”*  You should read the following discussiontogether with our condensed consolidated financial statements and notes theretoincluded in*“Part I — Item 1. FinancialStatements”* of this Quarterly Report. Unless otherwise noted or thecontext otherwise requires, we refer to Deerfield Capital Corp. as “DFR,” toDFR and its subsidiaries as “we,” “us,” “our” or “our company,” to Deerfield &Company LLC, one of our indirect wholly-owned subsidiaries, as “Deerfield” andto Deerfield Capital Management LLC, our former external manager and another ofour indirect wholly-owned subsidiaries, as “DCM.” We refer to our acquisitionof Deerfield pursuant to a merger agreement, dated as of December 17, 2007,among us, DFR Merger Company, LLC (our wholly-owned subsidiary that was mergedinto Deerfield), Deerfield and Triarc Companies, Inc., or Triarc (as sellers’representative) by which DFR Merger Company, LLC was merged with and intoDeerfield on December 21, 2007 as the “Merger.”

 

**Overview**

 

We are a Marylandcorporation with an Investment Management segment that manages approximately$10.3 billion of client assets ($590.3 million of which is also included in ourPrincipal Investing portfolio), as of April 1, 2009, including bank loans andother corporate debt, residential mortgage-backed securities, or RMBS,government securities and asset-backed securities, or ABS. In addition, ourPrincipal Investing segment has an investment portfolio of approximately $839.7million, as of March 31, 2009, comprised of fixed income investments, includingbank loans and other corporate debt and RMBS. Historically, we had elected tobe taxed as a REIT. However, our status as a REIT terminated in 2008 when, inan effort to increase stockholder value, we converted to a C corporation tomaximize use of potential significant tax benefits and provide more flexibilitywith respect to future capital investment.

 

We intend to operate, and to cause each of oursubsidiaries to operate, in such a way as to be excluded from registrationunder the Investment Company Act of 1940, as amended, or 1940 Act. DFR andDeerfield Capital LLC, or DC LLC, are excluded from registration under the 1940Act because no more than 40% of their assets, on an unconsolidated basis,excluding cash and government securities, are investment securities. We intendto continue to qualify for this exclusion by monitoring the value of all oursubsidiaries and any investment securities we own to ensure that at all times,no more than 40% of its assets, on an unconsolidated basis, excluding certainitems, will be investment securities under the 1940 Act.

 

After the close ofbusiness on October 16, 2008, we effected a 1-for-10 reverse stock split of ourcommon stock. All share and per share amounts throughout this Quarterly Reporthave been retroactively restated to reflect the reverse stock split, unlessotherwise noted.

 

***Our Business***

 

Our business is managedin two operating segments: Investment Management and Principal Investing. OurInvestment Management segment involves earning investment advisory fees formanaging a variety of investment products including collateralized debtobligations, or CDOs, separately managed accounts and investment funds. Our PrincipalInvesting segment involves maintaining an investment portfolio comprisedprimarily of bank loans and other corporate debt, Agency RMBS (as definedbelow) and non-Agency RMBS. Agency RMBS are backed by mortgage loans and areguaranteed as to principal and interest by federally chartered entities such asthe Federal National Mortgage Association, or Fannie Mae, or the Federal HomeLoan Mortgage Corporation, or Freddie Mac, and, in the case of the GovernmentNational Mortgage Association, or Ginnie Mae, the U.S. government. We refer tothese entities as “Agencies” and to RMBS guaranteed or issued by the Agenciesas “Agency RMBS.” Our Agency RMBS portfolio consists of Fannie Mae and FreddieMac securities. We refer to our investments in senior secured loans (first lienand second lien term loans), senior subordinated debt facilities and otherjunior securities, typically in middle market companies across a range ofindustries, as “Corporate Loans.”

 

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*InvestmentManagement Segment*

 

Our Investment Managementsegment is operated through DCM. DCM has managed investment accounts forvarious types of clients, including separately managed accounts (separate,non-pooled accounts established by clients), private investment funds and CDOs.Except for the separately managed accounts, these clients are collectiveinvestment vehicles that pool the capital contributions of multiple investors,which are typically financial institutions, such as insurance companies andbanks, employee benefits plans and “funds of funds” (investment funds that inturn allocate their assets to a variety of other investment funds). Our teamsthat manage these accounts are supported by various other groups within DCM,such as risk management, systems, accounting, operations and legal. DCM entersinto an investment management agreement with each client, pursuant to which theclient grants DCM discretion to purchase and sell securities and otherfinancial instruments.

 

Our primary source ofrevenue from our Investment Management segment is the investment advisory feespaid by the accounts we manage. These fees typically consist of management feesbased on the account’s assets and performance fees based on the profits wegenerate for the account.

 

***Assets Under Management***

 

As of April 1, 2009, DCM’stotal assets under management, or AUM, were approximately $10.3 billion, heldin 28 CDOs and six separately managed accounts.

 

The following tablesummarizes the AUM for each of our product categories:

 
| ** **                       | ** ** | **Number of** | ** ** | **AUM as of**      | ** ** |
|----------------------------------|------------|---------------|------------|--------------------|------------|
| ** **                       | ** ** | **Accounts**  | ** ** | **April 1, 2009**  | ** ** |
| ** **                       | ** ** | ** **    | ** ** | **(In thousands)** | ** ** |
| CDOs (1) :                       |       |          |       |               |       |
| CLOs                             |       | 12            |       | $                  | 4,184,002  |   |
| Asset-backed  securities         |       | 12            |       | 4,906,125          |       |
| Corporate bonds                  |       | 4             |       | 910,924            |       |
| Total CDOs                       |       | 28            |       | 10,001,051         |       |
| Separately  managed accounts (2) |       | 6             |       | 320,488            |       |
| Total AUM (3)                    |       |          |       | $                  | 10,321,539 |   |

 

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| (1) |   | CDO  AUM numbers generally reflect the aggregate principal or notional balance of  the collateral and, in some cases, the cash balance held by the CDOs and are  as of the date of the last trustee report received for each CDO prior to  April 1, 2009. The AUM for our Euro-denominated CDOs has been converted into  U.S. dollars using the spot rate of exchange on March 31, 2009.                                                                                                                                                                                                  |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | AUM  for certain of the separately managed accounts is a multiple of the capital  actually invested in such account. Management fees for these accounts are  paid on this higher AUM amount.                                                                                                                                                                                                                                                                                                                                                                                              |
| (3) |   | Included  in Total AUM are $296.5 million related to Market Square CLO Ltd., or Market  Square CLO, and $293.8 million related to DFR Middle Market CLO Ltd., or DFR  MM CLO, for April 1, 2009, which amounts are also included in the total AUM  reported for the Principal Investing portfolio as of March 31, 2009. DCM  manages these CDOs but is not contractually entitled to receive any  management fees so long as 100% of the equity is held by DC LLC or an  affiliate thereof. All other amounts included in the Principal Investing  portfolio are excluded from Total AUM. |

 

*PrincipalInvesting Segment*

 

Income from our PrincipalInvesting segment is influenced by three factors: (i) the net spread, ordifference, between the interest income we earn on our investment portfolio andthe cost of our borrowings net of hedging activities, (ii) the recognized gainsand losses on our investment portfolio and (iii) provision for loan losses, ifany. Our net interest income will vary based upon, among other things, thedifference between the interest rates earned on our interest-earning investmentsand the borrowing costs of the liabilities used to finance those investments.We use leverage to seek to enhance our returns, which can also magnify losses.The cost of borrowings to finance our investments comprises a significantportion of our operating expenses.

 

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The following table is asummary of our Principal Investing segment by asset class:

 
| ** **                                   | ** ** | **March 31, 2009** | ** ** |
|----------------------------------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **Carrying**       | ** ** | **% of Total** | ** ** |
| **Principal Investments**                    | ** ** | **Value**          | ** ** | **Investments** | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
|                                         |       |               |       |   |   |
| RMBS                                         |       | $                  | 338,729    |   | 39.3 | % |
| Corporate  leveraged loans:                  |       |               |       |   |   |
| Loans held in  DFR MM CLO                    |       | 292,108            |       | 33.9 | % |
| Loans held in  the Wachovia Facility         |       | 4,831              |       | 0.6 | % |
| Other corporate  leveraged loans             |       | 8,270              |       | 1.0 | % |
| Assets held in  Market Square CLO (1)        |       | 200,841            |       | 23.3 | % |
| Commercial real  estate loans and securities |       | 12,330             |       | 1.4 | % |
| Equity  securities                           |       | 4,764              |       | 0.5 | % |
| **Total  Investments**                       |       | 861,873            |       | 100.0 | % |
| Allowance for  loan losses                   |       | (22,171            | )          |   |   |
| **Net  Investments**                         |       | $                  | 839,702    |   |   |   |

 

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| (1) |   | Assets  held in Market Square CLO include syndicated bank loans of $197.5 million,  high yield corporate bonds and ABS of $2.6 million and other investments of  $0.7 million. |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**OurStrategy**

 

We are focused on growingthe Investment Management segment of our business by launching new investmentproducts that will diversify our revenue streams and take advantage of our corecompetencies of credit analysis and asset management. We intend to makeinvestments in certain of these new investment products. We believe that thegrowth of fee-based income through the management of alternative investmentproducts will provide the most attractive risk-adjusted return on capital.  On April 14, 2009, we announced that we hadentered into a new investment venture, Deerfield Pegasus Loan Capital LP, or DPLC,with Pegasus Capital Advisors L.P., or Pegasus. Pegasus and DFR have committed to invest $75.0 million and $15.0million, respectively, in DPLC with such amounts to be invested primarily incorporate bank loans and other senior secured corporate loans that DFR andPegasus believe are priced at attractive levels.  DPLC will be managed by DCM.  The commitments of each of Pegasus and DFRare subject to numerous conditions, any or all of which may not be satisfied.

 

On July 17, 2008 weacquired the management contract for Robeco CDO II Limited, or Robeco CDO, aCDO collateralized primarily by high-yield corporate bonds. On February 11,2009, we assumed the management contract for Mayfair Euro CDO I B.V., orMayfair Euro CDO, a Euro-denominated CDO collateralized primarily by investmentgrade and high-yield corporate bonds. These actions were in line with ourpreviously announced strategy to acquire or assume CDO management contractsfrom other investment managers, and we are continuing to pursue the acquisitionor assumption of additional management contracts.

 

We are focused onmanaging our Principal Investing segment by opportunistically selling CorporateLoans held outside of Market Square CLO Ltd., or Market Square CLO, and DFRMiddle Market CLO Ltd., or DFR MM CLO, as well as the preferred shares we ownin Market Square CLO, and redeploying our capital into other fee-basedstrategies. In the near term, we expect to continue to hold our RMBS portfolioboth for the net interest income it provides and as a source of liquidity.

 

Additionally, we continueto explore strategic opportunities in order to maximize value for ourstockholders.

 

**Trends**

 

The following trends thatwe have observed and believe to exist may also affect our business:

 

*Creditmarket dislocation.*  The well-publicized disruptions in thefinancial markets that began in 2007 escalated throughout 2008 and havecontinued into 2009. Over this period, global financial markets came underincreased stress as problems in the U.S. residential mortgage market spread tothe broader economy and the global financial sector. In addition, fears of aglobal recession increased and were exacerbated by further declines in thehousing and credit markets in the U.S. and Europe, which heightened concernsover the creditworthiness of some financial institutions. As a result, mostsectors of the financial markets experienced significant declines, includinginternational equity and credit markets, driven, in part, by deleveraging anddifficulty pricing risk in the market that has been affecting investors allover the world.

 

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In response, variousinitiatives by the U.S. government have been implemented to address credit andliquidity issues. Among other things, in September 2008, Fannie Mae andFreddie Mac were placed under conservatorship by the Federal Housing FinanceAgency, or FHFA, and the U.S. Treasury announced it would purchase seniorpreferred stock in Fannie Mae or Freddie Mac, up to a maximum of $100.0 billionper company if needed to maintain positive net worth. In November 2008, theFederal Reserve announced that it would buy up to $500.0 billion of AgencyRMBS. In January 2009, the Federal Reserve began to purchase Agency RMBSin accordance with this initiative. We believe that the stronger backing forthe guarantors of Agency RMBS, resulting from the conservatorship of Fannie Maeand Freddie Mac and the U.S. Treasury’s commitment to purchase senior preferredstock in these Agencies has positively impacted, and are expected to continueto positively impact, the value of our Agency RMBS. Moreover, the U.S.government has taken action to address credit and liquidity issues unrelated tothe Agencies and Agency RMBS. In October 2008, the U.S. Treasury createdthe Capital Purchase Program, as part of the $700.0 billion Troubled AssetRelief Program, allocating $250.0 billion to invest in U.S. financialinstitutions to help stabilize and strengthen the U.S. financial system. In November 2008,the U.S. Treasury announced the Term Asset Backed Security Loan Facility,intended to increase activity in the non-Agency asset-backed securities market.In February 2009, the Obama administration announced the HomeAffordability and Stability Plan, designed, in part, to stem foreclosures byhelping homeowners refinance or otherwise modify their loans, and thePublic-Private Investment Fund, formed to encourage the contribution of privatecapital that along with government funds could make large-scale purchases oftroubled and illiquid assets. These actions taken by the U.S. government, andother coordinated global actions have restored partially the capital base andreduced funding risks for many of the world’s largest financial institutions.

 

*Liquidity.*  Wedepend on the capital markets to finance our investments in RMBS. We enter intorepurchase agreements to provide short term financing for our RMBS portfolio.Financial institutions have historically provided sufficient liquidity tofinance our RMBS portfolio. Recent and continuing market events, however, havecaused such firms to change their credit standards and generally reduce theloan amounts available to borrowers, resulting in a decrease in overall marketliquidity. This has reduced our access to repurchase financing. This reductionin liquidity reduced the fair value of our non-Agency RMBS, which resulted inour need to post additional margin and, ultimately, to sell a significantportion of our RMBS portfolio at a time when we would not otherwise have chosento do so. The failure of one or more major market participants could furtherreduce the marketability of all fixed income securities, including Agency RMBS,which could reduce the value of the securities in our portfolio, thus furtherreducing our book value. If our lenders are unwilling or unable to provide uswith continued financing, we could be forced to sell a large portion of oursecurities at an inopportune time or on unfavorable terms. However, because thevast majority of our current RMBS portfolio consists of Agency RMBS, we believethat we are better positioned to convert our investment securities to cash orto negotiate an extended borrowing term should our lenders reduce the amount ofthe financing available to us.

 

*Corporatecredit performance.*  Earlier periods had demonstrated reasonablystable corporate credit performance, as evidenced by the relatively lowcorporate default rates. More recently, however, corporate default rates havebegun to increase as the U.S. economy has continued to weaken and has enteredinto a recession. A further weakening of the U.S. economy would likely have aneven more pronounced negative impact on corporate credit performance, which wewould expect to result in an increase in corporate default rates. Such anincrease would likely further reduce the returns associated with certain of ourinvestments, particularly the Corporate Loans held in both our PrincipalInvesting portfolio and in certain of the vehicles managed within ourInvestment Management segment. Furthermore, such an increase in default rateswould likely further increase our allowance for loan losses on loans held forinvestment and further increase our valuation allowance on loans held for sale.These events could result in significant losses and a reduction in our bookvalue. Increases in defaults could also cause us to trigger certain structuralprovisions in the CDOs that we own and manage. These structural provisionsinclude, but are not limited to, overcollateralization requirements that aremeant to protect investors from deterioration in the credit quality of theunderlying collateral pool.

 

*Creditspreads.*  Since the second half of 2007 the marketshave experienced significant widening of credit spreads across all of thecredit markets. This widening has resulted in a decline in the fair value formost of our investments and in the securities we manage, which has resulted ina decline in our book value and a reduction in our AUM. A continued wideningcould further reduce our book value but could also have the positive effect ofincreasing net interest income on future investment opportunities. However, wewould need to have capital available to take advantage of these investmentopportunities. We are pursuing the launch of new investment products within ourInvestment Management segment to take advantage of the widening credit spreads,including the recently-launched DPLC.

 

*CDOfinancing and management.*  The reduction in liquidity andwidening of credit spreads have resulted in significant downward pressure onthe market values of assets typically held in and financed by CDOs. Thesedecreased market values, along with increased default rates on assets held inCDOs and significant rating agency downgrades of the collateral underlyingcertain of our CDOs, have made it more likely that our CDOs may trigger certainof their structural protections and potentially events of default, either ofwhich would reduce our management fees and our AUM. Declines in market pricesof bank loans during 2008 and early 2009 have caused market value CLOs managedby DCM to breach their market value triggers. See “*Results of Operations — Investment Manageme*nt Segment —*  CDOs* ” for further information.

 

We anticipate that, givencurrent market conditions, it will be significantly more difficult to createnew CDOs in the near term than it has been in the past. Conditions in thecredit markets have led to banks charging higher fees to warehouse collateralfor the CDOs prior to their closing and potential investors demandingsignificantly increased interest rates on CDO liabilities. To the extent thatwe are successful in creating new CDOs, the management fees we earn frommanaging those CDOs may be significantly lower. This may negatively affect ourability to grow our AUM and revenue.

 

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During 2008, the CDOmanagement market experienced some consolidation, evidenced by CDO managementcontracts being transferred to or acquired by other investment managers. On July 17,2008, we acquired the management contract for Robeco CDO, and, on February 11,2009, we assumed the management contract for Mayfair Euro CDO. We expect thisconsolidation trend to continue in the near term, and we continue to pursue theacquisition and assumption of additional management contracts.

 

*MarketEnvironment.*  Inresponse to a rapidly deteriorating economic and credit environment, theFederal Reserve lowered the targeted Federal Funds rate from 4.25% to 0.25%during 2008. During 2008, the yield curve steepened, with the yield on thethree-month U.S. Treasury bill decreasing by 316 basis points, whilethe yield on the five-year U.S. Treasury note decreased by only189 basis points.  During the firstquarter of 2009, the shape of the yield curve remained relatively flat forintermediate maturities, but the general level of interest rates increased onthe long end of the curve.  During thisperiod, the yield on the three-month U.S. Treasury bill increased by 12 basispoints compared to an increase of 11 basis points in the yield on the five-yearU.S. Treasury note.  Also during thefirst quarter of 2009, the yield on 30-year Treasuries increased by 86 basispoints.  The increase in the spreadbetween short and longer maturities generally results in an increase in our netinterest income on our RMBS, as the financing of our RMBS is usually shorter interm than the fixed rate period of our RMBS, which is heavily weighted towardshybrid adjustable rate RMBS. Similarly, if the curve spread narrows or inverts,our net interest income would likely decrease. We expect our hedging program tooffset some of the impact of changes in the shape of the yield curve, but,since we do not hedge 100% of our interest rate exposure, the impact from thehedges will not fully offset the impact to net interest income.

 

*Valuationof investments.*  Fewerfinancing options and tighter lending standards resulted in the offer for saleof a significant amount of investment assets under increasingly distressed circumstances.This increase in investment assets for sale, together with investors’diminished confidence in their ability to assess the quality ofcredit-sensitive investments, caused significant price volatility in previouslystable asset classes. As a result, the valuation process for certain types ofinvestments has become more uncertain and subjective, and prices obtainedthrough such process may not necessarily represent what we would receive in anactual sale of a given investment.

 

**CriticalAccounting Policies**

 

Our financial statementsare prepared in accordance with accounting principles generally accepted in theUnited States of America, or GAAP. These accounting principles require us tomake some complex and subjective decisions and assessments. Our most criticalaccounting policies involve decisions and assessments that could affect ourreported assets and liabilities, as well as our reported revenues and expenses.We believe that all of the decisions and assessments inherent in our financialstatements were reasonable, based upon information available to us. We rely onmanagement’s experience and analysis of historical and current market data inorder to arrive at what we believe to be reasonable estimates. Under varyingconditions, we could report materially different amounts arising under thesecritical accounting policies.  We believethat the critical accounting policies upon which our financial condition andresults of operation depend, and which involve the most complex subjectivedecisions or assessments, are included in the discussion entitled “CriticalAccounting Policies” in “*Part II — Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations*” in our Annual Report. There have been no materialchanges to the critical accounting policies disclosed in our Annual Report.

 

*RecentAccounting Pronouncements*

 

In December 2007,the Financial Accounting Standards Board, or FASB, issued Statement ofFinancial Accounting Standards, or SFAS, No. 160, *NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51*,or SFAS No. 160, which established accounting and reporting standards forthe noncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary.  We adopted SFAS No. 160and the adoption had no impact on our condensed consolidated financialstatements.

 

In February 2008,the FASB issued Staff Position, or FSP, FAS 140-3*Accounting forTransfers of Financial Assets and Repurchase Financing Transactions*,or FSP FAS 140-3, which relates to SFAS No. 140,*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities,* or SFAS No. 140,in order to address certain situations where assets purchased from a particularcounterparty and financed through a repurchase agreement with the samecounterparty can be considered and accounted for as separate transactions.Historically, we recorded such assets and the related financing on a grossbasis in the condensed consolidated balance sheet and the correspondinginterest income and interest expense in our condensed consolidated statementsof operations. FSP FAS 140-3 assumes that an initial transfer of afinancial asset and a repurchase financing are considered part of the samearrangement, or a linked transaction. However, if certain criteria are met, theinitial transfer and repurchase financing are not treated as a linkedtransaction, but rather be evaluated separately under SFAS No. 140.We adopted FSP FAS 140-3 on January 1, 2009, and the adoption has hadno impact on our condensed consolidated financial statements as no linkedtransactions have occurred since adoption.

 

In March 2008, theFASB issued SFAS No. 161,*Disclosures about Derivative Instruments and Hedging Activities,*or SFAS No. 161, which amendsand expands the disclosure requirements of SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities*, or SFAS No. 133. SFAS No. 161 requiresqualitative disclosures regarding objectives and strategies for using 

 

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derivatives, quantitativedisclosures regarding fair value amounts of gains and losses on derivativeinstruments and disclosures regarding credit-risk-related contingent featuresin derivative contracts. We adopted SFAS No. 161 and included the requireddisclosures in our condensed consolidated financial statements in thisQuarterly Report.

 

In June 2008, theFASB issued FSP EITF 03-6-1,*Determining Whether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities,* or FSP EITF 03-6-1. FSPEITF 03-6-1 addresses whether instruments granted in share-based paymenttransactions are participating securities prior to vesting and need to beincluded in the earnings allocation in computing earnings per share under thetwo-class method described in FASB Statement No. 128,*Earnings per Share*. We adopted FSPEITF 03-6-1 on January 1, 2009, and the adoption had no impact on ourcondensed consolidated financial statements.

 

In April 2009, theFASB issued FSP FAS 107-1 and APB 28-1, *Interim Disclosures aboutFair Value of Financial Instruments,*or**FSPFAS 107-1 and APB 28-1.  FSP FAS 107-1and APB 28-1 requires disclosures regarding fair value of financial instrumentsfor interim reporting periods of publicly traded companies as well as in annualfinancial statements.  FSP FAS 107-1 andAPB 28-1 is effective for our interim reporting periods ending after June 15,2009.  We are currently evaluating theeffects that FSP FAS 107-1 and APB 28-1 will have on the disclosures includedin our condensed consolidated financial statements.

 

In April 2009, theFASB issued FSP FAS 157-4, *Determining Fair ValueWhen the Volume and Level of Activity for the Asset or Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly,*or FSP FAS 157-4.  FSP FAS 157-4 wasissued to provide additional guidance for estimating fair value when the volumeand level of activity have significantly decreased and to provide guidance onidentifying circumstances that indicate a transaction is not orderly.  In addition, FSP FAS 157-4 requires an entityto disclose, in interim and annual periods, the inputs and valuation techniquesused to measure fair value and a discussion of changes in valuation techniquesand related inputs, if any, during the period. FSP FAS 157-4 is effective interim and annual reporting periods endingafter June 15, 2009.  We arecurrently evaluating the effects that FSP FAS 157-4 will have on our condensedconsolidated financial statements.

 

In April 2009, theFASB issued FPSP FAS 115-2 and FAS 124-2, *Recognition andPresentation of Other-Than-Temporary Impairments,*or**FSP FAS 115-2 and FAS 124-2.  This statement was issued to amend theother-than-temporary impairment guidance in GAAP for debt securities to makethe guidance more operational and to improve the presentation and disclosure ofother-than-temporary impairments on debt and equity securities in the financialstatements.  FSP FAS 115-2 and FAS 124-2does not amend existing recognition and measurement guidance related toother-than-temporary impairments of equity securities.  FSP FAS 115-2 and FAS 124-2 is effective forinterim and annual reporting periods ending after June 15, 2009.  We are currently evaluating the effects thatFSP FAS 115-2 and FAS 124-2 will have on our condensed consolidated financialstatements and disclosures included in those condensed consolidate financialstatements.

 

**FinancialCondition**

 

The following tablesummarizes the carrying value of our investment portfolio by balance sheetclassification:

 
| ** **                              | ** ** | **Carrying Value**  | ** ** |
|-----------------------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **Available-for-**  | ** ** | **Trading** | ** ** | **Other** | ** ** | **Loans Held** | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Security Description**                | ** ** | **Sale Securities** | ** ** | **Securities** | ** ** | **Investments** | ** ** | **For Sale** | ** ** | **For Investment** | ** ** | **Total** | ** ** |
| ** **                              | ** ** | **(In  thousands)** | ** ** |
| RMBS                                    |       | $                   | —     |   | $ | 338,729 |   | $ | — |   | $ | — |   | $ | — |   | $ | 338,729 |   |
| Corporate  leveraged loans:             |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Loans held in  DFR MM CLO (1)           |       | —              |       | — |   | — |   | — |   | 292,108 |   | 292,108 |   |
| Loans held in  the Wachovia Facility    |       | —              |       | — |   | — |   | 4,831 |   | — |   | 4,831 |   |
| Other corporate  leveraged loans        |       | —              |       | — |   | — |   | 8,270 |   | — |   | 8,270 |   |
| Commercial  mortgage-backed assets (2)  |       | —              |       | — |   | — |   | — |   | 12,330 |   | 12,330 |   |
| Equity  securities                      |       | —              |       | — |   | 4,764 |   | — |   | — |   | 4,764 |   |
| Total structured  and syndicated assets |       | —              |       | — |   | 4,764 |   | 13,101 |   | 304,438 |   | 322,303 |   |
| Assets held in  Market Square CLO       |       | 2,619               |       | 707 |   | — |   | 197,515 |   | — |   | 200,841 |   |
| Total  alternative assets               |       | 2,619               |       | 707 |   | 4,764 |   | 210,616 |   | 304,438 |   | 523,144 |   |
| Total invested  assets                  |       | $                   | 2,619      |   | $ | 339,436 |   | $ | 4,764 |   | $ | 210,616 |   | 304,438 |   | 861,873 |   |
|                                    |       |                |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  loan losses              |       |                |       |   |   |   |   |   |   | (22,171 | ) | (22,171 | ) |
|                                    |       |                |       |   |   |   |   |   |   |   |   |   |   |
|                                    |       |                |       |   |   |   |   |   |   | $ |  282,267 |   | $ | 839,702 |   |

 

----

| (1) | Loans  held in DFR MM CLO classified as loans held for investment are reported gross  of the $15.6 million allowance for loan losses as of March 31,  2009.         |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Commercial  mortgage-backed assets classified as loans held for investment are reported  gross of the $6.5 million allowance for loan losses as of March 31,  2009. |

 

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***Residential Mortgage-Backed Securities***

 

As of March 31,2009, our Agency RMBS and non-Agency RMBS portfolios decreased to a fair valueof $333.9 million and $4.8 million, respectively, from$342.4 million and $5.4 million, respectively, as of December 31,2008.  The reduction in the RMBS balanceduring the three months ended March 31, 2009 was comprised of the receiptof RMBS principal paydowns of $14.5 million, partially offset by an increase inunrealized gains on the RMBS portfolio of $5.4 million.

 

As of March 31,2009, our RMBS portfolio had a net amortized cost of 99.95% of the face amount.Our total RMBS amortization for the three months ended March 31, 2009 and2008 was zero and $0.1 million, respectively. As of March 31, 2009and 2008, we had unamortized net discount of $0.2 million and$0.6 million, respectively, included in the cost basis of our RMBSportfolio. As of March 31, 2009 and 2008, the current weighted averagelife of the portfolio was 5.7 years and 6.5 years, respectively,which represents the average number of years for which each dollar of unpaidprincipal remains outstanding

 

Net portfolio duration,which is the difference between the duration of the RMBS portfolio and theduration of repurchase agreements, adjusted for the effects of our interestrate swap portfolio, was 0.49 years based on model-driven modified duration results.In order to fully assess the possible impact of a change in interest rates onthe RMBS portfolio, one should consider not only the duration, but also theportfolio’s leverage and spread risk.

 

The following tabledetails our RMBS holdings as of March 31, 2009:

 
| ** **                        | ** ** | ** **          | ** ** | ** **      | ** ** | **Weighted  Average** | ** ** |
|-----------------------------------|------------|---------------------|------------|-----------------|------------|-----------------------|------------|
| ** **                        | ** ** | ** **          | ** ** | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | **Contractual** | ** ** | **Constant** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Par**             | ** ** | **Estimated**   | ** ** | ** **            | ** ** | **Months  to** | ** ** | **Yield to** | ** ** | **Maturity** | ** ** | **Prepayment** | ** ** | **Modified** | ** ** |
| **Security  Description**         | ** ** | **Amount**          | ** ** | **Fair  Value** | ** ** | **Coupon**            | ** ** | **Reset  (1)** | ** ** | **Maturity** | ** ** | **(Month/Year)** | ** ** | **Rate (2)** | ** ** | **Duration  (3)** | ** ** |
| ** **                        | ** ** | **(In  thousands)** | ** ** | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hybrid Adjustable  Rate RMBS:     |       |                |       |            |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Rate reset in 1  year or less     |       | $                   | 165,720    |            | $          | 167,854               |       | 4.76 | % | 11 |   | 3.22 | % | 7/2035 |   | 12.4 |   | 1.0 |   |
| Rate reset in 1  to 3 years       |       | 97,958              |       | 100,649         |       | 5.07                  | %          | 24 |   | 3.13 | % | 6/2035 |   | 13.0 |   | 1.0 |   |
| Rate reset in 3  to 5 years       |       | 14,161              |       | 14,687          |       | 5.38                  | %          | 40 |   | 3.36 | % | 5/2036 |   | 10.1 |   | 2.1 |   |
| Rate reset in 5  to 7 years       |       | 21,062              |       | 22,038          |       | 5.27                  | %          | 82 |   | 2.44 | % | 12/2035 |   | 31.7 |   | (1.1 | ) |
| Rate reset in 7  to 10 years      |       | 14,791              |       | 3,960           |       | 5.96                  | %          | 87 |   | n/m |   | 6/2036 |   | 22.8 |   | n/m |   |
| Fixed Rate RMBS:                  |       |                |       |            |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| 30 year                           |       | 35,233              |       | 29,541          |       | 6.16                  | %          | n/a |   | 16.39 | % | 4/2034 |   | 28.4 |   | 2.4 |   |
| Total hybrid and  fixed rate RMBS |       | $                   | 348,925    |            | $          | 338,729               |       |   |   |   |   |   |   |   |   |   |   |   |   |

 

----

(1) Represents number ofmonths before conversion to floating rate.

(2) Constant prepaymentrate refers to the expected average annualized percentage rate ofprincipal prepayments over the remaining life of the security. The valuesrepresented in this table are estimates only and the results of a third partyfinancial model.

(3) Modified durationrepresents the approximate percentage change in fair value per 100 basispoint change in interest rates.

n/a — not applicable

n/m — not meaningful

 

Actual maturities of RMBSare generally shorter than stated contractual maturities, as they are affectedby the contractual lives of the underlying mortgages, normal monthlyamortization of principal and voluntary prepayments of principal. The statedcontractual final maturity of the mortgage loans underlying our RMBS portfolioranges up to 30 years from date of issuance, but the expected maturity issubject to change based on the actual and estimated prepayments of theunderlying loans.

 

The constant prepaymentrate, or CPR, attempts to predict the percentage of principal that will prepayover the next 12 months based on historical principal paydowns and thecurrent interest rate environment. As interest rates rise, the rate ofrefinancing typically declines, which we believe may result in lower rates ofprepayment and, as a result, a lower portfolio CPR.

 

As of March 31,2009, the mortgages underlying our hybrid adjustable-rate RMBS had fixedinterest rates for a weighted average period of approximately 23 monthsafter which time the interest rates reset and become adjustable. The averagelength of time until contractual maturity of those mortgages was approximately27 years from date of issuance as of March 31, 2009.

 

After the reset date,interest rates on our hybrid adjustable-rate RMBS float based on spreads overvarious LIBOR and U.S. Treasury indices. These interest rates are subjectto caps that limit the amount the applicable interest rate can increase duringany year, known as an annual cap, and through the maturity of the applicablesecurity, known as a lifetime cap. As of March 31, 2009, the weightedaverage lifetime rate cap for the portfolio was 10.2%, the weighted averagemaximum increase in the first year that the rates are adjustable, or initialcap, was 4.5% and the weighted average maximum annual increase for yearssubsequent to the first year was 1.9%.

 

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The following tablesummarizes our RMBS, according to their weighted average life:

 
| ** **                                       | ** ** | **Amortized**      | ** ** | **Estimated**  | ** ** |
|--------------------------------------------------|------------|--------------------|------------|----------------|------------|
| **Weighted Average Life**                        | ** ** | **Cost**           | ** ** | **Fair Value** | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** |
| Greater than one  year and less than five years  |       | $                  | 106,170    |           | $          | 92,021 |   |
| Greater than  five years and less than ten years |       | 235,724            |       | 239,784        |       |
| Greater than ten  years                          |       | 6,840              |       | 6,924          |       |
| Total                                            |       | $                  | 348,734    |           | $          | 338,729 |   |

 

The weighted averagelives in the table above are primarily based on a prepayment model thatconsiders current yield, forward yield, slope of the yield curve, mortgagerates, contractual rate of the outstanding loans, loan age, margin andvolatility. Most of the data used in this model is provided throughsubscription-based financial information services. Weighted average life is anestimate of how many years it will take to pay half of the outstandingprincipal.  Actual lives of RMBS aregenerally shorter than stated contractual maturities, are affected by thecontractual maturities of the underlying mortgages, periodic payments ofprincipal and prepayments of principal and differ materially from those setforth above.

 

***Loans***

 

The following summarizesour loan portfolio, by loan classification, as of March 31, 2009:

 
| ** **                        | ** ** | **Carrying Value** | ** ** |
|-----------------------------------|------------|--------------------|------------|
| ** **                        | ** ** | **Loans Held**     | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Type of Loan**                  | ** ** | **for Sale (1)**   | ** ** | **for Investment** | ** ** | **Total** | ** ** |
| ** **                        | ** ** | **(In thousands)** | ** ** |
| Loans held in  Market Square CLO  |       | $                  | 197,515    |   | $ | — |   | $ | 197,515 |   |
| Corporate  leveraged loans:       |       |               |       |   |   |   |   |
| Loans held in  DFR MM CLO (2)     |       | —             |       | 292,108 |   | 292,108 |   |
| Loans held in  Wachovia Facility  |       | 4,831              |       | — |   | 4,831 |   |
| Other corporate  leveraged loans  |       | 8,270              |       | — |   | 8,270 |   |
| Commercial real  estate loans (3) |       | —             |       | 12,330 |   | 12,330 |   |
|                              |       | $                  | 210,616    |   | 304,438 |   | 515,054 |   |
| Allowance for  loan losses        |       |               |       | (22,171 | ) | (22,171 | ) |
|                              |       |               |       | $ |  282,267 |   | $ | 492,883 |   |

 

----

(1) Carrying value ofloans held for sale is lower of cost or estimated fair value.

(2) Loans held in DFR MMCLO classified as loans held for investment reported gross of$15.6 million allowance for loan losses

(3) Commercial realestate loans classified as loans held for investment reported gross of$6.5 million allowance for loan losses.

 

The following summarizesour allowance for loan losses as of March 31, 2009:

 
| ** **                    | ** ** | **Number**   | ** ** | **Par**            | ** ** | **Allowance**       | ** ** |
|-------------------------------|------------|--------------|------------|--------------------|------------|---------------------|------------|
| **Type of Loan**              | ** ** | **of Loans** | ** ** | **Value**          | ** ** | **for Loan Losses** | ** ** |
| ** **                    | ** ** | ** **   | ** ** | **(In thousands)** | ** ** |
|                          |       |         |       |               |       |                |       |
| Loans held in  DFR MM CLO     |       | 2            |       | $                  | 17,704     |                | $          | 15,637 |   |
| Commercial real  estate loans |       | 4            |       | 11,118             |       | 6,534               |       |
| Total                         |       | 6            |       | $                  | 28,822     |                | $          | 22,171 |   |

 

We did not recognize$0.8 million of interest income earned, but not yet received, on impairedloans held for investment for the three months ended March 31, 2009,respectively. In addition, we did not recognize $1.9 million of interestincome earned, but not yet received, on loans held for sale for the threemonths ended March 31, 2009.

 

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***Loans Held in Market Square CLO***

 

Market Square CLO is avariable interest entity, or VIE, under FASB Interpretation No. 46 (revised2004), *Consolidation of Variable InterestEntities*, or**FIN 46(R), and we are theprimary beneficiary of the VIE, causing us to consolidate the entity. We own100% of the preference shares, representing substantially all of the equityinterests in Market Square CLO, which we purchased for $24.0 million. Asof March 31, 2009, Market Square CLO had loans outstanding with a carryingvalue of $197.5 million, net of a valuation allowance of $82.8 million asthese loans are carried at the lower of cost or fair value, which is includedin loans held for sale on the condensed consolidated balance sheet,$8.2 million of restricted cash and cash equivalents, which are generallyutilized to purchase additional loans and pay distributions to debt and equityholders, and $276.0 million of notes payable to third party investors,which is included in long term debt.

 

Market Square CLO is abankruptcy remote entity, and, although we consolidate 100% of the assets andliabilities of Market Square CLO, our maximum exposure to loss on ourinvestment in Market Square CLO is limited to our initial investment of$24.0 million. We have recorded losses in excess of our economic risk of$64.3 million consolidated in our total equity as of March 31, 2009.As of March 31, 2009, we have received distributions from Market SquareCLO equal to $23.7 million since its inception. The weighted averagecoupon on the loan portfolio was 3.91% and the weighted average contractualmaturity of the loan portfolio was 4.18 years as of March 31, 2009.

 

The Market Square CLOloan portfolio was diversified across 27 Moody’s industry classifications as ofMarch 31, 2009. The Market Square CLO loan portfolio as of March 31,2009 had a weighted average rating factor of 2616 which translates to a weightedaverage Moody’s rating of between “B1” and “B2”.

 

***Loans Held in DFR MM CLO***

 

DFR MM CLO is a VIE underFIN 46(R). We are the primary beneficiary of the VIE, causing us toconsolidate the entity. We own 100% of the equity interests, issued assubordinated notes and ordinary shares, in DFR MM CLO, which we purchased for$50.0 million. We also purchased all of the “BBB/Baa2” rated notes of DFRMM CLO for $19.0 million. As of March 31, 2009, DFR MM CLO had$309.3 million of loans outstanding, with a carrying value of$292.1 million, which is included in loans on the condensed consolidatedbalance sheet, reduced by an allowance for loan losses of $15.6 million.As of March 31, 2009, DFR MM CLO has restricted cash and cash equivalentsof $13.1 million, which are generally utilized to purchase additionalloans and pay distributions to debt and equity holders and $231.0 millionof notes payable to third party investors, which is included in long term debt.DFR MM CLO is a bankruptcy remote entity, and, although we consolidate 100% ofthe assets and liabilities of DFR MM CLO, our maximum exposure to loss on ourinvestment in DFR MM CLO is limited to our initial investment of$69.0 million. As of March 31, 2009, we have received distributionsfrom DFR MM CLO equal to $26.2 million since its inception. The weightedaverage coupon on the loan portfolio was 6.76% and the weighted average contractual maturity of the loan portfolio was4.7 years as of March 31, 2009.

 

The following tablesummarizes the carrying value of the DFR MM CLO loan portfolio:

 
| **Type of Loan**           | ** ** | **March 31, 2009** | ** **    |
|----------------------------|------------|-------------------------|---------------|
| ** **                 | ** ** | **(In thousands)**      | ** **    |
| First lien  secured        |       | $                       | 125,542       | (1) |
| Second lien  secured       |       | 153,062                 | (2)           |
| Mezzanine                  |       | 13,504                  |          |
|                       | ** ** | 292,108                 | ** **    |
| Allowance for  loan losses |       | (15,637                 | )             |
|                       | ** ** | $                       |  276,471 | ** ** |

 

----

(1) Presented gross of$7.0 million allowance for loan losses.

(2) Presented gross of$8.6 million allowance for loan losses.

 

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***Loans held in the Wachovia Facility and Other CorporateLeveraged Loans***

 

The following tablesummarizes the carrying value of the loans held in the Wachovia Facility andour other corporate leveraged loans, which are all classified as loans held forsale as of March 31, 2009:

 
| ** **           | ** ** | **Carrying Value (1)** | ** ** |
|----------------------|------------|------------------------|------------|
| **Type of Loan**     | ** ** | **Wachovia Facility**  | ** ** | **Other Corporate Leverage Loans** | ** ** |
| ** **           | ** ** | **(In thousands)**     | ** ** |
| First lien  secured  |       | $                      | —     |   | $ | 1,734 |   |
| Second lien  secured |       | 772                    |       | — |   |
| Mezzanine            |       | 4,059                  |       | 300 |   |
| Holding company      |       | —                 |       | 6,236 |   |
|                 |       | $                      | 4,831      |   | $ | 8,270 |   |
|                      |            |                        |            |  |  |  |  |  |

 

----

(1)        Carrying value of loans heldfor sale is lower of cost or fair value.

 

We had loans held in ouralternative asset revolving warehouse funding facility with Wachovia CapitalMarkets, LLC, or the Wachovia Facility, and other corporate leveraged loans,totaling $4.8 million and $8.3 million, respectively, classified as loansheld for sale on the condensed consolidated balance sheet as of March 31,2009. The weighted average coupon on the Wachovia Facility loan portfolio andother corporate leverage loans was 6.9% and 0.2%, respectively, as of March 31,2009.

 

Loans held in ourWachovia Facility and loans classified as other corporate leveraged loansconsist of loans that are not broadly syndicated and are, therefore, lessliquid. These loans had historically been primarily considered to be held forinvestment and were reported at amortized cost with an allowance for loanlosses, if necessary, unless we decided to sell one of these loans, in whichcase the loan was transferred to loans held for sale.  During the year ended December 31, 2008,we began actively seeking to sell all loans in the Wachovia Facility as wetriggered an acknowledged termination event thereunder on November 30,2008. We sold a significant portion of the loans held within the WachoviaFacility during the year ended December 31, 2008 and transferred all loansheld within the Wachovia Facility to loans held for sale.  During the three months ended March 31,2009, we entered into an agreement to sell loans held within the WachoviaFacility with a par value of $31.5 million for $10.8 million, net of interestof $0.2 million.  We realized a loss of$6.2 million reported in net gain (loss) on loans in the condensed consolidatedstatements of operations during the three months ended March 31, 2009 as aresult of these sales.  In addition,during the year ended December 31, 2008, we began to opportunisticallysell the other corporate leveraged loans in connection with our strategy ofincreasing liquidity in the Principal Investing segment and focusing on growingour Investment Management segment. As a result, during the year ended December 31,2008, we transferred all other corporate leveraged loans to loans held forsale.

 

***Derivatives and Hedging***

 

The following table is asummary of our derivative instruments as of March 31, 2009:

 
| ** **           | ** ** | ** ** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|----------------------|------------|------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **           | ** ** | **Count**  | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **           | ** ** | ** ** | ** ** | **(In thousands)** | ** ** |
| Interest rate  swaps |       | 5          |       | $                  | 165,000    |       | $          | —          |       | $                 | (13,708    | ) | $ | (13,708 | ) |
| Interest rate  cap   |       | 1          |       | 40,000             |       | —     |       | (109            | )          | (109              | )          |
| Warrants             |       | 3          |       | n/a                |       | 21         |       | —          |       | 21                |       |
|                 |       | 9          |       | $                  | 205,000    |       | $          | 21              |       | $                 | (13,817    | ) | $ | (13,796 | ) |

 

----

n/a — not applicable

 

In general, when afixed-rate or hybrid adjustable-rate RMBS is funded by a short term borrowing,we may enter into an interest rate swap agreement that effectively fixes aportion of the borrowing costs for a period close to the anticipatedweighted-average life of the fixed-rate portion of the related RMBS. Thisstrategy is designed to protect a portion of our portfolio from increasedfunding costs due to rising interest rates because the borrowing costs are notfixed for the duration of the fixed-rate period of the related residentialmortgage-backed security.  We havestructured our interest rate swaps to roll off or expire in conjunction with theestimated weighted average life of the fixed period of the mortgage portfolio.

 

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**Resultsof Operations**

 

The following sectionprovides a comparative discussion of our condensed consolidated results ofoperations as of and for the three months ended March 31, 2009 and 2008.

 

***Summary***

 

The following tablesummarizes selected historical consolidated financial information:

 
| ** **                                                                      | ** ** | **Three Months Ended March 31,**        | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                      | ** ** | **2009**                                     | ** ** | **2008** | ** ** |
| ** **                                                                      | ** ** | **(In millions, except for per share data)** | ** ** |
| ** **                                                                      | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| **Consolidated  Statements of Operations Data:**                                |       |                                         |       |   |   |
| Net interest  income                                                            |       | $                                            | 13.8       |   | $ | 13.8 |   |
| Net interest  income after provision for loan losses                            |       | $                                            | 4.7        |   | $ | 11.6 |   |
| Investment  advisory fees                                                       |       | $                                            | 4.7        |   | $ | 12.1 |   |
| Total expenses                                                                  |       | $                                            | 8.3        |   | $ | 44.1 |   |
| Net other income  and gain (loss)                                               |       | $                                            | 10.5       |   | $ | (450.4 | ) |
| Net income  (loss)                                                              |       | $                                            | 11.5       |   | $ | (463.6 | ) |
| Net income  (loss) attributable to common stockholders                          |       | $                                            | 11.5       |   | $ | (466.0 | ) |
| Net income  (loss) attributable to common stockholders per share - diluted |       | $                                            | 1.72       |   | $ | (84.78 | ) |
| Core earnings  (1)                                                              |       | $                                            | 5.0        |   | $ | 12.6 |   |
| Core earnings  per share - diluted (1)                                          |       | $                                            | 0.75       |   | $ | 2.29 |   |

 
| ** **                                     | ** ** | **As of March 31,**                     | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                     | ** ** | **2009**                                     | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | **(In millions, except for per share data)** | ** ** |
| **Consolidated  Balance Sheet Data:**          | ** ** | ** **                                   | ** ** | ** ** | ** ** |
| Residential  mortgage-backed securities        |       | $                                            | 338.7      |   | $ | 467.7 |   |
| U.S. Treasury  bills                           |       | $                                            | —     |   | $ | 999.3 |   |
| Total assets                                   |       | $                                            | 986.3      |   | $ | 2,476.3 |   |
| Repurchase  agreements                         |       | $                                            | 318.6      |   | $ | 1,423.9 |   |
| Long term debt:                                |       |                                         |       |   |   |
| Recourse:                                      |       |                                         |       |   |   |
| Trust preferred  securities                    |       | $                                            | 123.7      |   | $ | 123.7 |   |
| Series A and  Series B Notes    |       | $                                            | 71.9       |   | $ | 71.3 |   |
| Non-Recourse:                                  |       |                                         |       |   |   |
| Wachovia  Facility                             |       | $                                            | 12.0       |   | $ | 76.4 |   |
| Market Square  CLO                             |       | $                                            | 276.0      |   | $ | 276.0 |   |
| DFR MM CLO                                     |       | $                                            | 231.0      |   | $ | 231.0 |   |
| Stockholders’  (deficit) equity           |       | $                                            | (70.5      | ) | $ | 217.4 |   |
| **Metrics:**                                   |       |                                         |       |   |   |
| Book value per  share outstanding              |       | $                                            | (10.93     | ) | $ | 32.60 |   |
| Economic book  value per share outstanding (1) |       | $                                            | (0.97      | ) | $ | 33.78 |   |
| **AUM:**                                       |       |                                         |       |   |   |
| Investment  Management segment (2) (3)    |       | $                                            | 10,321.5   |   | $ | 14,236.7 |   |
| Principal  Investing segment (4)               |       | $                                            | 839.7      |   | $ | 2,419.3 |   |

 

----

(1) Core earnings andeconomic book value per share outstanding represent non-GAAP financialmeasures. Please see the “Reconciliation of Non-GAAP Financial Measures”,which follows, for a reconciliation between the comparable GAAP measure and adiscussion of the importance placed on these measures by management.

(2) AUM for ourInvestment Management segment includes CDO AUM numbers, which generally reflectthe aggregate principal or notional balance of the collateral and, in somecases, the cash balances held by the CDOs as of the date of the last trusteereport received for each CDO prior to the relevant measurement date. The AUMfor our Euro-denominated CDOs has been converted into U.S. dollars using theappropriate spot rate of exchange. AUM for our Investment Management segmentalso includes AUM for our separately managed accounts, which, in certain cases,is a multiple of the capital actually invested in such account. Management feesfor these accounts are paid on this higher AUM amount.

(3) Included in theInvestment Management segment AUM are $296.5 million and$294.7 million related to Market Square CLO and $293.8 and$300.5 million related to DFR MM CLO for April 1, 2009 and 2008,respectively, which amounts are also included in the Principal Investingsegment AUM as of March 31, 2009 and 2008. DCM manages these CDOs but isnot contractually entitled to receive any management fees so long as 100% ofthe equity is held by DC LLC or an affiliate thereof. All other amounts includedin the Principal Investing portfolio are excluded from Investment Managementsegment AUM.

(4) AUM for thePrincipal Investing segment is reflected net of allowance for loan losses of$22.2 million and $7.5 million as of March 31, 2009 and 2008, respectively.

 

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**Reconciliationof Non-GAAP Financial Measures**

 

We believe that coreearnings and economic book value per share, both non-GAAP financial measures,are useful metrics for evaluating and analyzing our performance. Thecalculation of core earnings, which we use to compare our own financial resultsfrom period to period, eliminates the impact of certain non-cash and specialcharges and income tax. The calculation of economic book value per shareeliminates losses in excess of the equity at risk because those losses would beborne solely by the relevant subsidiary’s debt holders. We believe that thecalculation of economic book value per share facilitates comparison of ourfinancial results to those of other comparable firms. The core earnings andeconomic book value per share provided herein may not be comparable to similarmeasures presented by other companies as they are non-GAAP financial measuresand may therefore be defined differently by other companies.  Core earnings includes the earnings from ourconsolidated VIEs, Market Square CLO and DFR MM CLO, which are not indicativeof cash flows received from these VIEs.

 

**CoreEarnings**

 

The table below providesa reconciliation between net income (loss) and core earnings:

 
| ** **                                               | ** ** | **Three months ended March 31,**                  | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                               | ** ** | **2009**                                               | ** ** | **2008** | ** ** |
| ** **                                               | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| ** **                                               | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Net income  (loss)                                       |       | $                                                      | 11,539     |   | $ | (463,610 | ) |
| Add back:                                                |       |                                                   |       |   |   |
| Provision for  loan losses                               |       | 2,107                                                  |       | 2,200 |   |
| Cost saving  initiatives                                 |       | 197                                                    |       | 257 |   |
| Depreciation and  amortization                           |       | 1,635                                                  |       | 2,687 |   |
| Impairment of  intangible assets and goodwill            |       | —                                                 |       | 27,906 |   |
| Net other income  and (gain) loss                        |       | (10,469                                                | )          | 450,358 |   |
| Income tax  expense (benefit)                            |       | 18                                                     |       | (7,202 | ) |
| Core earnings                                            |       | $                                                      | 5,027      |   | $ | 12,596 |   |
|                                                     |       |                                                   |       |   |   |
| Core earings per  share - diluted                        |       | $                                                      | 0.75       |   | $ | 2.29 |   |
| Weighted-average  number of shares outstanding - diluted |       | 6,702,329                                              |       | 5,496,522 |   |

 

**EconomicBook Value Per Share**

 

The table below providesa reconciliation between book value per common share and economic book valueper share:

 
| ** **                                                     | ** ** | **As of March 31,**                               | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2009**                                               | ** ** | **2008** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| Stockholders’  (deficit) equity                           |       | $                                                      | (70,526    | ) | $ | 217,394 |   |
| Add back:                                                      |       |                                                   |       |   |   |
| Negative Market  Square CLO equity in excess of amount at risk |       | 64,289                                                 |       | 7,874 |   |
| Economic book  value                                           |       | $                                                      | (6,237     | ) | $ | 225,268 |   |
|                                                           |       |                                                   |       |   |   |
| Book value per  share                                          |       | $                                                      | (10.93     | ) | $ | 32.60 |   |
| Economic book  value per share                                 |       | $                                                      | (0.97      | ) | $ | 33.78 |   |
| Total common shares  outstanding                               |       | 6,454,383                                              |       | 6,669,342 |   |

 

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**ExecutiveSummary of Results of Operations**

 

During the three months endedMarch 31, 2009, we recorded net income of $11.5 million as compared to anet loss of $463.6 during the same period in 2008.  Although core earnings, calculated in thetable above, declined during the three months ended March 31, 2009 ascompared to the same period in 2008, it remained positive at $5.0 millionfor the three months ended March 31, 2009.

 

During the three monthsended March 31, 2009, we experienced a $14.3 million decrease in netrevenues as compared to the same period in 2008, comprised of a decrease in netinterest income of $7.0 million and a decrease of investment advisory fees of$7.4 million.  The decrease in netinterest income is primarily a result of the significant RMBS sales andassociated repayment of repurchase agreement liabilities during the threemonths ended March 31, 2008, the sale of a significant amount of loansheld in the Wachovia Facility during 2008 and the first quarter of 2009 and theplacement of certain loans on non-accrual status during 2008 and during thethree months ended March 31, 2009. The decrease in investment advisory fees is primarily driven by theliquidation of the investment funds we previously managed during 2008, whichprovided $3.9 million of fee revenue during the three months ended March 31,2008, and the reduction of CDO investment advisory fee revenue of $3.5 millionduring the three months ended March 31, 2009, as compared to the sameperiod during 2008. The reduction in CDO investment advisory fee revenues isprimarily the result of the liquidation of five CDOs we previously managed andthe deferral of subordinated management fees during the three months ended March 31,2009 as a result of several of the CLOs failing certain overcollateralizationtests.

 

During the three monthsended March 31, 2009, we reduced expenses by $35.8 million as compared tothe same period in 2008, primarily driven by reduced impairment charges onintangible assets and goodwill and reduced compensation and benefitsexpense.  During the three months ended March 31,2008, our Investment Management segment recorded $27.9 million inimpairment charges on intangible assets and goodwill related to thedeterioration in the credit markets, the liquidation of the smaller of theinvestment funds that we previously managed and the liquidation of one of ourEuro-denominated CDOs.  During the threemonths ended March 31, 2009, we reduced our compensation and benefitsexpense by $5.7 million, primarily as a result of headcount reductions during2008 and a revision to our incentive compensation plan during 2009.

 

During the three monthsended March 31, 2009, dividend income and other net gain (loss) improvedby $460.9 million as compared to the same period in 2008.  During the three months ended March 31,2009, we recorded net gains in net other income and gain (loss) of $10.5million, primarily driven by net gains on trading securities of $5.1 millionand net gains on loans of $5.8 million. During the first three months of 2008, we were adversely impacted by thecontinuing deterioration of global credit markets, which resulted in a loss of$450.4 million in net other income and gain (loss), largely a result of netlosses of $200.7 million, $223.3 million and $26.5 million ontrading securities, derivatives and loans held for investment and held forsale, respectively.  The most pronouncedimpact was on our non-Agency RMBS portfolio. This portfolio experienced anunprecedented decrease in value during the first three months of 2008 fueled bythe ongoing liquidity crisis. This negative environment impacted our ability tosuccessfully finance and hedge this portfolio. As a result, we sold asignificant portion of our RMBS portfolio to improve our liquidity. Inconjunction with the sale of RMBS, we also repaid our repurchase agreements usedto finance the RMBS sold and terminated the associated interest rate swaps usedto hedge the interest rate exposure on those repurchase agreements.

 

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**Resultsof Operations by Segment**

 

Management evaluates theperformance of each business unit based on segment results. The following tablepresents the results of operations by segment:

 
| ** **                    | ** ** | **Three months ended March 31, 2009** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **Investment Management**                  | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(In thousands)**                         | ** ** |
| Net revenues                  |       | $                                          | 4,903      |   | $ | 5,974 |   | $ | (1,464 | )(1) | $ | 9,413 |   |
| Expenses                      |       | (6,541                                     | )          | (3,248 | ) | 1,464 | (1) | (8,325 | ) |
| Other income and  (loss) gain |       | (267                                       | )          | 10,736 |   | — |   | 10,469 |   |
| Income tax  expense           |       | (18                                        | )          | — |   | — |   | (18 | ) |
| Net (loss)  income            |       | $                                          | (1,923     | ) | $ | 13,462 |   | $ | — |   | $ | 11,539 |   |

 
| ** **                    | ** ** | **Three months ended March 31, 2008** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **Investment  Management**                 | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(In  thousands)**                        | ** ** |
| Net revenues                  |       | $                                          | 14,449     |   | $ | 13,179 |   | $ | (3,959 | )(1) | $ | 23,669 |   |
| Expenses                      |       | (41,781                                    | )          | (6,301 | ) | 3,959 | (1) | (44,123 | ) |
| Other income and  loss        |       | (2,111                                     | )          | (448,247 | ) | — |   | (450,358 | ) |
| Income tax  benefit (expense) |       | 8,670                                      |       | (1,468 | ) | — |   | 7,202 |   |
| Net loss                      |       | $                                          | (20,773    | ) | $ | (442,837 | ) | $ | — |   | $ | (463,610 | ) |

 

----

| (1) | Represents  the fees charged to the Principal Investing segment by the Investment  Management segment on a cost plus basis for investment advisory, management  and operational services. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**InvestmentManagement Segment**

 

***Revenues***

 

Our Investment Managementsegment revenues primarily represent the fee income earned for the managementof investment accounts for various types of clients. The following tablesummarizes our Investment Management segment revenues:

 
| ** **                                    | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|--------------|------------|
| ** **                                    | ** ** | **2009**                              | ** ** | **2008**     | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                    | ** ** | **(In thousands)**                    | ** ** |
| **Investment  Management Segment Revenues**   |       |                                  |       |         |       |   |   |
| Interest income                               |       | $                                     | 46         |         | $          | 342 |   | $ | (296 | ) |
| Interest expense                              |       | 1,344                                 |       | 1,971        |       | (627 | ) |
| Net interest  expense                         |       | (1,298                                | )          | (1,629       | )          | 331 |   |
| Investment  advisory fees (1)                 |       | 6,201                                 |       | 16,078       |       | (9,877 | ) |
| Total Investment  Management segment revenues |       | $                                     | 4,903      |         | $          | 14,449 |   | $ | (9,546 | ) |

 

----

| (1) | Investment  advisory fees include intercompany investment advisory fees of  $1.5 million and $4.0 million for the three months ended  March 31, 2009 and 2008, respectively, calculated in conjunction with  DCM’s management agreement with DFR, which are eliminated upon consolidation. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

*NetInterest Income*

 

Interest income for thethree months ended March 31, 2009 is primarily comprised of interestearned from our cash balances.  Interestincome for the three months ended March 31, 2008 is primarily comprised ofinterest earned on preferred shares of CDOs of $0.3 million and interest earnedfrom our cash balances of $53,000.  Weowned preferred shares issued by one and nine of the CDOs that we manage as of March 31,2009 and 2008, respectively.  The sale ofeight of these preferred shares during the year ended December 31, 2008was the primary driver in the reduction in interest income during the threemonths ended March 31, 2009, as compared to the same period in 2008.  Interest expense is primarily comprised of$1.3 million and $1.9 million of interest expense on our Series Aand Series B Notes for the three months ended March 31, 2009 and2008, respectively.  The reduction ininterest expense during the three months ended March 31, 2009, as comparedto the same period in 2008, was the result of a reduced interest rateenvironment.

 

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*InvestmentAdvisory Fees*

 

For the three monthsended March 31, 2009 and 2008, investment advisory fees were$6.2 million and $16.1 million, respectively, on a segment basis, and$4.7 million and $12.0 million, respectively, on a consolidated basisdue to the $1.5 million and $4.0 million, respectively, of feesearned by the Investment Management segment from the Principal Investingsegment, which are eliminated in consolidation. Our investment advisory fee revenue during the periods presented weregenerated by our CDOs, our investment funds, which have subsequentlyliquidated, and our separately managed accounts.

 

***CDOs***

 

The following tablesummarizes our investment advisory fee revenues from CDOs:

 
| ** **      | ** ** | **Three months ended March 31, 2009** | ** ** |
|-----------------|------------|----------------------------------------------------------------|------------|
| ** **      | ** ** | **Senior**                                                     | ** ** | **Subordinated** | ** ** | **Performance** | ** ** | **Total CDO** | ** ** |
| ** **      | ** ** | **Management Fees**                                       | ** ** | **Management Fees** | ** ** | **Fees (1)** | ** ** | **Advisory Fees** | ** ** |
| ** **      | ** ** | **(In thousands)**                                        | ** ** |
| CLOs            |       | $                                                              | 1,566      |   | $ | 1,427 |   | $ | — |   | $ | 2,993 |   |
| ABS             |       | 1,052                                                          |       | — |   | — |   | 1,052 |   |
| Corporate bonds |       | 320                                                            |       | (24 | ) | 152 | (2) | 448 |   |
| Total CDOs      |       | $                                                              | 2,938      |   | $ | 1,403 |   | $ | 152 |   | $ | 4,493 |   |

 
| ** **      | ** ** | **Three months ended March 31, 2008** | ** ** |
|-----------------|------------|----------------------------------------------------------------|------------|
| ** **      | ** ** | **Senior**                                                     | ** ** | **Subordinated** | ** ** | **Performance** | ** ** | **Total CDO** | ** ** |
| ** **      | ** ** | **Management Fees**                                       | ** ** | **Management Fees** | ** ** | **Fees (1)** | ** ** | **Advisory Fees** | ** ** |
| ** **      | ** ** | **(In thousands)**                                        | ** ** |
| CLOs            |       | $                                                              | 2,638      |   | $ | 3,242 |   | $ | — |   | $ | 5,880 |   |
| ABS             |       | 1,457                                                          |       | 217 |   | 72 |   | 1,746 |   |
| Corporate bonds |       | 222                                                            |       | 83 |   | — |   | 305 |   |
| Total CDOs      |       | $                                                              | 4,317      |   | $ | 3,542 |   | $ | 72 |   | $ | 7,931 |   |

 

----

(1)        Performance fees aregenerally earned after certain investors’ returns exceed a specified internalrate of return, or IRR. For purposes of this and the following table, and inaccordance with our accounting policies, we also classify any previouslydeferred senior or subordinated management fees that are subsequently paid asperformance fees.

(2)        Represents feesrelated to a previously liquidated corporate bond CDO as a result of asettlement received in connection with certain litigation relating to one ofthe assets previously held in the CDO.

 

Our fees differ fromaccount to account, but in general, our fees from CDOs consist of a seniormanagement fee (payable before the interest payable on the debt securitiesissued by the CDO) that ranges from 5 basis points to 25 basis pointsannually of the principal balance of the underlying collateral of the CDO, asubordinate management fee (payable after the interest payable on the debtsecurities issued by the CDO and certain other expenses) that ranges from5 basis points to 45 basis points annually of the principal balanceof the underlying collateral of the CDO, and, in certain CDOs, performance feesthat are paid after certain investors’ returns exceed an internal rate ofreturn, or IRR hurdle. The performance fees generally range from 10% to 20% ofresidual cash flows above the IRR hurdle and vary by transaction.

 

Under the investment management agreements between DCMand the CDOs it manages, the payment of DCM’s management fees is generallysubject to a “waterfall” structure. Pursuant to these “waterfalls,” all or aportion of DCM’s subordinated management fees may be deferred if the CDOs donot generate sufficient cash flows to pay the required interest on the notesthe CDOs have issued to investors and certain expenses they have incurred. Thiscould occur if, for example, the issuers of the collateral underlying the CDOsdefault on or defer payments of principal or interest relating to suchcollateral or the ratings assigned to such collateral are downgraded below aspecified threshold.  In addition, all ora portion of DCM’s subordinated management fees may be deferred if, among otherthings, overcollateralization tests and other structural protections built intothe CDOs divert cashflows to the prepayment of the debt securities issued bythe CDOs.

 

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The following tablesummarizes the average AUM and effective and contractual fee rates of our CDOs:

 
| ** **           | ** ** | **Three months ended March 31, 2009** | ** ** |
|----------------------|------------|----------------------------------------------------------------|------------|
| ** **           | ** ** | ** **                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **           | ** ** | ** **                                                     | ** ** | **Effective Rate (2)** | ** ** | **Contractual Rate (3)** | ** ** |
| ** **           | ** ** | ** **                                                     | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **           | ** ** | **Average AUM (1)**                                  | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **           | ** ** | **(In thousands)**                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (4)             |       | $                                                              | 3,627,386  |   | 0.17 | % | 0.16 | % | 0.18 | % | 0.33 | % |
|                 |       |                                                           |       |   |   |   |   |   |   |   |   |
| ABS:                 |       |                                                           |       |   |   |   |   |   |   |   |   |
| High-grade ABS       |       | 3,364,298                                                      |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other ABS            |       | 1,679,118                                                      |       | 0.15 | % | 0.00 | % | 0.15 | % | 0.22 | % |
| Total ABS            |       | 5,043,416                                                      |       | 0.08 | % | 0.00 | % | 0.08 | % | 0.11 | % |
|                 |       |                                                           |       |   |   |   |   |   |   |   |   |
| Corporate bonds  (5) |       | 839,050                                                        |       | 0.15 | % | -0.01 | % | 0.21 | % | 0.23 | % |
| Total CDOs           |       | $                                                              | 9,509,852  |   | 0.12 | % | 0.06 | % | 0.13 | % | 0.20 | % |

 
| ** **           | ** ** | **Three months ended March 31, 2008** | ** ** |
|----------------------|------------|----------------------------------------------------------------|------------|
| ** **           | ** ** | ** **                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **           | ** ** | ** **                                                     | ** ** | **Effective Rate (2)** | ** ** | **Contractual Rate (3)** | ** ** |
| ** **           | ** ** | ** **                                                     | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **           | ** ** | **Average AUM (1)**                                  | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **           | ** ** | **(In thousands)**                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (4)             |       | $                                                              | 5,269,944  |   | 0.20 | % | 0.25 | % | 0.21 | % | 0.28 | % |
|                 |       |                                                           |       |   |   |   |   |   |   |   |   |
| ABS:                 |       |                                                           |       |   |   |   |   |   |   |   |   |
| High-grade ABS       |       | 3,755,358                                                      |       | 0.05 | % | 0.01 | % | 0.05 | % | 0.06 | % |
| Other ABS            |       | 2,997,199                                                      |       | 0.13 | % | 0.01 | % | 0.14 | % | 0.19 | % |
| Total ABS            |       | 6,752,557                                                      |       | 0.09 | % | 0.01 | % | 0.09 | % | 0.11 | % |
|                 |       |                                                           |       |   |   |   |   |   |   |   |   |
| Corporate bonds  (5) |       | 644,152                                                        |       | 0.14 | % | 0.05 | % | 0.20 | % | 0.20 | % |
| Total CDOs           |       | $                                                              | 12,666,653 |   | 0.14 | % | 0.11 | % | 0.14 | % | 0.19 | % |

 

----

| (1) |   | Average  AUM is calculated as the average of the AUM on the first day of January,  February, March and April. CDO AUM numbers generally reflect the  aggregate principal or notional balance of the collateral and, in some cases,  the cash balance held by the CDO and are as of the date of the last trustee  report received for each CDO prior to the AUM date, as appropriate. The AUM  for our Euro-denominated CDOs has been converted to U.S. dollars using the  spot rate of exchange as of the respective AUM date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | The  effective rates for the three months ended March 31, 2009 and 2008 are  calculated by taking management fees earned during the period divided by the  average AUM. The senior and subordinated management fee effective rates may differ  from the contractual fee rates for various reasons, including the following:  (a) we may have entered into agreements with specific investors pursuant  to which a portion of our management fees are paid to those investors and  (b) our senior and subordinated management fees may be deferred as a  result of certain structural provisions built into the documents governing  the CDO. In certain circumstances, we may at a later date and subject to  certain performance triggers, be entitled to repayment of the fees paid to  investors described in (a) above. In addition, we may at a later date  and subject to the satisfaction of certain structural provisions, be entitled  to payment of the deferred fees described in (b) above. |
| (3) |   | The  weighted average contractual senior and subordinated management fee rates are  obtained by multiplying the contractual fee rates for each CDO by that CDO’s  average AUM and dividing that number by the total average AUM for the  relevant asset class.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| (4) |   | Market  Square CLO and DFR MM CLO have been excluded from all categories in this  table as DCM manages these CLOs, but is not contractually entitled to receive  any third party fees so long as 100% of the equity is held by DC LLC or an  affiliate thereof.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| (5) |   | The  effective and contractual rates for Robeco CDO are calculated based on the  fees that we are entitled to receive pursuant to the asset purchase agreement  between DCM and Robeco Investment Management, Inc. and are not the total  fees paid by the CDO or the contractual fee rate set forth in the management  agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

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The following tablesummarizes select details of the structure of each of our CDOs:

 
| ** **                          | ** ** | **Closing Date** | ** ** | **April 1, 2009 AUM (1)** | ** ** | **First Optional  Call Date (2)** | ** ** | **Auction Call  Date (3)** | ** ** | **Termination of  Reinvestment  Period (4)** | ** ** | **Maturity  Year** | ** ** |
|-------------------------------------|------------|-----------------------|------------|-------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------|------------|---------------------------------------------------|------------|--------------------|------------|
| ** **                          | ** ** | **Month/Year**        | ** ** | **(In thousands)**             | ** ** | **Month/Year**                                   | ** ** | ** **                           | ** ** |
| **CLOs:**                           |       |                  |       |                                |       |                                             |       |                                 |       |                                              |       |               |       |
| Rosemont CLO,  Ltd.                 |       | 01/02                 |       | $                                   | 164,416    |                                             | 10/05      |                                 | n/a        |                                              | 01/07      |               | 2013       |   |
| Forest Creek CLO  Ltd.              |       | 05/03                 |       | 302,077                             |       | 07/07                                            |       | n/a                                  |       | 07/08                                             |       | 2015               |       |
| Long Grove CLO  Ltd.                |       | 06/04                 |       | 398,480                             |       | 08/08                                            |       | n/a                                  |       | 05/10                                             |       | 2016               |       |
| Market Square CLO  Ltd. (5)         |       | 05/05                 |       | 296,500                             |       | 07/07                                            |       | n/a                                  |       | 04/11                                             |       | 2017               |       |
| Cumberland II CLO  Ltd.             |       | 09/05                 |       | 391,900                             |       | 02/10                                            |       | n/a                                  |       | 11/11                                             |       | 2019               |       |
| Marquette Park  CLO Ltd.            |       | 12/05                 |       | 295,784                             |       | 04/10                                            |       | n/a                                  |       | 01/12                                             |       | 2020               |       |
| Bridgeport CLO  Ltd.                |       | 06/06                 |       | 495,086                             |       | 10/09                                            |       | n/a                                  |       | 07/13                                             |       | 2020               |       |
| Burr Ridge CLO  Plus Ltd.           |       | 12/06                 |       | 292,053                             |       | 06/12                                            |       | n/a                                  |       | 03/13                                             |       | 2023               |       |
| Schiller Park CLO  Ltd.             |       | 05/07                 |       | 379,886                             |       | 07/11                                            |       | n/a                                  |       | 04/13                                             |       | 2021               |       |
| Bridgeport CLO II  Ltd.             |       | 06/07                 |       | 500,263                             |       | 12/10                                            |       | n/a                                  |       | 09/14                                             |       | 2021               |       |
| DFR Middle Market  CLO Ltd. (5)     |       | 07/07                 |       | 293,814                             |       | 07/10                                            |       | n/a                                  |       | 07/10                                             |       | 2019               |       |
| Gillespie CLO PLC  (7)              |       | 08/07                 |       | 373,743                             |       | 02/13                                            |       | n/a                                  |       | 08/13                                             |       | 2023               |       |
| **Total  CLOs**                     |       |                  |       | 4,184,002                           |       |                                             |       |                                 |       |                                              |       |               |       |
|                                |       |                  |       |                                |       |                                             |       |                                 |       |                                              |       |               |       |
| **ABS  CDOs:**                      |       |                  |       |                                |       |                                             |       |                                 |       |                                              |       |               |       |
| Mid Ocean CBO  2000-1 Ltd.          |       | 01/01                 |       | 117,788                             |       | 04/06                                            |       | n/a                                  |       | 01/06                                             |       | 2036               |       |
| Mid Ocean CBO  2001-1 Ltd.          |       | 10/01                 |       | 132,902                             |       | 02/06                                            |       | n/a                                  |       | 01/06                                             |       | 2036               |       |
| Oceanview CBO I,  Ltd.              |       | 06/02                 |       | 184,804                             |       | 06/06                                            |       | 06/12                                |       | 06/06                                             |       | 2032, 2037(6)      |       |
| Northlake CDO I,  Limited           |       | 02/03                 |       | 154,157                             |       | 03/06                                            |       | 03/13                                |       | 03/07                                             |       | 2033               |       |
| Knollwood CDO  Ltd.                 |       | 03/04                 |       | 163,295                             |       | 04/07                                            |       | 04/12                                |       | 04/08                                             |       | 2039               |       |
| River North CDO  Ltd.               |       | 01/05                 |       | 253,988                             |       | 02/09                                            |       | 02/13                                |       | 02/09                                             |       | 2040               |       |
| Buckingham CDO  Ltd.                |       | 07/05                 |       | 839,160                             |       | 08/10                                            |       | 08/13                                |       | 08/10                                             |       | 2040               |       |
| Pinetree CDO Ltd.                   |       | 11/05                 |       | 229,606                             |       | 01/10                                            |       | 01/14                                |       | 01/10                                             |       | 2045               |       |
| Buckingham CDO II  Ltd.             |       | 12/05                 |       | 1,209,870                           |       | 03/11                                            |       | 03/14                                |       | 03/11                                             |       | 2041               |       |
| Knollwood CDO II  Ltd.              |       | 07/06                 |       | 256,509                             |       | 07/09                                            |       | 07/13                                |       | n/a                                               |       | 2046               |       |
| Buckingham CDO  III Ltd.            |       | 08/06                 |       | 1,253,375                           |       | 09/11                                            |       | 09/14                                |       | 09/11                                             |       | 2051               |       |
| Aramis CDO                          |       | 03/07                 |       | 110,671                             |       | 03/12                                            |       | n/a                                  |       | n/a                                               |       | 2047               |       |
| **Total  ABS CDOs**                 |       |                  |       | 4,906,125                           |       |                                             |       |                                 |       |                                              |       |               |       |
|                                |       |                  |       |                                |       |                                             |       |                                 |       |                                              |       |               |       |
| **Corporate  Bond CDOs:**           |       |                  |       |                                |       |                                             |       |                                 |       |                                              |       |               |       |
| Valeo Investment  Grade CDO Ltd.    |       | 01/01                 |       | 294,443                             |       | 01/05                                            |       | n/a                                  |       | 01/06                                             |       | 2013               |       |
| Valeo Investment  Grade CDO II Ltd. |       | 05/01                 |       | 293,916                             |       | 06/05                                            |       | n/a                                  |       | 06/06                                             |       | 2013               |       |
| Robeco CDO II  Limited              |       | 08/01                 |       | 169,774                             |       | 08/05                                            |       | n/a                                  |       | 02/06                                             |       | 2013               |       |
| Mayfair Euro CDO  I B.V. (7)        |       | 06/01                 |       | 152,791                             |       | 05/06                                            |       | n/a                                  |       | 5/06                                              |       | 2013               |       |
| **Total  Corporate Bond CDOs**      |       |                  |       | 910,924                             |       |                                             |       |                                 |       |                                              |       |               |       |
|                                |       |                  |       |                                |       |                                             |       |                                 |       |                                              |       |               |       |
| **Total  CDO AUM**                  |       |                  |       | $                                   | 10,001,051 |                                             |       |                                 |       |                                              |       |               |       |   |

 

----

| (1) |   | CDO  AUM numbers generally reflect the aggregate principal or notional balance of  the collateral and, in some cases, the cash balance held by the CDOs and are  as of the date of the last trustee report received for each CDO prior to  April 1, 2009.                                                                |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | CDOs  are generally callable by equity holders once per quarter beginning on the  “first option call date” and subject to satisfaction of certain conditions.                                                                                                                                                       |
| (3) |   | ABS  CDOs generally contain a provision requiring the manager thereof to liquidate  the collateral held therein on the “auction call date,” subject to certain  conditions, generally including that the proceeds from any such liquidation  be sufficient to redeem the notes and pay certain additional expenses. |
| (4) |   | Termination  of reinvestment period refers to the date after which we can no longer use  certain principal collections to purchase additional collateral, and such  collections are instead used to repay the outstanding amounts of certain debt  securities issued by the CDO.                                              |
| (5) |   | We  are not contractually entitled to receive any management fees from these CLOs  so long as 100% of the equity is held by DC LLC or an affiliate thereof.                                                                                                                                                                   |
| (6) |   | Maturity  date varies by tranche of notes.                                                                                                                                                                                                                                                                                    |
| (7) |   | The  AUM for our Euro-denominated CDOs has been converted into U.S. dollars using  the spot rate of exchange on March 31, 2009.                                                                                                                                                                                          |

 

The CDOs that we managegenerally contain certain structural provisions, including, but not limited to,overcollateralization requirements and/or market value triggers that are meantto protect investors from deterioration in the credit quality of the underlyingcollateral pool. Recent increased defaults and downgrades of the collateralunderlying our CDOs have put downward pressure on overcollateralization ratiosand increased the likelihood that the CDOs we manage will experience events ofdefault or trigger other structural protections. In certain cases, breaches ofthese structural provisions can lead to events of default under the indenturesgoverning the CDOs and, ultimately, acceleration of the notes issued by the CDOand the liquidation of the underlying collateral. Certain of our CDOs containprovisions prohibiting the liquidation of the CDO following an event of defaultunless either the proceeds from the liquidation will be sufficient to pay offall of the notes issued by the CDO along with certain specified expenses or amajority or supermajority of certain specified classes of notes vote toliquidate the CDO. We believe that CDOs that contain these provisions are lesslikely to liquidate upon the occurrence of an event of default.

 

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CLO investment advisoryfee revenue declined by $2.9 million for the three months ended March 31,2009, as compared to the three months ended March 31, 2008. We managedfour market value CLOs during 2008, all of which contained liquidation triggersand events of default based on the market value of the CLO’s assets. Thesignificant decline in liquidity in the credit markets during the year ended December 31,2008 had a negative impact on the market values of the assets held in our CLOs.All four of our market value CLOs breached their market value trigger duringthe year ended December 31, 2008 and were subsequently liquidated. For thethree months ended March 31, 2008, we earned senior management fees of$1.0 million and subordinated management fees of $0.2 million on these marketvalue CLOs.   The remainder of our CLOsare cash flow CDOs. Triggers and events of default in these deals are not basedon the market value of the portfolio.

 

In addition, subordinatedmanagement fees on CLOs declined by $1.8 million during the three months ended March 31,2009, as compared to the three months ended March 31, 2008.  This was primarily the result of the failureof the overcollateralization tests for several of the CLOs during the threemonths ended March 31, 2009, resulting in the deferral of subordinatedmanagement fees on those CLOs.  We earnedsubordinated management fees of $1.3 million and $2.9 million for the threemonths ended March 31, 2009 and 2008, respectively, related to those CLOsthat have failed their overcollateralization tests or that we expect will failtheir overcollateralization tests.  Weexpect our CLO subordinated investment advisory fees to further decline and besubject to deferral in the near term. However, over time and with improved market conditions, we expect theCLOs to regain compliance with their overcollateralization tests, and, subjectto the satisfaction of certain other conditions, we expect to recoup at least aportion of the deferred subordinated management fees and to receive futuresubordinated management fees on a current basis.

 

The decline in ABS CDOrevenue of $0.6 million for the three months ended March 31, 2009 ascompared to the three months ended March 31, 2008, is primarily the resultof three of the ABS CDO’s triggering events of default during 2008 and thereduction in AUM for the remainder of our ABS CDOs as compared to the sameperiod in 2008.  Two of the ABS CDOs thatwe currently manage, Knollwood CDO Ltd. and Knollwood CDO II, Ltd. havetriggered events of default resulting primarily from downgrades of theirunderlying collateral. However, we believe it is unlikely that a liquidation ofthese CDOs will occur in the near term. As a result of the significant decline in AUM of these two ABS CDOs, weexperienced a decline in senior management fees during the three months ended March 31,2009 as compared to March 31, 2008 of $0.1 million related to these twoABS CDOs. One additional ABS CDO that we managed during 2008, Western SpringsCDO Ltd., or Western Springs CDO, triggered an event of default in the firstquarter of 2008 and was subsequently liquidated. For the three months ended March 31,2008, we earned senior management fees of $0.1 million and subordinatedmanagement fees of $22,000 on Western Springs CDO. In addition, two CDOs, whichearned subordinated fees of $0.2 million during the three months ended March31, 2008, failed their overcollateralization tests during 2008, resulting inthe deferral of those fees.

 

We are continuing tofocus on our previously announced strategy of acquiring existing CDO managementcontracts. On July 17, 2008, we acquired the management contract forRobeco CDO, and, on February 11, 2009, we assumed the management contractfor Mayfair Euro CDO.

 

***Other Investment Advisory Fees***

 

The following tablesummarizes the respective investment advisory fee revenues for our investmentmanagement contracts related to our separately managed accounts, our fixedincome arbitrage investment funds and other investment advisory fees:

 
| ** **                                                      | ** ** | **Average   AUM (1)** | ** ** | **Management  Fees** | ** ** | **Performance  Fees** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **(In thousands)**         | ** ** |
| **Three months ended March 31, 2009:** | ** ** | ** **                      | ** ** | ** **           | ** ** | ** **            | ** ** |
| Separately  managed accounts and other investment advisory fees |       | $                               | 294,676    |                 | $          | 244                   |       | n/a |   |
|                                                            |       |                            |       |                 |       |                  |       |
| **Three  months ended March 31, 2008:**                    |       |                            |       |                 |       |                  |       |
| Fixed income  arbitrage investment funds                        |       | $                               | 707,863    |                 | $          | 2,756                 |       | $ | 1,186 |   |
| Separately  managed accounts                                    |       | $                               | 403,941    |                 | $          | 246                   |       | n/a |   |
|                                                                 |            |                                 |            |                      |            |                       |            |  |  |  |

 

----

(1)        Average AUM is calculated asthe average of the AUM on the first day of January, February and March.

n/a — not applicable

 

The reduction in otherinvestment advisory fees during the three months ended March 31, 2009, ascompared to the same period in 2008, is primarily driven by the liquidation ofour fixed income arbitrage investment funds during 2008.  For the three months ended March 31,2008, we earned management fees of $2.8 million and incentive fees of$1.2 million related to these liquidated investment funds.

 

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*Intercompanyinvestment advisory fees*

 

As a result of theMerger, we entered into a new management agreement with DCM. Management feespaid pursuant to this agreement are eliminated upon consolidation in accordancewith GAAP. Fees are paid on a cost plus margin basis for investment advisory,management and operational services. All ancillary services, including backoffice support and certain operating expenses, are charged at cost. For thethree months ended March 31, 2009 and 2008, the intercompany investmentadvisory fees earned were $1.5 million and $4.0 million,respectively.

 

***Expenses***

 

Thefollowing table summarizes our Investment Management segment expenses for theperiods presented:

 
| ** **                                          | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                                          | ** ** | **2009**                                             | ** ** | **2008**     | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                          | ** ** | **(In millions)**                               | ** ** |
| Salaries                                            |       | $                                                    | 2.2        |         | $          | 4.3 |   | $ | (2.1 | ) |
| Incentive  compensation                             |       | 1.0                                                  |       | 4.3          |       | (3.3 | ) |
| Employee  benefits                                  |       | 0.2                                                  |       | 0.5          |       | (0.3 | ) |
| Total  compensation and benefits                    |       | 3.4                                                  |       | 9.1          |       | (5.7 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Audit and  audit-related fees                       |       | 0.1                                                  |       | 0.2          |       | (0.1 | ) |
| Other  professional fees                            |       | —                                               |       | 0.1          |       | (0.1 | ) |
| Total  professional services                        |       | 0.1                                                  |       | 0.3          |       | (0.2 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Insurance  expense                                  |       | 0.1                                                  |       | 0.2          |       | (0.1 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Software and  data feeds                            |       | 0.3                                                  |       | 0.5          |       | (0.2 | ) |
| Other general  and administrative fees              |       | 0.2                                                  |       | 0.2          |       | — |   |
| Total general  and administrative expense           |       | 0.5                                                  |       | 0.7          |       | (0.2 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Fixed asset  depreciation                           |       | 0.3                                                  |       | 0.3          |       | — |   |
| Intangible asset  amortization                      |       | 1.3                                                  |       | 2.4          |       | (1.1 | ) |
| Total  depreciation and amortization                |       | 1.6                                                  |       | 2.7          |       | (1.1 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Occupancy                                           |       | 0.6                                                  |       | 0.6          |       | — |   |
|                                                |       |                                                 |       |         |       |   |   |
| Cost savings  initiatives                           |       | 0.2                                                  |       | 0.3          |       | (0.1 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Impairment of  intangible assets                    |       | —                                               |       | 7.9          |       | (7.9 | ) |
| Impairment of  goodwill                             |       | —                                               |       | 20.0         |       | (20.0 | ) |
| Total impairment  of intangible assets and goodwill |       | —                                               |       | 27.9         |       | (27.9 | ) |
|                                                |       |                                                 |       |         |       |   |   |
| Total Investment  Management segment expenses       |       | $                                                    | 6.5        |         | $          | 41.8 |   | $ | (35.3 | ) |

 

The decrease in expensesof $35.3 million for the three months ended March 31, 2009 compared to thesame period in 2008 was primarily attributable to decreases in impairment of intangibleassets and goodwill of $27.9 million, compensation and benefits of $5.7 millionand depreciation and amortization of $1.1 million.

 

The $5.7 million decrease in 2009 compensation and benefits, ascompared to 2008, was primarily the result of the implementation of two costsavings initiatives and to a lesser extent a reduction in our projected 2009incentive compensation for existing employees. On March 1, 2008, inresponse to the adverse credit markets, we implemented an initial cost savinginitiative and reduced our headcount by 13 employees, or 10% of the thencurrent workforce, across a broad range of functions. In November 2008, inresponse to the continued deterioration in market conditions, we implemented asecond cost saving initiative and reduced our headcount by 24 employees, orapproximately 26% of the then current workforce, reduced bonus compensation andinstituted a salary freeze. The compensation payable to those 24 employeesaccounted for approximately 37% of our annual compensation expense in 2008. Theheadcount reductions were largely related to the fixed income arbitrage tradingbusiness and the associated back-office infrastructure. We believe these costsavings initiatives will improve our financial results without adversely impactingour ability to operate our business in a sound manner. As of March 31,2009, we had approximately 65 employees, as compared to approximately 114employees as of March 31, 2008.

 

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During the three monthsended March 31, 2008, we recorded impairment charges on our intangibleassets of $7.9 million. The impairment charges consisted of $4.6 millionrelated to the intangible assets associated with the management contract forour smallest investment fund, which subsequently liquidated, and $3.3 millionrelated to the management contract for Coltrane CLO PLC which triggered amarket-value event of default and was subsequently liquidated.  The decrease in depreciation and amortizationof $1.1 million for the three months ended March 31, 2009 was a result ofthe impairment of intangible assets which occurred during 2008.

 

During the three monthsended March 31, 2008, we also recorded a $20.0 million impairment ongoodwill.  A significant decline in ouroverall market value during the first quarter of 2008 was a triggering eventfor an analysis of possible goodwill impairment. Although the estimated cashflows generated were generally expected to be consistent with the estimatedcash flows at the time of the Merger, the market multiple for the companiesthat we considered comparable had decreased. This decline in market multipleslargely contributed to the $20.0 million of goodwill impairment.

 

***Other Income and Gain (Loss)***

 

Other income and gain(loss) for the Investment Management segment primarily consisted of therealized and unrealized losses related to our investments in preferred sharesof CDOs that are managed by DCM. During the three months ended March 31,2009 and 2008, we recognized unrealized losses of $0.1 million and$2.2 million, respectively, in net (gain) loss on trading securities inthe condensed consolidated statements of operations related to these investments.  As of March 31, 2009, our one remaininginvestment in the preferred shares of a CDO we manage is valued at zero.

 

***Income Tax Expense***

 

For the three monthsended March 31, 2009, the Investment Management segment recorded incometax expense of $18,000 due to our subsidiary in London. For income taxpurposes, impairments of intangibles and goodwill are not recognized but areamortized straight-line over a 15-year life from the date we established a taxbasis. There is a full valuation allowance on all of our deferred tax assetsexcept for those associated with our subsidiary in London.

 

**PrincipalInvesting Segment**

 

***Revenues***

 

Our Principal Investingsegment revenues represent the net spread, or difference, between the interestincome we earn on our investment portfolio and the cost of our borrowings. Wealso recognize the impact of our provision for loan losses on our PrincipalInvesting segment revenues. The following table summarizes the PrincipalInvesting segment revenues:

 
| ** **                                  | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                                  | ** ** | **2009**                                             | ** ** | **2008**     | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                  | ** ** | **(In millions)**                               | ** ** |
| **Principal  Investing Segment Revenues**   |       |                                                 |       |         |       |   |   |
| Interest income                             |       | $                                                    | 13.7       |         | $          | 61.0 |   | $ | (47.3 | ) |
| Interest expense                            |       | 5.7                                                  |       | 45.6         |       | 39.9 |   |
| Net interest  income                        |       | 8.1                                                  |       | 15.4         |       | (7.4 | ) |
| Provision for  loan losses                  |       | 2.1                                                  |       | 2.2          |       | 0.1 |   |
| Total Principal  Investing segment revenues |       | $                                                    | 6.0        |         | $          | 13.2 |   | $ | (7.3 | ) |

 

The following tablesummarizes our Principal Investing segment interest income:

 
| ** **                                   | ** ** | ** **                                           | ** ** | ** **   | ** ** | ** **                                           | ** ** | **% of total interest income** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                   | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** | **Three months ended March 31,** | ** ** |
| ** **                                   | ** ** | **2009**                                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**                          | ** ** | **2009**                                           | ** ** | **2008** | ** ** |
| ** **                                   | ** ** | **(In millions)**                               | ** ** | ** **   | ** ** | ** **                                           | ** ** |
| **Real  Estate Investments:**                |       |                                                 |       |         |       |                                                 |       |                                               |       |   |   |
| RMBS                                         |       | $                                                    | 4.5        |         | $          | 41.7                                                 |       | $                                                  | (37.2      | ) | 32.8 | % | 68.3 | % |
| Corporate loans  and securities:             |       |                                                 |       |         |       |                                                 |       |                                               |       |   |   |
| Loans held in  DFR MM CLO                    |       | 5.8                                                  |       | 8.2          |       | (2.4                                                 | )          | 42.4                                               | %          | 13.4 | % |
| Loans held in  Wachovia Facility             |       | 0.6                                                  |       | 3.4          |       | (2.8                                                 | )          | 4.4                                                | %          | 5.6 | % |
| Other corporate  leveraged loans             |       | —                                               |       | 0.4          |       | (0.4                                                 | )          | 0.0                                                | %          | 0.7 | % |
| Loans held in  Market Square CLO             |       | 3.1                                                  |       | 5.2          |       | (2.1                                                 | )          | 22.6                                               | %          | 8.5 | % |
| Commercial real  estate loans and securities |       | (0.1                                                 | )          | 1.2          |       | (1.3                                                 | )          | -0.7                                               | %          | 2.0 | % |
| Treasuries and  short term investments       |       | —                                               |       | 0.9          |       | (0.9                                                 | )          | 0.0                                                | %          | 1.5 | % |
| Equities and  other investments              |       | (0.2                                                 | )          | —       |       | (0.2                                                 | )          | -1.5                                               | %          | 0.0 | % |
| **Total  interest income**                   |       | $                                                    | 13.7       |         | $          | 61.0                                                 |       | $                                                  | (47.3      | ) | 100.0 | % | 100.0 | % |

 

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The decrease in interestincome of $47.3 million for the three months ended March 31, 2009,was attributable primarily to the reduction of our RMBS and alternative assetsportfolios as compared to the three months ended March 31, 2008 and, to alesser extent, to a lower interest rate environment. As of March 31, 2009,our RMBS and alternative asset portfolios totaled $338.7 million and$523.1 million, respectively, as compared to $467.7 million and$689.9 million, respectively, at March 31, 2008.  During the three months ended March 31,2008, we sold RMBS with an amortized cost of $6.2 billion.  As a result, RMBS interest income decreasedby $37.2 million for the three months ended March 31, 2009, ascompared to the same period in 2008. The $10.1 million decrease inalternative assets interest income for the three months ended March 31,2009, compared to the same period in 2008, was primarily the result of a lowerinvestment balances and a lower interest rate environment during the threemonths ended March 31, 2009, as compared to the same period in 2008. Othercorporate leveraged loans, loans held in the Wachovia Facility and loans heldin DFR MM CLO totaled $305.2 million as of March 31, 2009 as comparedto $407.0 million as of March 31, 2008.  Reductions in interest rates and theplacement of certain loans on non-accrual status contributed to the reductionsin interest income on loans held in DFR MM CLO, loans held in Market Square CLOand commercial real estate loans and securities.  The decrease in interest income on assetsheld in the Wachovia Facility of $2.8 million for the three months ended March 31,2009, was the result of the sale of a substantial portion of the loans in theportfolio.

 

The following tablesummarizes our Principal Investing segment interest expense:

 
| ** **                          | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                          | ** ** | **2009**                                             | ** ** | **2008**     | ** ** | **2009 vs. 2008** | ** ** |
| ** **                          | ** ** | **(In millions)**                               | ** ** |
| Repurchase  agreements              |       | $                                                    | 0.7        |         | $          | 31.3 |   | $ | (30.6 | ) |
| Hedging activity                    |       | 0.1                                                  |       | 5.2          |       | (5.1 | ) |
| Long term debt:                     |       |                                                 |       |         |       |   |   |
| Recourse:                           |       |                                                 |       |         |       |   |   |
| Trust preferred  securities         |       | 1.4                                                  |       | 2.1          |       | (0.7 | ) |
| Non-Recourse:                       |       |                                                 |       |         |       |   |   |
| Wachovia  Facility                  |       | —                                               |       | 0.7          |       | (0.7 | ) |
| Market Square  CLO                  |       | 1.6                                                  |       | 3.3          |       | (1.7 | ) |
| DFR MM CLO                          |       | 1.5                                                  |       | 2.9          |       | (1.4 | ) |
| Total long term  debt               |       | 4.5                                                  |       | 9.0          |       | (4.5 | ) |
| Amortization of  debt issuance cost |       | 0.4                                                  |       | 0.1          |       | 0.3 |   |
| Total interest  expense             |       | $                                                    | 5.7        |         | $          | 45.6 |   | $ | (39.9 | ) |

 

The decrease in interestexpense of $39.9 million for the three months ended March 31, 2009,compared to the three months ended March 31, 2008, was primarily theresult of significantly reduced repurchase agreement balances, decreasedinterest rates and decreased long term debt balances during the three monthsended March 31, 2009, as compared to the same period in 2008.

 

During the first quarterof 2008, we significantly reduced our RMBS portfolio through sales, which inturn resulted in the repayment of the outstanding repurchase agreements used tofinance that RMBS and the termination of the associated interest rate swapsused to hedge our interest rate risk on those repurchase agreements. Thedecrease in the average outstanding repurchase agreement balance and swapsoutstanding for the three months ended March 31, 2009, combined with alower interest rate environment during the three months ended March 31,2009, as compared to the three months ended March 31, 2008, contributed toa $35.7 million decrease in interest expense.

 

The interest expense relatedto long term debt decreased by $4.5 million for the three months ended March 31,2009, as compared to the same period in 2008. This decrease was primarilydriven by lower interest rates on our long term debt, which provided a decreaseof $3.8 million for the three months ended in March 31, 2009, as comparedto the same period in 2008.  In addition,from March 31, 2008 to March 31, 2009, we decreased the outstandingbalance in the Wachovia Facility from $76.4 million to $12.0 millionthrough sales and paydowns on the portfolio. This resulted in a reduction toour interest expense of $0.7 million for the three months ended March 31,2009, as compared to the same period in 2008.

 

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***Provision for Loan Losses***

 

The following tablesummarizes our Principal Investing segment provision for loan losses:

 
| ** **                       | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                             | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(In millions)**                               | ** ** |
| Loans held in  DFR MM CLO        |       | $                                                    | 0.8        |   | $ | — |   |
| Other corporate  leveraged loans |       | —                                               |       | 2.2 |   |
| Commercial real  estate loans    |       | 1.3                                                  |       | — |   |
| Total provision  for loan losses |       | $                                                    | 2.1        |   | $ | 2.2 |   |
|                                  |            |                                                      |            |  |  |  |  |  |  |  |  |

 

During the three monthsended March 31, 2009 and 2008, we recognized provisions for loan losses of$2.1 million and $2.2 million, respectively. During the three months endedMarch 31, 2009, we recorded additional provisions for loan losses of $0.8 millionrelated to two loans held in the DFR MM CLO with total outstanding principal of$17.7 million and $1.3 million related to three commercial real estateloans still being held for investment with total outstanding principal of $10.1million.

 

During the three monthsended March 31, 2008, we determined that an allowance for loan loss in theamount of $7.5 million was required for a held for investment loan with a totaloutstanding principal of $10.0 million. Accordingly, an addition to the provision for loan loss of $2.2 millionwas recorded.

 

***Expenses***

 

The following tablesummarizes Principal Investing segment expenses for the periods presented:

 
| ** **                                   | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2009**                                             | ** ** | **2008**     | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                   | ** ** | **(In millions)**                               | ** ** |
| ** **                                   | ** ** | ** **                                           | ** ** | ** **   | ** ** | ** ** | ** ** |
| Management fee  expense to related party (1) |       | $                                                    | 1.5        |         | $          | 4.0 |   | $ | (2.5 | ) |
|                                         |       |                                                 |       |         |       |   |   |
| Audit and  audit-related fees                |       | 0.1                                                  |       | 0.7          |       | (0.6 | ) |
| Legal fees                                   |       | 0.4                                                  |       | 0.1          |       | 0.3 |   |
| Other  professional fees                     |       | 0.1                                                  |       | 0.3          |       | (0.2 | ) |
| Total  professional services                 |       | 0.6                                                  |       | 1.1          |       | (0.5 | ) |
|                                         |       |                                                 |       |         |       |   |   |
| Insurance  expense                           |       | 0.7                                                  |       | 0.6          |       | 0.1 |   |
|                                         |       |                                                 |       |         |       |   |   |
| Board of  directors fees                     |       | 0.3                                                  |       | 0.2          |       | 0.1 |   |
| Banking and  other administrative fees       |       | 0.1                                                  |       | 0.3          |       | (0.2 | ) |
| Software and  data feeds                     |       | —                                               |       | 0.1          |       | (0.1 | ) |
| Other general  and administrative fees       |       | —                                               |       | —       |       | — |   |
| Total general  and administrative expenses   |       | 0.4                                                  |       | 0.6          |       | (0.2 | ) |
|                                         |       |                                                 |       |         |       |   |   |
| Total Principal  Investing segment expenses  |       | $                                                    | 3.2        |         | $          | 6.3 |   | $ | (3.1 | ) |

 

----

| (1) | Management  fee expense for the three months ended March 31, 2009 and 2008 of  $1.5 million and $4.0 million, respectively, is charged in  conjunction with our new management agreement with DCM, which is eliminated  in consolidation. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

The decrease in expensesof $3.1 million for the three months ended March 31, 2009, compared to thesame period in 2008, was attributable to decreases in management fee expense torelated party, professional services and general and administrative expenses of$2.5 million, $0.5 million and $0.2 million, respectively, partially offset byincreased insurance expense of $0.1 million. Management fee expense to related party is eliminated upon consolidationand is based upon a cost plus margin basis for investment advisory, managementand operational services. The decrease in total professional services of $0.5million was primarily the result of decreased audit and audit-related feesbased on a reduction in estimated fee for services during 2009.  The $0.2 million decrease in general andadministrative expenses is primarily driven by a decrease in our monthlybanking fees as a result of significantly lower trading activity. The $0.1million increase in insurance expense reflects an increase in insurancepremiums over the prior period presented.

 

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***Other Income and Gain (Loss)***

 

The following tablesummarizes our Principal Investing segment other income and (loss) gain for theperiods presented:

 
| ** **                                            | ** ** | **Three months ended March 31,** | ** ** | **Variance** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                                            | ** ** | **2009**                                             | ** ** | **2008**     | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                            | ** ** | **(In millions)**                               | ** ** |
|                                                  |       |                                                 |       |         |       |   |   |
| Net realized  loss on trading securities              |       | $                                                    | —     |         | $          | (169.1 | ) | $ | 169.1 |   |
| Net unrealized  gain (loss) on trading securities     |       | 5.3                                                  |       | (29.5        | )          | 34.8 |   |
| Net gain (loss)  on trading securities                |       | 5.3                                                  |       | (198.6       | )          | 203.9 |   |
|                                                  |       |                                                 |       |         |       |   |   |
| Net realized  loss on loans                           |       | (5.2                                                 | )          | (4.9         | )          | (0.3 | ) |
| Net unrealized  gain (loss) on loans                  |       | 11.0                                                 |       | (21.6        | )          | 32.6 |   |
| Net gain (loss)  on loans                             |       | 5.8                                                  |       | (26.5        | )          | 32.3 |   |
|                                                  |       |                                                 |       |         |       |   |   |
| Net realized  gain (loss) on interest rate swaps      |       | 0.5                                                  |       | (267.3       | )          | 267.8 |   |
| Net realized  loss on credit default swaps            |       | (0.5                                                 | )          | (2.1         | )          | 1.6 |   |
| Net realized  loss on total return swaps              |       | —                                               |       | (0.7         | )          | 0.7 |   |
| Net realized  loss on interest rate floors and caps   |       | —                                               |       | (1.6         | )          | 1.6 |   |
| Net unrealized  (loss) gain on interest rate swaps    |       | (0.7                                                 | )          | 48.0         |       | (48.7 | ) |
| Net unrealized  gain (loss) on credit default swaps   |       | 0.4                                                  |       | (0.1         | )          | 0.5 |   |
| Net unrealized  loss on total return swaps            |       | —                                               |       | (0.5         | )          | 0.5 |   |
| Net unrealized  gain on interest rate floors and caps |       | —                                               |       | 1.1          |       | (1.1 | ) |
| Net unrealized  loss on warrants                      |       | (0.1                                                 | )          | (0.1         | )          | — |   |
| Net loss on  derivatives                              |       | (0.4                                                 | )          | (223.3       | )          | 222.9 |   |
|                                                  |       |                                                 |       |         |       |   |   |
| Dividend income                                       |       | —                                               |       | 0.1          |       | (0.1 | ) |
| Dividend income  and other net (loss) gain            |       | —                                               |       | 0.1          |       | (0.1 | ) |
|                                                  |       |                                                 |       |         |       |   |   |
| Net other income  and gain (loss)                     |       | $                                                    | 10.7       |         | $          | (448.3 | ) | $ | 459.0 |   |
|                                                  |       |                                                 |       |         |       |   |   |
| Total realized  loss                                  |       | $                                                    | (5.2       | )            | $          | (445.6 | ) | $ | 440.4 |   |
| Total unrealized  gain (loss)                         |       | $                                                    | 15.9       |         | $          | (2.7 | ) | $ | 18.6 |   |

 

Net other income and gain(loss) improved by $459.0 million for the three months ended March 31,2009, compared to the same period for 2008. This was primarily attributable toimprovements on trading securities, derivatives and loans of$203.9 million, $222.9 million and $32.3 million, respectively.

 

The decrease in netlosses on trading securities and derivatives was primarily a result of thesignificant sales of our RMBS portfolio and associated reductions in ouroutstanding interest rate swaps during the first quarter of 2008.  During the first quarter of 2008, our RMBSportfolio experienced a significant decrease in value fueled by the ongoingcredit crisis. This reduced our ability to successfully finance and hedge ourRMBS portfolio. We sold a substantial portion of our non-Agency RMBS and AgencyRMBS to improve liquidity, which resulted in realized trading losses of$169.1 million for the three months ended March 31, 2008.  In conjunction with the sale of a substantialportion of our RMBS portfolio during the three months ended March 31,2008, we terminated 188 interest rate swaps with a notional amount of$6.2 billion, which resulted in net losses on interest rate swaps duringthe three months ended March 31, 2008 of $219.3 million.

 

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Prior to these sales, asof January 1, 2008, in conjunction with the adoption of SFAS No. 159,*The Fair Value Option for Financial Assets andLiabilities*, or SFAS No. 159, we de-designated$3.8 billion (notional) of interest rate swaps previously designated as ahedge with a net negative fair value of $85.9 million at de-designation,including accrued interest.  As of theadoption date, the other comprehensive loss related to the de-designation ofinterest rate hedges was $69.9 million. To the extent that the forecastedrolls on repurchase agreement transactions continued as anticipated, we wouldhave amortized this loss and the $27.3 million in other comprehensive lossrelated to previously de-designated swaps from other comprehensive loss intointerest expense over the remaining original hedge period, and all futurechanges in fair value of the interest rate swaps would be reflected in thecondensed consolidated statements of operations. However, due to thesignificant RMBS sales activity and corresponding repurchase agreementrepayment during the three months ended March 31, 2008, forecasted rollson the repaid repurchase agreements did not continue as anticipated. As aresult, a loss of $91.7 million (including $69.6 million ofaccelerated amortization on interest rate swaps) was recognized during thethree months ended March 31, 2008 in the condensed consolidated statementsof operations in net loss on derivatives, and a corresponding cumulative netloss relating to newly and previously de-designated and terminated interestrate swaps in other comprehensive loss was removed.

 

During the three monthsended March 31, 2009, the unrealized gains on trading securities were $5.3million, primarily driven by valuation increases on the RMBS portfolio.  During the three months ended March 31,2008, unrealized losses on trading securities were $29.5 million, as a resultof the overall decrease in the value within the RMBS market.

 

The improvement in netgain (loss) on loans during the three months ended March 31, 2009 is theresult of stronger market performance which in turn increased the valuation ofour held for sale portfolios within the Market Square and WachoviaFacility.  Unrealized gains on loans heldfor sale include recoveries up to original cost or value on the date the loanwas transferred from loans held for investment to loans held for sale.  This was partially offset by decreasedperformance in loans held for sale in our structured and syndicated loanportfolio which drove down valuations on these loans. In addition, we realizednet losses on sales of loans held for investment and loans held for sale of $5.2million during the three months ended March 31, 2009, primarily as aresult of an agreement to sell loans held within the Wachovia Facility with apar value of $31.5 million for $10.8 million, net of interest of $0.2 million.

 

**Off-BalanceSheet Arrangements**

 

In September 2005,August 2006 and October 2006, we formed Deerfield Capital Trust I,Deerfield Capital Trust II and Deerfield Capital Trust III, or the Trusts,which are VIEs. Through our wholly-owned subsidiary, DC LLC, we own 100% of thecommon shares of the Trusts, which issued, in the aggregate,$120.0 million of preferred shares to unaffiliated investors. DC LLCissued junior subordinated debt securities to the Trusts in the aggregate of$123.7 million, which are guaranteed by us. The rights of common shares ofthe Trusts are subordinate to the rights of the preferred shares only in theevent of a default. Otherwise, the common stockholders’ economic and votingrights rank pari passu with the preferred stockholders. We record theinvestment in the Trusts’ common shares as other investments at cost and recorddividend income upon declaration by the Trust. The junior subordinated debtsecurities are recorded as long term debt, and debt issuance costs are deferredin prepaid and other assets in the consolidated balance sheet. Interest on thedebt securities and amortization of debt issuance costs are recorded in theconsolidated statements of operations as interest expense.

 

As of March 31,2009, we did not maintain any other relationships with unconsolidated entitiesor financial partnerships, such as entities often referred to as structuredfinance, special purpose or VIEs, established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes. Further, as of March 31, 2009, we had not guaranteed anyobligations of unconsolidated entities or entered into any commitment or intentto provide additional funding to any such entities, except for the Trusts.

 

**Liquidityand Capital Resources**

 

We held cash and cashequivalents of $42.4 million as of March 31, 2009.

 

Our operating activitiesused cash of $2.9 million for the three months ended March 31, 2009,primarily through the following:

 

Net inflows and non-cashadjustments of $16.7 million, consisting of the following:

 

·                            Net income — $11.5 million

·                            Provision for loan losses — $2.1 million

·                            Depreciation and amortization— $1.6 million

·                            Net proceeds of loans held forsale — $1.0 million

·                            Non-cash rental expense — $0.1 million

·                            Changes in undesignated derivatives —$0.1 million

·                            Amortization of net loss on previously designatedderivatives — $0.1 million

·                            Deferred tax benefit — $0.1 million

·                            Share-based compensation — $0.1 million

 

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Net outflows and non-cashadjustments totaled $19.6 million, consisting of the following:

·                  Net gain on loans and tradingsecurities— $11.0 million

·                  Net change in operating assets and liabilities — $8.0 million

·                  Net purchases of tradingsecurities — $0.6 million

 

Our investing activitiesprovided cash of $21.6 million for the three months ended March 31, 2009,primarily from the change in restricted cash and cash equivalents of $53.0million, principal payments from trading securities previously classified asavailable-for-sale of $14.4 million, principal payments and proceeds from thesale of loans of $10.1 and $12.1 million, respectively, partially offsetby the origination and purchase of loans held for investment of$68.0 million.

 

Our financing activitiesused cash of $9.1 million for the three months ended March 31, 2009,primarily for payments on repurchase agreements of $7.1 million. Additionaluses of cash included payments made on the Wachovia Facility of$1.9 million and debt issuance costs of $0.1 million.

 

***Leverage***

 

The sale of a substantialportion of our RMBS portfolio has decreased our reliance on short term debt, inthe form of repurchase agreements, used to finance that portfolio. Our RMBSholdings were $338.7 million as of March 31, 2009. Our repurchaseagreements liabilities were $318.6 million as of March 31, 2009. Asdiscussed in more detail in the following section “Liquidity and Sources of Funds,”our remaining debt of $714.6 million consists of $519.0 million ofnon-recourse debt, $71.9 million of Series A and Series B Notes,due in 2012, and $123.7 million of trust preferred securities with$51.6 million and $72.1 million due in 2035 and 2036, respectively.

 

Although we continue toclosely monitor our leverage, the changes in our business resulting from theMerger in 2007 and the termination of our REIT status on September 30,2008 (retroactive to January 1, 2008) impacted how we expect to useand manage leverage going forward. The acquisition of Deerfield, and oursubsequent focus on our Investment Management segment, significantly reducesour need for leverage and equity to support our operations because of thegeneration of cash flows from contractual investment advisory fees.Additionally, the termination of our REIT status provides us with moreflexibility to allocate capital to assets other than RMBS, although, in thenear term, we expect to continue to hold our RMBS portfolio.

 

**Liquidityand Sources of Funds**

 

We believe that ourcurrent cash and cash equivalents, unencumbered liquid assets, net equity infinanced RMBS portfolio along with cash flows from operations are adequate tomeet anticipated liquidity requirements through April 1, 2010.Unencumbered RMBS and unrestricted cash and cash equivalents aggregated$47.3 million at March 31, 2009. In addition, net equity in thefinanced RMBS portfolio (including associated interest rate swaps), excludingthe unencumbered RMBS included above, totaled $17.8 million at quarterend. In total, we had unrestricted cash and cash equivalents, unencumbered RMBSand net equity in the financed RMBS portfolio of $65.1 million as of March 31,2009. As of March 31, 2009, the fair value of our Agency RMBS andnon-Agency RMBS portfolios were $333.9 million and $4.8 million,respectively. Our largest repurchase agreement counterparty has required thatwe maintain a minimum of $20.0 million of cash in their custody in orderto maintain our current repurchase agreement margin percentages on our AgencyRMBS. If we fail to satisfy this requirement, the counterparty will have theright to increase the margin percentages under our repurchase agreements andexercise other remedies.

 

On November 7, 2008,we entered into a letter agreement, or the November Letter Agreement, withthe representatives of our trust preferred securities, or the Trust PreferredSecurities.  The November LetterAgreement provided a waiver of any prior noncompliance by DC LLC with the networth covenant contained in the indentures governing our Trust PreferredSecurities and waived any further noncompliance with such covenant through April 1,2010.  We do not expect to be incompliance with the net worth covenant on April 1, 2010 and, therefore, expectto discuss a potential longer term solution with the holders of the TrustPreferred Securities.  No assurances canbe provided that we will have any success in obtaining such a longer termsolution with respect to the Trust Preferred Securities.

 

We attempt to maintainour leverage at a level that ensures that our cash and cash equivalents will besufficient to satisfy our liquidity requirements. However, if we are notsuccessful, we may be required to sell additional RMBS or Corporate Loans andmay be unable to do so on favorable terms or at all. Sales of additional RMBSor Corporate Loans at prices lower than their carrying value would result infurther realized losses and reduced income. For further discussions concerningthe availability of repurchase agreement financing, which we use to finance ourRMBS portfolio, see*“Trends — Liquidity”*above. We may increase our capital resources by consummating offerings ofsecurities or issuing new debt, possibly including preferred stock, commonstock, commercial paper, medium-term notes, CDOs, collateralized mortgageobligations and other borrowings. The ability to execute these strategies willdepend on, among other things, market conditions for capital raises and for theinvestment of any proceeds.

 

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The lease on ourcorporate headquarters requires us to maintain a letter of credit, which wasrenewed in May 2008 and requires us to maintain $2.3 million of cashon deposit, with annual reductions of $0.3 million, with the letter ofcredit provider in a restricted account.

 

As we focus on growingour Investment Management segment, we expect to utilize our cash and liquidityto invest in new investment products, such as DPLC.  For additional information regarding DPLC,see *“Recent Developments”*below.  We also may use our cash in connection withthe acquisition of CDO management contracts or other Investment Managementopportunities. We expect to continue to focus on selling the remaining portionof our non-CLO Corporate Loan portfolio during 2009.  We expect our CLO subordinated investmentadvisory fees to further decline and be subject to deferral in the nearterm.  However, over time and withimproved market conditions, we expect the CLOs to regain compliance with theirovercollateralization tests, and, subject to the satisfaction of certain otherconditions, we expect to recoup at least a portion of the deferred subordinatedmanagement fees and to receive future subordinated management fees on a currentbasis. Additionally, we do not expect to receive equity distributions in theforeseeable future from either DFR MM CLO or Market Square CLO. Although theconsolidation of those CLOs impacts our earnings, due to certain structuralprovisions, the equity distributions are not expected to be paid.

 

***Investment Management Segment***

 

The following is asummary of our recourse Investment Management segment borrowings as of March 31,2009:

 
| ** **                                      | ** ** | **Series A and**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **Series B Notes** | ** ** |
| Outstanding  balance (in thousands)             |       | $                       | 71,905     | (1) |
| Weighted average  borrowing rate                |       | 6.44                    | %          |
| Weighted-average  remaining maturity (in years) |       | 3.75                    |       |
|                                                 |            |                         |            |  |

 

----

(1)  Principal outstanding of $71.9 million is presented netof a $2.0 million discount.

 

***Principal Investing Segment***

 

The following is asummary of our Principal Investing segment borrowings as of March 31,2009:

 
| ** **                                      | ** ** | **Recourse**   | ** ** | **Non-Recourse** | ** ** | ** **    | ** ** |
|-------------------------------------------------|------------|----------------|------------|------------------|------------|---------------|------------|
| ** **                                      | ** ** | ** **     | ** ** | **Trust**        | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Repurchase** | ** ** | **Preferred**    | ** ** | **Term**      | ** ** | **Wachovia** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Agreements** | ** ** | **Securities**   | ** ** | **Financing** | ** ** | **Facility** | ** ** | **Total** | ** ** |
| Outstanding  balance (in thousands)             |       | $              | 318,641    |             | $          | 123,717       |       | $ | 507,000 | (2) | $ | 12,000 |   | $ | 961,358 |   |
| Weighted average  borrowing rate                |       | 0.75           | %          | 3.95             | %          | 1.73          | %          | 3.00 | % | 1.77 | % |
| Weighted-average  remaining maturity (in years) |       | 0.02           |       | 27.18            | (1)        | 9.09          | (3)        | — | (4) | 8.00 |   |
|                                                 |            |                |            |                  |            |               |            |  |  |  |  |  |  |  |  |  |

 

----

| (1) | $51.6 million  of the trust preferred securities are callable by us after October 30,  2010, and $72.1 million are callable by us after October 30, 2011.                                                                                                                                                               |
|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | $276.0 million  of the term financing is currently callable quarterly by us, and  $231.0 million is callable on July 20, 2010 and quarterly  thereafter.                                                                                                                                                                     |
| (3) | Excludes  $19.0 million of DFR MM CLO debt that is owned by us and eliminated upon  consolidation. Had this debt been included, the weighted-average borrowing  rate would be 1.85%, and the weighted-average remaining maturity would be  9.13 years.                                                                            |
| (4) | On  November 30, 2008, we triggered an acknowledged termination event under  the Wachovia Facility. We have entered into a forbearance agreement with  respect to such acknowledged termination event that extends through July 7,  2009. See “Recent Developments” for subsequent events related to the Wachovia  Facility. |

 

*RecourseDebt*

 

Recourse debtrefers to debt that is a general obligation of ours. None of our long term debtis subject to potential margin calls for additional pledges of our cash orassets.

 

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*RepurchaseAgreements*

 

As of March 31,2009, proceeds from repurchase agreements totaling $318.6 million, with aweighted-average current borrowing rate of 0.75%, were used to finance theacquisition of RMBS. We expect to continue borrowing funds in the form ofrepurchase agreements. As of March 31, 2009, we had outstanding repurchaseagreement balances with two financial institutions. Our repurchase agreementliabilities are significantly concentrated with one counterparty that providesfinancing totaling 84.6% of the $318.6 million of repurchase agreementliabilities as of March 31, 2009. Increases in interest rates could reducethe value of our RMBS, which could limit our borrowing ability or cause ourlenders to initiate additional margin calls. An increase in the percentage deductionof fair value of RMBS collateral that we receive in cash at the inception ofthe repurchase agreement, which we sometimes refer to as a haircut, imposed byour counterparties would limit our borrowing capacity. Amounts due uponmaturity of our repurchase agreements will be funded primarily through therollover or re-issuance of repurchase agreements and monthly principal andinterest payments received on our RMBS.

 

The following tablepresents certain information regarding the amount at risk related to ourrepurchase agreements:

 
| ** **                                | ** ** | ** **             | ** ** | **Weighted-Average**       | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | ** **             | ** ** | **Maturity of Repurchase** | ** ** |
| ** **                                | ** ** | **Amount at Risk (1)** | ** ** | **Agreements**             | ** ** |
| ** **                                | ** ** | **(In thousands)**     | ** ** | **(In days)**              | ** ** |
| **Repurchase  Agreement Counterparties:** |       |                   |       |                       |       |
| Deutsche Bank  Securities Inc.            |       | $                      | 4,990      |                       | 7          |   |
| Fortis  Securities LLC                    |       | 11,620                 |       | 6                          |       |
| Total                                     |       | $                      | 16,610     |                       | 6          |   |
|                                           |            |                        |            |                            |            |  |  |

 

----

(1)        Equal to the fair value ofsecurities pledged minus repurchase agreement liabilities and related accruedinterest payable.

 

We are currently inviolation of substantially all of our International Swap Dealers Association,or ISDA, agreements with our interest rate swap counterparties. Each of theseISDA agreements contains an equity decline trigger that we breached during thefirst quarter of 2008. This violation generally gives the counterparties theright to terminate the ISDA agreements and the related interest rate swaps. Wehave notified our active counterparties of the breach, and none of thosecounterparties has expressed an intention to terminate the ISDA agreements. Todate, the violations of our ISDA agreements have not had a material adverseeffect on our operations.

 

*Non-RecourseDebt*

 

Non-recourse debtrefers to debt with recourse only to specific assets pledged as collateral tothe lenders, such as warehouse facilities and the debt issued by CDOs that areconsolidated by us as VIEs. The creditors of the non-recourse debt have norecourse to our other assets. None of the long term debt is subject topotential margin calls for additional pledges of our cash or assets. Thecarrying value of the collateral of the entities which the non-recourse debtholders have recourse for the repayment of outstanding debt are $16.1 million,$209.8 million and $291.8 million for the Wachovia Facility, Market Square CLOand DFR MM CLO, respectively.

 

*WachoviaFacility.  *During the three months ended March 31, 2009, we entered into anagreement to sell loans held within the Wachovia Facility with a par value of$31.5 million for $10.8, net of interest of $0.2 million.  Proceeds from the settlement of this tradereduced the outstanding debt associated with the Wachovia Facility. See “RecentDevelopments” for subsequent events related to the Wachovia Facility.

 

***Distribution Policy***

 

We are no longer subjectto the distribution requirements applicable to REITs. The covenants containedin our indebtedness currently prohibit us from declaring dividends ordistributions on our common stock, and therefore, we do not expect to makedividend distributions in the foreseeable future.

 

***Inflation***

 

Virtually all of ourassets and liabilities are interest rate sensitive. As a result, interest ratesand other factors influence our performance more than inflation. Our financialstatements are prepared in accordance with GAAP, and our distributions aredetermined by our board of directors, or Board, based primarily on cash flowconsiderations; in each case, our activities and balance sheet are measuredwith reference to historical cost or fair value without considering inflation.

 

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***RightsPlan***

 

On March 11, 2009,our Board adopted a stockholder rights plan, or Rights Plan, and declared adividend of one right, or Right, for each outstanding share of our common stockto stockholders of record at the close of business on March 11, 2009. TheRights will also attach to any additional shares of our common stock issuedafter March 11, 2009. The Rights Plan was not adopted in response to anyeffort to acquire control of our company, but as a means to preserve the use ofpreviously accumulated net operating losses, or NOLs, net capital losses, orNCLs, and certain other tax attributes by dissuading investors from aggregatingownership in our company and triggering an ownership change for purposes ofSections 382 and 383 of the Internal Revenue Code of 1986, as amended.

 

Initially, the Rightswill not be exercisable and will be attached to and automatically trade withour common stock. The Rights will separate from our common stock and a “distributiondate” will occur, with certain exceptions, upon the earlier of (i) tenbusiness days following a public announcement that a person or group ofaffiliated or associated persons has acquired beneficial ownership of 4.9% or moreof our outstanding common stock, which person or group would then qualify as an“acquiring person,” or (ii) ten business days following the first publicannouncement of a person’s intention to commence or the commencement of atender offer or exchange offer that would result in a person becoming anacquiring person. If at the time of the adoption of the Rights Plan, any personor group of affiliated or associated persons was the beneficial owner of 4.9%or more of the outstanding shares of our common stock, such person shall notbecome an acquiring person unless and until such person acquires any additionalshares of our common stock. In addition to other exceptions, a person will notbecome an acquiring person if such person acquired the shares of our commonstock, directly or indirectly, as the result of a warrant, the exercisethereof, the transfer or acquisition of such warrant or common stock acquiredthereby, where such warrant had first been issued upon approval by our Boardunless and until such person and its affiliates and associates acquire anyadditional shares of our common stock then outstanding that are unrelated tothe warrant. If the Rights become exercisable, each Right will entitle itsholder to purchase one one-thousandth of a share of our Series A JuniorParticipating Preferred Stock at a purchase price of $16.00 per fractionalshare, subject to adjustment. The Rights have no voting privileges and willexpire at the close of business on March 10, 2019, unless earlier expired,redeemed or exchanged by us. The Rights will expire at such time as the StateDepartment of Assessments and Taxation of Maryland accepts for record a charteramendment providing for (as determined in good faith by our Board) restrictionson the transfer of our securities in order to preserve the benefits of ourNOLs, NCLs or other tax attributes.

 

The Rights Plan containscustomary “flip-in” and “flip-over” provisions such that if a person or groupacquires beneficial ownership of 4.9% or more of our common stock and isdetermined by our Board to be an acquiring person, each Right (other thanRights held by the acquiring person) will entitle the holder to purchase commonstock having a value of two times the exercise price of the Right.

 

The foregoing descriptionof the Rights Plan does not purport to be complete and is qualified in itsentirety by reference to the Rights Agreement, by and between us and AmericanStock Transfer & Trust Company LLC, as rights agent, dated as of March 11,2009. There was no impact on our financial results as a result of the adoptionof the Rights Plan.

 

**RecentDevelopments**

 

***New Investment Venture***

 

On April 14, 2009,we announced the launch of DPLC.  Pegasusis a U.S. based private equity firm. Pegasus and DFR have committed to invest$75.0 million and $15.0 million, respectively, in DPLC with such amounts to beinvested primarily in corporate bank loans and other senior secured corporateloans.  DPLC will be managed by DCM. Thecommitments of each of Pegasus and DFR are subject to numerous conditions, anyor all of which may not be satisfied.

 

In connection with thelaunch of DPLC, we issued to Pegasus Deerfield (AIV), LLC, an affiliate ofPegasus, or Pegasus Deerfield, (i) a five-year warrant to purchase2,500,000 shares of our common stock at an exercise price of $4.25 per share,or Warrant A and (ii) a five-year warrant to purchase 500,000 shares ofour common stock at an exercise price of $10.00 per share, or Warrant B andtogether with Warrant A, the Warrants. The Warrants are subject to certainvesting conditions including that none of the Warrants vest prior to April 9,2011 and that the Warrants vest only if Pegasus maintains a certain minimuminvestment in DPLC. In addition, Pegasus will be required by a certainspecified date to make an election to either retain the Warrants or receive ashare of the incentive allocations and investment advisory fees paid to us andDCM in respect of certain future investment funds and separately managedaccounts managed by DCM that invest primarily in syndicated bank loans to andbonds issued by non-investment grade borrowers.  In the event that Pegasuselects to receive these subsequent fund economics, they will forfeit theWarrants. Simultaneously with the execution of the Warrants, we entered into aregistration rights agreement, dated as of April 9, 2009, with PegasusDeerfield that provides registration rights with respect to the shares of ourcommon stock underlying the Warrants.

 

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***Notice of Non-Compliance with NYSE Amex Continued ListingStandard***

 

On April 15,2009, we were notified by the NYSE Amex LLC, or the NYSE Amex, that we are notin compliance with a NYSE Amex continued listing standard applicable to ourcommon stock. Specifically, the letter from the NYSE Amex states that a reviewof our public filings indicates that we are not in compliance with Section 1003(a)(i) ofthe NYSE Amex Company Guide, or the Company Guide, because we have stockholders’equity of less than $2,000,000 and have sustained losses from continuingoperations and/or net losses in two of our three most recent fiscal years.

 

Under the NYSEAmex rules, we must submit a plan to the NYSE Amex by May 15, 2009addressing how we intend to regain compliance with Section 1003(a)(i) ofthe Company Guide by October 15, 2010, and that plan must be accepted bythe NYSE Amex in order for us to maintain our listing. If our plan is acceptedby the NYSE Amex, but we are not in compliance with all continued listingstandards set forth in the Company Guide by October 15, 2010 or we do notmake progress consistent with our plan, the NYSE Amex stated that we willbecome subject to delisting proceedings.

 

***SecondAmended and Restated Forbearance Agreement under Wachovia Facility***

 

On May 8,2009, we entered into a second amended and restated forbearance agreementrelated to the Wachovia Facility extending the period through which no actionwill be taken in respect of any prior noncompliance with the covenant requiringus to maintain stockholders’ equity of at least $240.0 million as well ascertain other covenants under the Wachovia Facility through the earlier of July 7,2009 and the date of any breach of the forbearance agreement by us.  The outstanding balance under the WachoviaFacility as of May 8, 2009 was approximately $0.9 million. A copy of thesecond amended and restated forbearance agreement is attached as Exhibit 10.1to this Quarterly Report.

 

**ITEM 3.   QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

As of March 31,2009, the primary component of our market risk was interest rate and spreadrisk, as described below. While we do not seek to avoid risk completely, weactively manage interest rate risk and regularly assess whether earnings in theportfolio include appropriate compensation for the inherent market risks towhich it is exposed. In light of these risks, we regularly consider our capitallevels and currently are focused on redeploying capital from PrincipalInvesting activities to growing our Investment Management segment.

 

**InterestRate Risk**

 

We are subject tointerest rate risk primarily in connection with our investments in hybridadjustable-rate and fixed-rate RMBS and our debt obligations related to thoseinvestments, which are generally repurchase agreements of short duration thatperiodically reset at current market rates. We seek to manage this risk throughutilization of derivative contracts, primarily interest rate swap agreements.

 

**Effecton Net Interest Income**

 

We fund our investmentsin RMBS primarily with short term borrowings under repurchase agreements.During periods of rising interest rates, short term borrowing costs tend toincrease while the income earned on hybrid adjustable-rate (during thefixed-rate period of such securities) and fixed-rate RMBS may remainsubstantially unchanged. This results in a narrowing of the net interest spreadbetween the related assets and borrowings and may even result in losses.

 

In order to mitigate ourinterest rate exposure, we have five interest rate swap transactionsoutstanding as of March 31, 2009. The following table summarizes theexpiration dates of these contracts and their notional amounts:

 
| **Year of Expiration** | ** ** | **Notional Amount** | ** ** |
|------------------------|------------|---------------------|------------|
| ** **             | ** ** | **(In thousands)**  | ** ** |
| 2009                   |       | $                   | 80,000     |   |
| 2010                   |       | 10,000              |       |
| 2012                   |       | 50,000              |       |
| 2018                   |       | 25,000              |       |
| Total                  |       | $                   | 165,000    |   |

 

Our hedging strategiesare partly based on assumed levels of prepayments of our RMBS. If prepaymentsare slower or faster than assumed, the life of the RMBS will be longer orshorter, which changes the net impact of our hedging activity and may causeunexpected gains or losses on such transactions. Hedging strategies involvingthe use of derivative instruments are highly complex and may produce volatilereturns.

 

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**ExtensionRisk**

 

The majority of our RMBSportfolio consists of hybrid adjustable-rate RMBS, which have interest ratesthat are fixed for the first several years of the loan (typically three, five,seven or 10 years) and, thereafter, reset periodically on the same basisas adjustable-rate RMBS. We compute the projected weighted-average life of ourRMBS based on assumptions regarding the rate at which the borrowers will prepaythe underlying mortgages. In general, when a fixed-rate or hybridadjustable-rate residential mortgage-backed security is funded by a short termborrowing, we may, but are not required to, enter into an interest rate swapagreement or other hedging instrument that effectively fixes a portion of ourborrowing costs for a period close to the anticipated weighted-average life ofthe fixed-rate portion of the related RMBS. This strategy is designed toprotect a portion of our portfolio from increased funding costs due to risinginterest rates because the borrowing costs are not fixed for the duration ofthe fixed-rate period of the related residential mortgage-backed security.

 

We have structured ourinterest rate swaps to roll off or expire in conjunction with the estimatedweighted average life of the fixed period of the mortgage portfolio. However,if prepayment rates decrease in a rising interest rate environment, theweighted average life of the fixed-rate portion of the related RMBS couldextend beyond the term of the swap agreement or other hedging instrument. Thiscould have a negative impact on our results of operations, as borrowing costswould no longer be effectively fixed after the maturity of the hedginginstrument, while the income earned on the remaining hybrid adjustable-rateRMBS would remain fixed for a period of time. This situation may also cause themarket value of our hybrid adjustable-rate RMBS to decline, with little or nooffsetting gain from the related hedging transactions. We may be forced to sellassets to maintain adequate liquidity, which could cause us to incur losses,and we may be unable to sell assets on favorable terms or at all.

 

**HybridAdjustable-Rate RMBS Interest Rate Cap Risk**

 

We also invest in hybridadjustable-rate RMBS which are based on mortgages that are typically subject toperiodic and lifetime interest rate caps and floors, which limit the amount bywhich the security’s interest rate may change during any given period. However,our borrowing costs pursuant to our repurchase agreements will not be subjectto similar restrictions. Therefore, in a period of increasing interest rates,interest rate costs on our borrowings could increase without limitation bycaps, while the interest-rate yields on our hybrid adjustable-rate RMBS couldbe limited by caps. These factors could lower our net interest income or causea net loss during periods of rising interest rates, which would negativelyimpact our financial condition, cash flows and results of operations.

 

**InterestRate Mismatch Risk**

 

We intend to fund asubstantial portion of our purchases of RMBS with borrowings that, after theeffect of hedging, have interest rates based on indices and repricing termssimilar to, but of somewhat shorter maturities than, the interest rate indicesand repricing terms of the RMBS. Thus, we anticipate that in most cases theinterest rate indices and repricing terms of our mortgage assets and ourfunding sources will not be identical, thereby creating an interest ratemismatch between assets and liabilities. Therefore, our cost of funds wouldlikely rise or fall more quickly than would our earnings rate on assets. Duringperiods of changing interest rates, such interest rate mismatches couldnegatively impact our financial condition, cash flows and results ofoperations. To mitigate interest rate mismatches, we may utilize hedgingstrategies discussed above.

 

Our analysis of portfoliorisks is based on management’s experience, estimates, quantitative analysis andassumptions. These analyses rely on models, which utilize estimates of fairvalue and interest rate sensitivity. Actual economic conditions orimplementation of investment decisions by our management may produce resultsthat differ significantly from the estimates and assumptions used in our modelsand the projected results reflected herein.

 

**PrepaymentRisk**

 

Prepayments are the fullor partial repayment of principal prior to contractual due dates of a mortgageloan and often occur due to refinancing activity. Prepayment rates for existingRMBS generally increase when prevailing interest rates fall below the marketrate existing when the underlying mortgages were originated. In addition,prepayment rates on adjustable-rate and hybrid adjustable-rate RMBS generallyincrease when the spread between long-term and short-term interest ratesdeclines or becomes negative. Prepayments of RMBS could impact our results ofoperations in several ways. Some adjustable-rate mortgages underlying ouradjustable-rate RMBS may bear initial teaser interest rates that are lower thantheir fully-indexed rates, which refers to the applicable index rates plus aspread. In the event that such an adjustable-rate mortgage is prepaid prior toor soon after the time of adjustment to a fully-indexed rate, the holder of therelated residential mortgage-backed security would have held such securitywhile it was less profitable and lost the opportunity to receive interest atthe fully-indexed rate over the expected life of the adjustable-rateresidential mortgage-backed security. Additionally, we currently own RMBS thatwere purchased at a premium. The prepayment of such RMBS at a rate faster thananticipated would result in a write-off of any remaining unamortized premiumand a corresponding reduction of our net interest income by such amount.

 

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**Effecton Fair Value**

 

Another component ofinterest rate risk is the effect changes in interest rates will have on thefair value of our assets. We face the risk that the fair value of our assetswill increase or decrease at different rates than that of our liabilities,including our hedging instruments.

 

We primarily assess ourinterest rate risk by estimating the duration of our assets and the duration ofour liabilities. Duration essentially measures the market price volatility offinancial instruments as a function of interest rates changes. We calculateduration using various third party financial models and empirical data.Different models and methodologies can produce different duration numbers forthe same securities.

 

The following sensitivityanalysis table shows the impact on the estimated fair value of our RMBSinterest rate-sensitive investments and interest rate swaps as of March 31,2009, assuming rates instantaneously fall 100 basis points and rise100 basis points. The below table excludes the securities held in MarketSquare CLO and DFR MM CLO because these investments are impacted by cash flowsand the terms of their respective indentures, rather than fair values.

 
| ** **                         | ** ** | **Interest Rates**         | ** ** | ** **    | ** ** | **Interest Rates** | ** ** |
|------------------------------------|------------|----------------------------|------------|---------------|------------|--------------------|------------|
| ** **                         | ** ** | **Fall 100**               | ** ** | ** **    | ** ** | **Rise 100**       | ** ** |
| ** **                         | ** ** | **Basis Points**           | ** ** | **Unchanged** | ** ** | **Basis Points**   | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| **RMBS**                           |       |                       |       |          |       |               |       |
| Fair value                         |       | $                          | 343,639    |          | $          | 338,729            |       | $ | 332,342 |   |
| Change in fair  value              |       | $                          | 4,910      |          |       |               | $          | (6,387 | ) |
| Change as a  percent of fair value |       | 1.45                       | %          |          |       | (1.89              | )%         |
| **Interest  Rate Swaps**           |       |                       |       |          |       |               |       |
| Fair value                         |       | $                          | (15,245    | )             | $          | (13,708            | )          | $ | (7,268 | ) |
| Change in fair  value              |       | $                          | (1,537     | )             |       |               | $          | 6,440 |   |
| Change as a  percent of fair value |       | n/m                        |       |          |       | n/m                |       |
| **Net  Portfolio Impact**          |       | $                          | 3,373      |          |       |               | $          | 53 |   |

 

----

n/m — not meaningful

 

The impact of changinginterest rates on fair value can change significantly when interest rateschange beyond 100 basis points from current levels. Therefore, thevolatility in the fair value of our assets could increase significantly wheninterest rate changes exceed 100 basis points. In addition, other factorsimpact the fair value of our interest rate-sensitive investments and hedginginstruments, such as the shape of the yield curve, market expectations as tofuture interest rate changes and other market conditions. Accordingly, in theevent of changes in actual interest rates, the change in the fair value of ourassets would likely differ from that shown above, and such difference might bematerial and adverse to our stockholders.

 

As of March 31,2009, substantially all investments in our alternative investments portfolio(non-RMBS) are instruments with variable interest rates that are indexed toLIBOR. Because the variable rates on these instruments are short term innature, we are not exposed to material changes in fair value as a result ofchanges in interest rates.

 

**Risk Management**

 

We look at investment risk across all of our productsspecifically as it relates to the product’s target returns or asset/liabilitymanagement framework. We believe that in order to achieve long-term investmentperformance consistent with our clients’ expectations, we need an understandingof the investment risks taken, or proposed to be taken, in each portfoliorelative to the corresponding liability and return profile, as well as thoserisks inherent in the increasingly complex global capital markets. Our riskmanagement process emphasizes trading system and data integrity, counterpartycreditworthiness, adherence to investment guidelines and client communication.

 

We employ active risk monitoring for both ourportfolio management and operational activities within the business. Our riskmanagement program seeks to address not only the risks of unexpected portfoliolosses, but also the operational risks that can have major adverse impacts onour business results. Portfolio risks include, for example, potential lossesdue to price volatility, position sizing and leverage. Operational risksinclude, for example, settlement and clearing of transactions, properlyrecording and valuing positions, supervision of traders, counterparty creditmonitoring and approval, custodian reconciliations, trader authorization,accounting and regulatory.

 

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**ITEM4. CONTROLS AND PROCEDURES**

 

**Evaluationof Effectiveness of Disclosure Controls and Procedures**

 

Pursuant to Rule 13a-15(b) underthe Securities Exchange Act of 1934, as amended, the Exchange Act, we carriedout an evaluation, with the participation of our management, including ourChief Executive Officer and our Senior Vice President, Chief Financial Officerand Treasurer, of the effectiveness of our disclosure controls and procedures(as defined under Rule 13a-15(e) under the Exchange Act), as of theend of the period covered by this Quarterly Report. Based upon that evaluation,our Chief Executive Officer and our Senior Vice President, Chief FinancialOfficer and Treasurer concluded that our disclosure controls and procedures areeffective.

 

**Changesin Internal Control Over Financial Reporting**

 

There have been nochanges in our internal control over financial reporting during the threemonths ended March 31, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**InherentLimitations on Effectiveness of Controls**

 

There are inherentlimitations in the effectiveness of any control system, including the potentialfor human error and the circumvention or overriding of the controls andprocedures. Additionally, judgments in decision-making can be faulty andbreakdowns can occur because of simple errors or mistakes. An effective controlsystem can provide only reasonable, not absolute, assurance that the controlobjectives of the system are adequately met. Accordingly, our management,including our Chief Executive Officer and our Senior Vice President, ChiefFinancial Officer and Treasurer do not expect that our control system canprevent or detect all error or fraud. Finally, projections of any evaluation orassessment of effectiveness of a control system to future periods are subjectto the risks that, over time, controls may become inadequate because of changesin an entity’s operating environment or deterioration in the degree ofcompliance with policies or procedures.

 

**PART II.OTHER INFORMATION**

 

**ITEM1A. RISK FACTORS**

 

In addition to the riskfactors disclosed in “*Part I — Item 1A.Risk Factors*” of our Annual Report, set forth in this section areadditional risk factors we believe are applicable to our business.

 

***TheNYSE Amex may delist our securities, which could limit investors’ ability tomake transactions in our securities and subject us to additional tradingrestrictions.***

 

On April 15, 2009,we received a notice from the NYSE Amex that we are not in compliance with Section 1003(a)(i) ofthe Company Guide because we have stockholders’ equity of less than $2,000,000and losses from continuing operations and net losses in two of our three mostrecent fiscal years.  We are required tosubmit a plan of compliance by May 15, 2009 addressing how we intend toregain compliance with Section 1003(a)(i) of the Company Guide withina maximum period of 18 months, or the Plan Period.  The Corporate Compliance Departmentmanagement of the NYSE Amex will evaluate our plan and determine whether wehave reasonably demonstrated that we will be able to regain compliance with theNYSE Amex’s continued listing standards. If the plan is accepted, we will be subject to review during the PlanPeriod.  We intend to submit our plan by May 15,2009.  If we do not submit a plan or ifour plan is not accepted, we will immediately become subject to delistingproceedings.  Additionally, if the planis accepted but we are not in compliance with the continued listing standardsof the Company Guide within the appropriate time periods, or if we do not makeprogress consistent with the plan during the Plan Period, we will becomesubject to delisting proceedings.

 

If the NYSE Amex delistsour securities from trading, we could face significant consequences including:

 

·                  a limited availability for market quotations for our securities;

 

·                  reduced liquidity with respect to our securities;

 

·                  a determination that our common stock is a “penny stock” which wouldrequire brokers trading in our common stock to adhere to more stringent rules andpossible result in a reduced level of trading activity in the secondary tradingmarket for our common stock;

 

·                  limited amount of news and analyst coverage for our company; and

 

·                  a decreased ability to issue additional securities or obtain additionalfinancing in the future.

 

As a result, holders ofour common stock may be unable to sell their shares at a price equal to orgreater than that which such stockholders paid, if at all, and investors couldlose some or all of their investment.

 

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***Pegasusmay not invest the full amount of its capital commitments into DPLC.***

 

Pegasus has committed toinvest $75.0 million in DPLC.  However,that capital commitment is subject to numerous conditions, any or all of whichmay be outside of our control and may not be satisfied.  In the event that Pegasus does not invest thefull amount of its $75.0 million capital commitment, our revenues from DPLC,both in the form of management fees and incentive allocations and in the formof return on our investment in DPLC, are likely to be significantly lower thanexpected, which may adversely affect our financial condition and results ofoperations.  Furthermore, we havecommitted $15.0 million in DPLC, and we may not invest all of such amount ifPegasus does not invest the full amount of its capital commitment.

 

***DPLCmay not perform as anticipated, which may affect future investment advisoryfees and/or the loss of some or all of our investment.***

 

We expect to deriverevenue from DPLC principally from three sources (i) management fees basedon the net asset value of the investment portfolio, (ii) incentiveallocations based on the performance of DPLC and (iii) investment incomefrom our investment in DPLC, which we may not receive until DPLC is liquidatedaccording to its terms.  If economic andmarket conditions are unfavorable, or if we are unsuccessful in selectingappropriate investments for DPLC’s portfolio, DPLC may not perform well.  In the event that DPLC does not perform aswell as we expect, our revenues from DPLC may be significantly lower thanexpected, and we could lose some or all of our direct investment in the DPLC,each of which may adversely affect our financial condition and the value of ourcommon stock. Furthermore, in the event DPLC is not successful, it could besignificantly less likely that we will be able to successfully launch newinvestment products and implement this aspect of our business strategy.

 

**ITEM5. OTHER INFORMATION**

 

The information set forthunder “*Part I – Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations*–*RecentDevelopments*” of this quarterly report on Form 10-Q isincorporated by reference into this Part II – Item 5.

 

***Amendmentto Trutter Employment Agreement***

 

Mr. Trutter’soriginal employment agreement with DCM, dated June 26, 2004,  provides for a retention bonus of $2,000,000,or the Retention Bonus, if Mr. Trutter remains employed by DCM through June 25,2009.  In consideration for Mr. Trutter’sagreement to commit to invest $500,000 in DPLC, DCM agreed to accelerate thevesting of a portion of Mr. Trutter’s Retention Bonus equal to $400,000, aftertaxes, in a letter agreement, dated May 11, 2009, between DCM and Mr. Trutter,or the Trutter Letter Agreement.  Mr.Trutter will receive the $400,000, after taxes, within five days following May11, 2009 and the remainder of his Retention Bonus within five days followingJune 25, 2009.  Mr. Trutter’s originalemployment agreement, or the Original Trutter Agreement, was filed as Exhibit10.1 to our Current Report on Form 8-K filed on December 21, 2007.

 

On May 11, 2009,DCM entered into Amendment No. 1, or the Trutter Amendment, to Mr. Trutter’soriginal employment agreement.  TheTrutter Amendment extends the term of the original employment agreement so thatit expires on December 31, 2010.  It alsoprovides that the terms of the original employment agreement will remain infull force and effect except as modified by the terms of the Trutter Amendment.

 

Under the TrutterAmendment, Mr. Trutter will receive a cash bonus for fiscal 2009 equal to his2008 cash bonus, which was $783,750. Further, Mr. Trutter will receive a cash bonus for fiscal 2010 equal to50% of his 2008 cash bonus, which will equal $391,875.  The Trutter Amendment also provides that inthe event of a “change of control” (as defined in our First Amended and RestatedStock Incentive Plan) during fiscal 2010, Mr. Trutter will receive a bonusequal to 100% of his 2008 cash bonus if he is terminated without “cause” (asdefined in the Trutter Amendment) or if his duties and responsibilities aresubstantially diminished from those in effect as of the date of the TrutterAmendment.  Mr. Trutter’s originalemployment agreement did not provide for a bonus payment upon a change ofcontrol

 

The Trutter Amendmentfurther provides that if Mr. Trutter is terminated without “cause” by theCompany or if he leaves for “good reason” (as defined in the Trutter Amendment)he will be entitled to his retention bonus, as described below, if not alreadypaid, his base salary through December 31, 2010 and the guaranteed bonusesdescribed above for fiscal 2009 and fiscal 2010.  Under his original employment agreement, Mr.Trutter would have received his retention bonus and his base salary andguaranteed bonus for three years following such a termination.

 

 

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The TrutterAmendment also clarifies Mr. Trutter’s non-competition and non-solicitationobligations by defining their geographic scope, revising the non-compete andnon-solicitation period and incorporating the terms of a letter agreementbetween DCM and Mr. Trutter dated April 9, 2009, which was filed as Exhibit10.5 to our Current Report on Form 8-K filed on April 15, 2009.   

 

The foregoingdescription does not purport to be complete and is qualified in its entirety byreference to the Trutter Amendment and the Trutter Letter Agreement, filed asExhibits 10.4 and 10.5 to this Quarterly Report on Form 10-Q, the originalemployment agreement, filed as Exhibit 10.1 to our Current Report on Form 8-Kfiled on December 21, 2007, and the letter agreement, filed as Exhibit 10.5 toour Current Report on Form 8-K filed on April 15, 2009. 

 

***RetentionLetter Agreements***

 

On May 11, 2009,DCM entered into a letter agreement, or the Straub Retention Agreement, withFrancis P. Straub III, providing certain assurances with respect to Mr.Straub’s 2009 compensation for his continued service as an officer of DCM andDFR.  Mr. Straub has served as the ChiefFinancial Officer and a Managing Director of DCM since May 2008 and as ourSenior Vice President, Chief Financial Officer and Treasurer since November2008.  The Straub Retention Agreementprovides that Mr. Straub’s 2009 annual salary will be no less than his 2008annual salary of $350,000.  The StraubRetention Agreement also provides that DCM will pay Mr. Straub a guaranteed2009 cash bonus of $112,500 by March 31, 2010, provided that he remainsemployed by DCM on the date of such payment. If his employment with DCM is terminated without “cause” (as determinedby our compensation committee) prior to the payment of the guaranteed 2009 cashbonus described above, Mr. Straub will receive a cash payment of $150,000 underthe Straub Retention Agreement within ten days of his termination.

 

On May 11, 2009,DCM entered into a letter agreement, or the Contreras Retention Agreement, withRobert A. Contreras, providing certain assurances with respect to Mr.Contreras’ 2009 compensation for his continued service as an officer of DCM andDFR.  Mr. Contreras as served as the GeneralCounsel and a Managing Director of DCM since May 2008 and as our Senior VicePresident, General Counsel and Secretary since November 2008.  The Contreras Retention Agreement providesthat Mr. Contreras’ 2009 annual salary will be no less than his 2008 annualsalary of $200,000.  The ContrerasRetention Agreement also provides that DCM will pay Mr. Contreras a guaranteed2009 cash bonus of $187,500 by March 31, 2010, provided that he remainsemployed by DCM on the date of such payment. If his employment with DCM is terminated without “cause” (as determinedby our compensation committee) prior to the payment of the guaranteed 2009 cashbonus described above, Mr. Contreras will receive a cash payment of $250,000under the Contreras Retention Agreement within ten days of his termination.

 

The foregoing descriptiondoes not purport to be complete and is qualified in its entirety by referenceto the Straub Retention Agreement and the Contreras Retention Agreement, filedas Exhibits 10.2 and 10.3, respectively, to this Quarterly Report.

 

**ITEM6. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 
| **Exhibit No.** | ** ** | **Description  of Exhibit**                                                                                                                                                                                                                                                                                                                                         |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 10.1                 |       | Second Amended  and Restated Forbearance Agreement, dated as of May 8, 2009 by and among  DWFC, LLC and Deerfield TRS (Bahamas) Ltd., as borrowers, Deerfield Capital  LLC, as originator and servicer, Wachovia Bank, National Association, as  swingline purchaser and institutional purchaser, and Wachovia Capital  Markets, LLC, as administrative agent. |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 10.2                 |       | Letter  Agreement, dated May 11, 2009, between Deerfield Capital Management LLC and  Francis P. Straub III.                                                                                                                                                                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 10.3                 |       | Letter  Agreement, dated May 11, 2009, between Deerfield Capital Management LLC and  Robert A. Contreras.                                                                                                                                                                                                                                                           |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 10.4                 |       | Amendment No. 1,  dated as of May 11, 2009, to the Employment Agreement by and between Deerfield  Capital Management LLC and Jonathan W. Trutter, dated as of June 26, 2004.                                                                                                                                                                                        |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 10.5                 |       | Letter  Agreement, dated May 11, 2009, by and between Deerfield Capital Management  LLC and Jonathan W. Trutter.                                                                                                                                                                                                                                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 31.1                 |       | Certification of  Principal Executive Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 31.2                 |       | Certification of  Principal Financial Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                |
| 32.1                 |       | Certification of  Principal Executive Officer and Principal Financial Officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                 |

 

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**SIGNATURES**

 

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

 

 
|                     |   | DEERFIELD  CAPITAL CORP.                                   |
|--------------------------|--------|------------------------------------------------------------|
|                     |   | (Registrant)                                               |
|                     |   |                                                       |
|                     |   |                                                       |
| Date:  May 11, 2009 |   | By: /s/ JONATHAN  W. TRUTTER                               |
|                     |   | Jonathan W.  Trutter, Chief Executive Officer and Director |
|                     |   | (Principal  Executive Officer)                             |
|                     |   |                                                       |
| Date:  May 11, 2009 |   | By: /s/ FRANCIS  P. STRAUB III                             |
|                     |   | Francis P.  Straub III, Senior Vice President,             |
|                     |   | Chief Financial  Officer and Treasurer                     |
|                     |   | (Principal  Financial and Accounting Officer)              |

 

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