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**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****      QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended June 30, 2010**

 

**OR**

 

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

 

**For the transition periodfrom             to             **

 

**Commissionfile number: 1-32551**

 

**DEERFIELDCAPITAL CORP.**

(Exact name of registrant as specified in its charter)

 

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

 

**6250 NorthRiver Road, 12th Floor, Rosemont, Illinois 60018**

**(773) 380-1600**

(Address, including zip code, and telephone number,

including area code, of registrant’s principal executive offices)

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate 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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

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

 

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

 

Therewere 11,000,812 shares of the registrant’s Common Stock outstanding as of August 13,2010.

 

 

 

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**DEERFIELDCAPITAL CORP.**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE QUARTER ENDED JUNE 30, 2010**

 

**INDEX**

 
| ** **                                                                                                     | **Page** |
|----------------------------------------------------------------------------------------------------------------|----------|
|                                                                                                           |     |
| Part I. Financial Information                                                                             |     |
|                                                                                                           |     |
| Item 1.  Condensed Consolidated Financial Statements and Notes (Unaudited)                                | 5        |
|                                                                                                           |     |
| Condensed Consolidated Balance Sheets — June 30,  2010 and December 31, 2009                    | 5        |
|                                                                                                           |     |
| Condensed Consolidated Statements of Operations —  Three and Six Months Ended June 30, 2010 and 2009 | 6        |
|                                                                                                           |     |
| Condensed Consolidated Statement of Stockholders’  Equity — Six Months Ended June 30, 2010      | 7        |
|                                                                                                           |     |
| Condensed Consolidated Statements of Cash Flows — Six  Months Ended June 30, 2010 and 2009           | 8        |
|                                                                                                           |     |
| Notes to Condensed Consolidated Financial Statements                                                           | 9        |
|                                                                                                           |     |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations       | 34       |
|                                                                                                           |     |
| Item 3. Quantitative and Qualitative Disclosures  About Market Risk                                       | 74       |
|                                                                                                           |     |
| Item 4. Controls and Procedures                                                                           | 77       |
|                                                                                                           |     |
| Part II. Other Information                                                                                |     |
|                                                                                                           |     |
| Item 1A.  Risk Factors                                                                                    | 77       |
|                                                                                                           |     |
| Item 6. Exhibits                                                                                          | 78       |
|                                                                                                           |     |
| Signatures                                                                                                     | 79       |

 

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**CERTAIN DEFINITIONS**

 

Unless otherwise noted or the context otherwise requires, we refer toDeerfield Capital Corp. as “DFR,” to DFR and its subsidiaries as “we,” “us,” “our”or “our company,” to Deerfield & Company LLC, one of our indirectwholly-owned subsidiaries, as “Deerfield” and to Deerfield CapitalManagement LLC, another of our indirect wholly-owned subsidiaries, as “DCM.”

 

**SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Certain statements in this Quarterly Report on Form 10-Q (the “QuarterlyReport”) and the information incorporated by reference into this QuarterlyReport are forward-looking as permitted by the Private Securities LitigationReform Act of 1995. These include statements regarding future results orexpectations. Forward-looking statements can be identified by forward-lookinglanguage, including words such as “believes,” “anticipates,” “expects,” “estimates,”“intends,” “may,” “plans,” “projects,” “will” and similar expressions, or thenegative of these words. Such forward-looking statements are based on facts andconditions as they exist at the time such statements are made. Forward-lookingstatements are also based on predictions as to future facts and conditions, theaccurate prediction of which may be difficult and involve the assessment ofevents beyond our control. Forward-looking statements are further based onvarious operating assumptions. Caution must be exercised in relying onforward-looking statements. Due to known and unknown risks, actual results maydiffer materially from expectations or projections. Forward-looking statementscontained in this Quarterly Report are made as of the date hereof, and we donot undertake any obligation to update any forward-looking statement to reflectsubsequent events, new information or circumstances arising after the date ofthis Quarterly Report. 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 todiffer materially from those described in the forward-looking statements:

 

·                  general economic and marketconditions, particularly as they relate to the markets for debt securities,such as RMBS and CDOs

 

·                  continued availability offinancing and our ability to access capital markets on commercially reasonableterms;

 

·                  our ability to maintainadequate liquidity;

 

·                  our ability to maintaincompliance with our existing debt instruments and other contractualobligations;

 

·                  impact of restrictionscontained in our existing debt instruments;

 

·                  our future operatingresults;

 

·                  our business prospects andthe business prospects of companies in which we invest;

 

·                  changes in our investment,hedging or credit strategies or the performance and values of our investmentportfolios;

 

·                  reductions in our assetsunder management and related management and advisory fee revenue;

 

·                  our ability to makeinvestments in new investment products and realize growth of fee-based income;

 

·                  our receipt of previouslydeferred CLO subordinated management fees and receipt of future CLOsubordinated management fees on a current basis;

 

·                  our ability to assume orotherwise acquire additional CDO management contracts on favorable terms, or atall;

 

·                  Our ability to maintain ourexemption from registration as an investment company pursuant to the InvestmentCompany Act of 1940;

 

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·                  the costs and effects of thecurrent SEC investigation into certain of our mortgage securities tradingprocedures, and the accounting related thereto, in connection with which DFRhas received a “Wells notice” from the staff of the SEC;

 

·                  changes in, and our abilityto remain in compliance with laws, regulations or government policies affectingour business, including investment management regulations and accountingstandards;

 

·                  our failure to realize theexpected benefits of the****transactionswith Columbus Nova Credit Investments Management, LLC;

 

·                  Other risks described in Part I—Item1A, “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31,2009, and from time to time in our other filings with the Securities andExchange Commission.

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 
| ** **                                                                                                                                              | ** ** | **June 30,**               | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                              | ** ** | **2010**                        | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                              | ** ** | **(In thousands, except share** | ** ** |
| ** **                                                                                                                                              | ** ** | **and per share amounts)**      | ** ** |
| **ASSETS**                                                                                                                                              | ** ** | ** **                      | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                               |       | $                               | 42,963     |                  | $          | 48,711 |   |
| Due from broker                                                                                                                                         |       | 27,489                          |       | 14,606                |       |
| Restricted cash and cash equivalents                                                                                                                    |       | 10,456                          |       | 19,296                |       |
| Investments at fair value, including $293,293 and  $303,763 pledged                                                                                     |       | 319,717                         |       | 326,810               |       |
| Other investments                                                                                                                                       |       | 1,412                           |       | 4,287                 |       |
| Derivative assets                                                                                                                                       |       | 29                              |       | 74                    |       |
| Loans held for sale                                                                                                                                     |       | 109                             |       | 536                   |       |
| Loans held for investment                                                                                                                               |       | 281,582                         |       | 278,585               |       |
| Allowance for loan losses                                                                                                                               |       | (13,055                         | )          | (15,889               | )          |
| Loans held for investment, net of allowance for  loan losses                                                                                            |       | 268,527                         |       | 262,696               |       |
| Investment advisory fee receivables                                                                                                                     |       | 1,226                           |       | 2,117                 |       |
| Interest receivable                                                                                                                                     |       | 3,786                           |       | 3,420                 |       |
| Other receivables                                                                                                                                       |       | 4,502                           |       | 2,890                 |       |
| Prepaid and other assets                                                                                                                                |       | 7,851                           |       | 7,043                 |       |
| Equipment and improvements, net                                                                                                                         |       | 1,857                           |       | 6,505                 |       |
| Intangible assets, net                                                                                                                                  |       | 29,398                          |       | 21,231                |       |
| Goodwill                                                                                                                                                |       | 10,410                          |       |                  |       |
| Assets held in Consolidated Investment Products:                                                                                                        |       |                            |       |                  |       |
| Due from broker                                                                                                                                         |       | 22,252                          |       | —                |       |
| Restricted cash and cash equivalents                                                                                                                    |       | 141,746                         |       | —                |       |
| Investments at fair value                                                                                                                               |       | 3,781,592                       |       | —                |       |
| Derivative assets                                                                                                                                       |       | 27                              |       | —                |       |
| Interest receivable                                                                                                                                     |       | 13,627                          |       | —                |       |
| Other receivable                                                                                                                                        |       | 2,726                           |       | —                |       |
| Total assets held in Consolidated Investment  Products                                                                                                  |       | 3,961,970                       |       | —                |       |
| TOTAL ASSETS                                                                                                                                            |       | $                               | 4,691,702  |                  | $          | 720,222 |   |
|                                                                                                                                                    |       |                            |       |                  |       |
| **LIABILITIES**                                                                                                                                         | ** ** | ** **                      |       |                  |       |
| Repurchase agreements                                                                                                                                   |       | $                               | 282,246    |                  | $          | 291,463 |   |
| Due to broker                                                                                                                                           |       | 38,343                          |       | 803                   |       |
| Derivative liabilities                                                                                                                                  |       | 10,381                          |       | 450                   |       |
| Interest payable                                                                                                                                        |       | 922                             |       | 1,103                 |       |
| Accrued and other liabilities                                                                                                                           |       | 16,276                          |       | 6,214                 |       |
| Long term debt                                                                                                                                          |       | 354,593                         |       | 413,329               |       |
| Liabilities held in Consolidated Investment  Products:                                                                                                  |       |                            |       |                  |       |
| Due to broker                                                                                                                                           |       | 48,979                          |       | —                |       |
| Derivative liabilities                                                                                                                                  |       | 5,709                           |       | —                |       |
| Interest payable                                                                                                                                        |       | 5,673                           |       | —                |       |
| Long term debt                                                                                                                                          |       | 3,494,410                       |       | —                |       |
| Total liabilities held in Consolidated Investment  Products                                                                                             |       | 3,554,771                       |       | —                |       |
| TOTAL LIABILITIES                                                                                                                                       |       | 4,257,532                       |       | 713,362               |       |
|                                                                                                                                                    |       |                            |       |                  |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                           | ** ** | ** **                      |       |                  |       |
| 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; 11,000,812 and 6,455,357 shares issued and 11,000,812  and 6,454,924 shares outstanding |       | 11                              |       | 6                     |       |
| Additional paid-in capital                                                                                                                              |       | 886,890                         |       | 866,557               |       |
| Accumulated other comprehensive loss                                                                                                                    |       | (110                            | )          | (87                   | )          |
| Accumulated deficit                                                                                                                                     |       | (859,435                        | )          | (877,155              | )          |
| Appropriated retained earnings of Consolidated  Investment Products                                                                                     |       | 401,722                         |       | —                |       |
| Noncontrolling interest in consolidated entity                                                                                                          |       | 5,092                           |       | 17,539                |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                                                         |       | 434,170                         |       | 6,860                 |       |
|                                                                                                                                                    |       |                            |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                         |       | $                               | 4,691,702  |                  | $          | 720,222 |   |

 

See notes to condensedconsolidated financial statements.

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                                             | ** ** | **Three months ended June 30,**                   | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                             | ** ** | **2010**                                               | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                             | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| **Revenues**                                                                           | ** ** | ** **                                             | ** ** | ** **                         | ** ** | ** ** |   |   |   |
| Interest income                                                                        |       | $                                                      | 37,183     |                               | $          | 14,098 |   | $ | 68,685 |   | $ | 27,880 |   |
| Interest expense                                                                       |       | 8,272                                                  |       | 5,666                              |       | 15,966 |   | 12,665 |   |
| Net interest income                                                                    |       | 28,911                                                 |       | 8,432                              |       | 52,719 |   | 15,215 |   |
| Provision for loan losses                                                              |       | 291                                                    |       | 9,119                              |       | 4,477 |   | 11,226 |   |
| Net interest income (expense) after provision for  loan losses                         |       | 28,620                                                 |       | (687                               | )          | 48,242 |   | 3,989 |   |
| Investment advisory fees                                                               |       | 3,782                                                  |       | 4,009                              |       | 6,678 |   | 8,746 |   |
| Total net revenues                                                                     |       | 32,402                                                 |       | 3,322                              |       | 54,920 |   | 12,735 |   |
|                                                                                   |       |                                                   |       |                               |       |   |   |   |   |
| **Expenses**                                                                           | ** ** | ** **                                             | ** ** | ** **                         | ** ** | ** ** |   |   |   |
| Compensation and benefits                                                              |       | 3,077                                                  |       | 3,029                              |       | 5,918 |   | 6,383 |   |
| Professional services                                                                  |       | 2,096                                                  |       | 728                                |       | 2,920 |   | 1,518 |   |
| Insurance expense                                                                      |       | 752                                                    |       | 771                                |       | 1,444 |   | 1,535 |   |
| Other general and administrative expenses                                              |       | 1,693                                                  |       | 4,814                              |       | 3,604 |   | 5,760 |   |
| Depreciation and amortization                                                          |       | 3,025                                                  |       | 1,629                              |       | 8,763 |   | 3,264 |   |
| Occupancy                                                                              |       | 386                                                    |       | 569                                |       | 876 |   | 1,208 |   |
| Management and incentive fee expense to related  party                                 |       | —                                                 |       | 295                                |       | — |   | 295 |   |
| Cost savings initiatives                                                               |       | —                                                 |       | 28                                 |       | — |   | 225 |   |
| Impairment of intangible assets                                                        |       | —                                                 |       | 126                                |       | 168 |   | 126 |   |
| Total expenses                                                                         |       | 11,029                                                 |       | 11,989                             |       | 23,693 |   | 20,314 |   |
|                                                                                   |       |                                                   |       |                               |       |   |   |   |   |
| **Other Income (Expense) and Gain  (Loss)**                                            | ** ** | ** **                                             |       |                               | ** ** | ** ** |   |   |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities                    |       | (27,925                                                | )          | 29,030                             |       | (40,661 | ) | 39,548 |   |
| Strategic transactions expenses                                                        |       | (2,558                                                 | )          | —                             |       | (4,022 | ) | — |   |
| Net gain on the discharge of the Senior Notes                                          |       | 17,418                                                 |       | —                             |       | 17,418 |   | — |   |
| Net gain on the deconsolidation of Market Square  CLO                                  |       | —                                                 |       | 29,551                             |       | — |   | 29,551 |   |
| Other, net                                                                             |       | (920                                                   | )          | 152                                |       | 126 |   | 103 |   |
| Net other income (expense) and gain (loss)                                             |       | (13,985                                                | )          | 58,733                             |       | (27,139 | ) | 69,202 |   |
| Income before income tax expense                                                       |       | 7,388                                                  |       | 50,066                             |       | 4,088 |   | 61,623 |   |
| Income tax expense                                                                     |       | 2                                                      |       | 160                                |       | 2 |   | 178 |   |
|                                                                                   |       |                                                   |       |                               |       |   |   |   |   |
| **Net income**                                                                         |       | 7,386                                                  |       | 49,906                             |       | 4,086 |   | 61,445 |   |
| Net loss attributable to noncontrolling interest  and Consolidated Investment Products |       | 10,471                                                 |       | 2,960                              |       | 13,634 |   | 2,960 |   |
| **Net income attributable to  Deerfield Capital Corp.**                                |       | $                                                      | 17,857     |                               | $          | 52,866 |   | $ | 17,720 |   | $ | 64,405 |   |
|                                                                                   |       |                                                   |       |                               |       |   |   |   |   |
| **Net income attributable to  Deerfield Capital Corp.****per  share - basic**          |       | $                                                      | 2.26       | ** **                         | $          | 7.85 |   | $ | 2.42 |   | $ | 9.59 |   |
| **Net income attributable to Deerfield  Capital Corp.****per share -  diluted**        |       | $                                                      | 2.25       | ** **                         | $          | 7.85 |   | $ | 2.41 |   | $ | 9.59 |   |
|                                                                                   |       |                                                   |       |                               |       |   |   |   |   |
| WEIGHTED-AVERAGE NUMBER OF SHARES OUTSTANDING -  BASIC                                 |       | 7,883,912                                              |       | 6,730,655                          |       | 7,326,601 |   | 6,716,570 |   |
| WEIGHTED-AVERAGE NUMBER OF SHARES OUTSTANDING -  DILUTED                               |       | 7,944,180                                              |       | 6,730,655                          |       | 7,360,420 |   | 6,716,570 |   |

 

See notes to condensedconsolidated financial statements.

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY(UNAUDITED)**

 
| ** **                                                                                                        | ** ** | **Deerfield  Capital Corp. Stockholders** | ** ** | ** **     | ** ** | ** **  | ** ** | ** **        | ** ** | ** **           | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|----------------|------------|-------------|------------|-------------------|------------|----------------------|------------|
| ** **                                                                                                        | ** ** | ** **                                | ** ** | ** **     | ** ** | ** **  | ** ** | ** **        | ** ** | ** **           | ** ** | **Appropriated** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                        | ** ** | ** **                                | ** ** | ** **     | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** **           | ** ** | **retained  earnings** | ** ** | **Noncontrolling** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                        | ** ** | **Common  Stock**                         | ** ** | **Additional** | ** ** | **Other**   | ** ** | ** **        | ** ** | **of  Consolidated** | ** ** | **Interest  in** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                        | ** ** | ** **                                | ** ** | **Par**        | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**      | ** ** | **Investment** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                        | ** ** | **Shares**                                | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Loss**          | ** ** | **Deficit**          | ** ** | **Products** | ** ** | **Entity** | ** ** | **Total** | ** ** | **Income** | ** ** |
| ** **                                                                                                        | ** ** | **(In  thousands)**                       | ** ** |
| **Balance - January 1, 2010**                                                                                |       | 6,455                                     |       | $              | 6          |        | $          | 866,557           |       | $                    | (87        | ) | $ | (877,155 | ) | $ | — |   | $ | 17,539 |   | $ | 6,860 |   |   |   |
| Cumulative  effect adjustment from the adoption of the amendments to ASC Topic 810                                |       |                                      |       |           |       |        |       |              |       |                 |       | 244,865 |   |   |   | 244,865 |   |   |   |
| Net  income (loss)                                                                                                |       |                                      |       |           |       |        |       |              |       | 17,720               |       | (14,157 | ) | 523 |   | 4,086 |   | $ | 4,086 |   |
| Adoption  of the amendments to ASC Topic 810 for the Consolidated Investment Products  acquired during the period |       |                                      |       |           |       |        |       |              |       |                 |       | 186,007 |   |   |   | 186,007 |   |   |   |
| Distributions  to investors in Consolidated Investment Products                                                   |       |                                      |       |           |       |        |       |              |       |                 |       | (14,993 | ) |   |   | (14,993 | ) |   |   |
| Distributions  to DPLC noncontrolling interest                                                                    |       |                                      |       |           |       |        |       |              |       |                 |       |   |   | (12,970 | ) | (12,970 | ) |   |   |
| Issaunce  of common stock, net of issuance costs                                                                  |       | 4,545                                     |       | 5              |       | 19,395      |       |              |       |                 |       |   |   |   |   | 19,400 |   |   |   |
| Previously  designated derivatives - amortization of net loss                                                     |       |                                      |       |           |       |        |       | 31                |       |                 |       |   |   |   |   | 31 |   | 31 |   |
| Foreign  currency translation loss                                                                                |       |                                      |       |           |       |        |       | (54               | )          |                 |       |   |   |   |   | (54 | ) | (54 | ) |
| Issuance  of stock warrants                                                                                       |       |                                      |       |           |       | 529         |       |              |       |                 |       |   |   |   |   | 529 |   |   |   |
| Share-based  compensation                                                                                         |       |                                      |       |           |       | 409         |       |              |       |                 |       |   |   |   |   | 409 |   |   |   |
| **Balance - June 30, 2010**                                                                                  |       | 11,000                                    |       | $              | 11         |        | $          | 886,890           |       | $                    | (110       | ) | $ | (859,435 | ) | $ | 401,722 |   | $ | 5,092 |   | $ | 434,170 |   | $ | 4,063 |   |

 

See notes to condensedconsolidated financial statements.

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

 
| ** **                                                                                       | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                       | ** ** | **2010**                           | ** ** | **2009** | ** ** |
| ** **                                                                                       | ** ** | **(In thousands)**                 | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                                       | ** ** | ** **                         |       |   |   |
| Net income                                                                                       |       | $                                  | 4,086      |   | $ | 61,445 |   |
| **Adjustments to reconcile net  income to net cash provided by (used in) operating activities:** |       |                               |       |   |   |
| Net premium and discount amortization on  investments, loans and debt issuance costs             |       | 1,681                              |       | (444 | ) |
| Share-based compensation                                                                         |       | 409                                |       | 297 |   |
| Issuance of stock warrants                                                                       |       | 529                                |       | — |   |
| Net purchases of investments at fair value                                                       |       | (45,182                            | )          | (7,430 | ) |
| Net gain from investments at fair value                                                          |       | (29,281                            | )          | (6,311 | ) |
| Net loss on liabilties at fair value                                                             |       | 73,054                             |       | — |   |
| Net gain on the deconsolidation of Market Square  CLO                                            |       | —                             |       | (29,551 | ) |
| Other-than-temporary impairment on  available-for-sale securities                                |       | —                             |       | 31 |   |
| Net other losses                                                                                 |       | 1,220                              |       | — |   |
| Net sales of loans held for sale                                                                 |       | —                             |       | (866 | ) |
| Net gain on loans                                                                                |       | (6,991                             | )          | (30,691 | ) |
| Provision for loan losses                                                                        |       | 4,477                              |       | 11,226 |   |
| Net gain on the discharge of the Senior Notes                                                    |       | (17,418                            | )          | — |   |
| Net changes in undesignated derivatives                                                          |       | (1,056                             | )          | (12,767 | ) |
| Amortization of net loss on previously designated  derivatives                                   |       | 31                                 |       | 95 |   |
| Depreciation and amortization                                                                    |       | 8,763                              |       | 3,264 |   |
| Impairment of intangible assets                                                                  |       | 168                                |       | 126 |   |
| Non-cash rental expense                                                                          |       | (243                               | )          | 77 |   |
| Provision for income taxes                                                                       |       | 2                                  |       | 28 |   |
| **Changes in operating assets and  liabilities:**                                                |       |                               |       |   |   |
| Due from broker                                                                                  |       | (16,540                            | )          | 11,152 |   |
| Interest receivable                                                                              |       | 271                                |       | (112 | ) |
| Other receivable                                                                                 |       | (3,968                             | )          | 4,230 |   |
| Prepaid and other assets                                                                         |       | (124                               | )          | (66 | ) |
| Accrued interest on repurchase agreements                                                        |       | (12                                | )          | (324 | ) |
| Due to broker                                                                                    |       | 25,812                             |       | 547 |   |
| Interest payable                                                                                 |       | 1,061                              |       | (3,945 | ) |
| Accrued and other liabilities                                                                    |       | 982                                |       | (10,912 | ) |
| **Net cash provided (used in) by  operating activities**                                         |       | 1,731                              |       | (10,901 | ) |
|                                                                                             |       |                               |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                                       |       |                               |       |   |   |
| Change in restricted cash and cash equivalents                                                   |       | 39,230                             |       | 43,996 |   |
| Proceeds from the sale of investments at fair  value previously classified as available-for-sale |       | 103,124                            |       | 12,779 |   |
| Principal receipts on investments at fair value  previously classified as available-for-sale     |       | 19,381                             |       | 30,514 |   |
| Origination and purchase of loans held for  investment                                           |       | (86,222                            | )          | (78,992 | ) |
| Principal receipts on loans held for investment                                                  |       | 59,785                             |       | 13,843 |   |
| Proceeds from sale of loans held for investment                                                  |       | 23,238                             |       | 12,390 |   |
| Principal receipts on loans held for sale  previously classified as held for investment          |       | 6,874                              |       | 11,960 |   |
| Proceeds from sale of loans held for sale  previously classified as held for investment          |       | 24                                 |       | — |   |
| Proceeds from sale of other investments                                                          |       | 2                                  |       | — |   |
| Net cash aquired from the CNCIM Acquisition                                                      |       | 2,470                              |       | — |   |
| (Purchases) sales of equipment and improvements                                                  |       | (1,237                             | )          | 7 |   |
| **Net cash provided by investing  activities**                                                   |       | 166,669                            |       | 46,497 |   |
|                                                                                             |       |                               |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                                       |       |                               |       |   |   |
| Net payments under repurchase agreements                                                         |       | (9,206                             | )          | (31,317 | ) |
| Proceeds from issuance of long term debt                                                         |       | 25,000                             |       | — |   |
| Payments made on Wachovia Facility                                                               |       | —                             |       | (13,161 | ) |
| Payments made on long term debt                                                                  |       | (160,888                           | )          | (2,136 | ) |
| Payment of stock and debt issuance costs                                                         |       | (1,044                             | )          | (136 | ) |
| Contributions from noncontrolling interest                                                       |       | —                             |       | 20,133 |   |
| Distributions to noncontrolling interest and  investors in Consolidated Investment Products      |       | (27,963                            | )          | — |   |
| **Net cash used in financing  activities**                                                       |       | (174,101                           | )          | (26,617 | ) |
|                                                                                             |       |                               |       |   |   |
| Foreign currency translation                                                                     |       | (47                                | )          | 76 |   |
| Net increase (decrease) in cash and cash  equivalents                                            |       | (5,748                             | )          | 9,055 |   |
| Cash and cash equivalents at beginning of period                                                 |       | 48,711                             |       | 32,791 |   |
| **Cash and cash equivalents at end  of period**                                                  |       | $                                  | 42,963     |   | $ | 41,846 |   |
|                                                                                             |       |                               |       |   |   |
| **SUPPLEMENTAL DISCLOSURE:**                                                                     |       |                               |       |   |   |
| Cash paid for interest                                                                           |       | $                                  | 14,403     |   | $ | 15,425 |   |
| Cash paid for income taxes                                                                       |       | 16                                 |       | 27 |   |

 

See notes to condensedconsolidated financial statements.

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.ORGANIZATION**

 

Deerfield Capital Corp., a Maryland corporation (“DFR” and, togetherwith its subsidiaries, “us,” “we” or “our”), through its wholly-ownedsubsidiary, Deerfield Capital Management LLC (“DCM”), manages client assets,including bank loans and other corporate debt, residential mortgage-backedsecurities (“RMBS”), government securities and asset-backed securities (“ABS”).In addition, we have a Principal Investing segment with an investment portfolioprimarily comprised of fixed income investments, including bank loans and othercorporate debt and RMBS.

 

On March 22, 2010, we entered into an Acquisition and InvestmentAgreement (the “Acquisition Agreement”)with Bounty Investments, LLC (“Bounty”) and Columbus Nova Credit InvestmentsManagement, LLC (“CNCIM”), pursuant to which we agreed to acquire all of theoutstanding equity interests of CNCIM from Bounty (the “CNCIM Acquisition”).  The CNCIM Acquisition was completed on June 9,2010.  CNCIM is an investment managerspecializing in bank loans that currently manages four collateralized debtobligations (the “CNCIM CDOs”).  See Note3 for additional information regarding the CNCIM Acquisition and associatedtransactions.

 

***Business Segments***

 

We operate in three business segments:

 

*Investment Management*— We manage assets within avariety of investment vehicles, including collateralized debt obligations (“CDOs”),separately managed accounts and other investment vehicles and earn investmentadvisory fees (primarily management fees) for providing our services. Wespecialize in managing fixed income investments, including corporate debt,RMBS, government securities and ABS. Unless otherwise noted or the contextotherwise requires, references to DCM’s investment management activitiesinclude the activities of CNCIM.

 

*Principal Investing*— We manage our own assets,which are comprised primarily of fixed income investments, including bank loansand other corporate debt and RMBS. Income from this business segment isinfluenced by four factors: (i) the difference between the interest incomewe earn on our investment portfolio and the cost of our borrowings net ofhedges, if any, (ii) the net recognized gains and losses, if any, on ourinvestment portfolio, (iii) provision for loan losses, if any, and(iv) the volume or aggregate amount of such investments. We refer to investmentsin senior secured loans (first lien and second lien term loans), seniorsubordinated debt facilities and other junior securities as “Corporate Loans.”We consolidate Deerfield Pegasus Loan Capital LP (“DPLC”), DPLC General PartnerLLC (“DPLC GP”) and DFR Middle Market CLO Ltd. (“DFR MM CLO”) into ourPrincipal Investing segment.

 

*ConsolidatedInvestment Products—*We provide investment management services tocertain CDOs that we are required to consolidate as Variable Interest Entities(“VIEs”). In accordance with consolidation guidance in the Financial AccountingStandards Board (“FASB”) Accounting Standards Codification (“Codification”)Topic 810—*Consolidation* (“ASCTopic 810”), as amended by Accounting Standards Update (“ASU”) 2009-17 (“ASU2009-17”), effective January 1, 2010 we consolidated seven CDOs into ourConsolidated Investment Products segment. In conjunction with the CNCIMAcquisition, effective June 9, 2010, we also consolidated the four CNCIMCDOs into this segment in accordance with ASC Topic 810 (which, along with theseven CDOs we previously consolidated, we refer to as the “CIP CDOs”). We earncontractually-negotiated management fees for providing services to the CIPCDOs. Management fees vary by contract and performance, but typically includesenior fees, subordinated fees and incentive fees.  Our Consolidated Investment Products segmentwas established on January 1, 2010, and we have elected the fair valueoption for all assets and liabilities of the CIP CDOs.

 

**2.ACCOUNTING POLICIES AND RECENT ACCOUNTING UPDATES**

 

*Basis of Presentation*—The accompanying unauditedcondensed consolidated financial statements have been prepared by us inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”) for interim financial information and are in the formprescribed by the Securities and Exchange Commission (the “SEC”) pursuant toRegulation S-X and the instructions to Form 10-Q. Accordingly, we donot include all of the information and footnotes for complete financialstatements as required by GAAP. The interim unaudited condensed consolidatedfinancial statements should be read in conjunction with our audited financialstatements as of and for the year ended December 31, 2009, which areincluded in our Annual Report on Form 10-K filed with SEC onMarch 23, 2010 (our “2009 10-K”). In the opinion of our management, alladjustments, consisting of only normal recurring accruals, necessary for a fairpresentation of our financial position, results of operations and cash flowshave been included. The nature of our business is such that the results of anyinterim period information are not necessarily indicative of results for a fullyear. All intercompany balances and transactions have been eliminated uponconsolidation.

 

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*Principles of Consolidation*—The condensedconsolidated financial statements include the financial statements of DFR andour subsidiaries which are (i) wholly-owned subsidiaries,(ii) subsidiaries in which DFR has a controlling interest under theconsolidation guidance in ASC Topic 810 and (iii) entities that are VIEswith respect to which we are the primary beneficiary under ASC Topic 810.

 

As of June 30, 2010, we consolidate DFR MM CLO into our PrincipalInvesting segment as we own all of its preference shares. Although weconsolidate 100% of the assets and liabilities of DFR MM CLO, our maximumexposure to loss on our investment in this entity is limited to our initialinvestment of $69.0 million ($50.0 million of preference shares and $19.0million of debt). The debt holders of DFR MM CLO have recourse only to theassets of the DFR MM CLO and not to our general assets. The economic impact ofour investment in DFR MM CLO is determined by the cash flows distributed to uson our investment therein. Our preference shares investment is subject todiversion of cash flows in accordance with the DFR MM CLO indenture. For thethree and six months ended June 30, 2010, the net income of $7.4 millionand $10.6 million, respectively, recorded in our condensed consolidatedstatements of operations for DFR MM CLO was not indicative of the cash flowdistributions of $4.1 million and $7.9 million for the three and six monthsended June 30, 2010, respectively. These cash distributions included $3.9million and $7.5 million related to our investment in the preference shares forthe three and six months ended June 30, 2010, respectively, and $0.2million and $0.4 million in interest on our investment in debt for the threeand six months ended June 30, 2010, respectively. We have not received andwill not receive a cash distribution related to our investment in thepreference shares in the third quarter of 2010. While we expect to receivefuture cash flows from this investment in the preference shares, it is verydifficult to predict the timing and amount of such future cash flows. Weconsolidated assets of $285.5 million and liabilities of$217.8 million related to DFR MM CLO as of June 30, 2010.

 

Wealso consolidated Market Square CLO Ltd. (“Market Square CLO”) into ourPrincipal Investing segment for the three and six months ended June 30,2009 as we owned all of its preference shares during those periods. OnJune 30, 2009, we sold all of our preference shares in Market Square CLOto an unrelated third party in exchange for an upfront payment and a delayedpurchase price in the form of a right to receive a portion of the future distributions,if any, on the preference shares.  As a result of the sale, wedeconsolidated Market Square CLO as of June 30, 2009.  We are,however, deemed to retain a beneficial interest in the preference shares ofMarket Square CLO as a result of the delayed purchase price.  The carryingvalue of the beneficial interest was $4.4 million as of June 30,2010.  As of January 1, 2010, however, the amendments to ASC Topic810 required us to again consolidate Market Square CLO, and it is now part ofour Consolidated Investment Products segment.

 

For the three and six months ended June 30, 2010 and 2009, weconsolidated DPLC into our Principal Investing segment as a result of ourcontrol of DPLC GP, the general partner of DPLC. Effective March 31,2010, we withdrew the entire portion of our capital account attributable to ourinvestment in DPLC GP.  See Notes 3and 14 for details related to the warrants we issued in connection withthe formation of DPLC and in connection with the restructuring of DPLC. The netincome attributable to DFR in our condensed consolidated statements ofoperations excludes the net loss attributable to the noncontrolling interest inDPLC. We consolidated assets of $4.0 million and liabilities of$0.1 million related to DPLC as of June 30, 2010.

 

*Reclassifications* — Certain amounts in thecondensed consolidated statements of operations for the three and six monthsended June 30, 2009 have been reclassified to conform to the presentationfor the three and six months ended June 30, 2010.  Net loss on available-for-sale securities,net gain (loss) on investments at fair value, net gain (loss) on liabilities atfair value, net gain on loans and net gain (loss) on derivatives are presentedas a combined net gain (loss) on investments, loans, derivatives andliabilities line item in the current quarter condensed consolidated statementsof operations.   In addition, strategictransactions expenses of $1.5 million, which were included in professionalservices during the three months ended March 31, 2010, are included as aseparate line item in the current quarter condensed consolidated statements ofoperations.

 

*Variable Interest Entities*—ASC Topic 810generally requires the consolidation of the assets, liabilities and results ofoperations of a VIE into the financial statements of the enterprise that has acontrolling financial interest in the VIE. ASC Topic 810 provides a frameworkfor determining whether an entity should be considered a VIE and evaluated forconsolidation. Pursuant to this framework, we consider all parties to determinewhether the entity is a VIE and, if so, whether our involvement with the entityresults in a variable interest in the entity. If we determine that we do have avariable interest in the entity, we perform an analysis to determine whether weare the primary beneficiary. If we determine that we are the primary beneficiary,we consolidate the VIE into our consolidated financial statements. Under ASCTopic 810, a company is the primary beneficiary of a VIE if it has a controllingfinancial interest in the VIE.  A companyis deemed to have a controlling financial interest in a VIE if it has both(i) the power to direct the activities of the VIE that most significantlyimpact the VIE’s economic performance and (ii) the obligation to absorbthe losses of the VIE that could potentially be significant to the VIE or theright to receive benefits from the VIE that could potentially be significant tothe VIE. See Note 4 for our analysis of the entities we consolidated as VIEsunder ASC Topic 810.

 

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Other than DFR MM CLO, we have a variable interest in each of the CDOswe manage due to the provisions of the management agreements relating to thoseCDOs. As of June 30, 2010, we had direct investments in certain of thoseCDOs, which represent a small portion of the total debt and equity issued bythe CDOs. We generally invest only in the unrated, junior subordinated tranchesof the CDOs that we manage. These investments, which we refer to herein as “preferenceshares,” can take the form of subordinated notes or preference shares.Beginning January 1, 2010, we consolidated the CIP CDOs into our ConsolidatedInvestment Products segment. There have been no changes to the terms of ourmanagement contracts with the CIP CDOs, the revenues we are contractuallyentitled to receive from the CIP CDOs or our exposure to liability with respectto the CIP CDOs. Although we consolidate 100% of the assets, liabilities andequity of the CIP CDOs, our maximum exposure to loss related to the CIP CDOs islimited to $2.3 million, consisting of $0.8 million of preference shares and$1.5 million of CDO debt that we own, and our management fees, which are earnedover the life of the CIP CDOs. The debt holders of the CIP CDOs have recourseonly to the assets of the respective CDO and not to our general assets.

 

As of June 30, 2010, we have a variable interest in 19 additionalCDOs that are not consolidated as part of our Consolidated Investment Productssegment as we have determined we are not the primary beneficiary of these VIEs.Our maximum exposure to loss associated with nonconsolidated CDOs is limited toany future management fees associated with the CDOs. As of June 30, 2010,we have recorded management fee receivables of $1.0 million collectively fromthe unconsolidated CDOs. See Note 4 for additional discussion of ourConsolidated Investment Products.

 

*Significant Accounting Policies*— Oursignificant accounting policies are discussed in the Notes to the ConsolidatedFinancial Statements included in our 2009 10-K.

 

***Recent Accounting Updates***

 

In June 2009, the FASB issued SFAS No. 167, *Amendments to FASB Interpretation No. 46(R) *(“SFASNo. 167”). In December 2009, the FASB issued ASU 2009-17 to revisethe Codification to include SFAS No. 167 within ASC Topic 810. InFebruary 2010, the FASB issued ASU 2010-10, *Amendments for Certain Investment Funds*(“ASU 2010-10”), to defer theeffective date of the amendments to the consolidation requirements of ASC Topic810 resulting from the issuance of ASU 2009-17 for reporting entities withinterests in entities with all the attributes of an investment company butspecifically excluding interests in securitization entities. This statementrequires an enterprise to perform an analysis to determine whether theenterprise’s variable interest or interests give it a controlling financialinterest in a VIE. The amendments to ASC Topic 810 also amendFIN 46(R) to eliminate the quantitative approach to determining theprimary beneficiary of a VIE and require ongoing reassessments of VIE status.We adopted the amendments to ASC Topic 810 on January 1, 2010 and createdour Consolidated Investment Products segment. See further disclosure related toour Consolidated Investment Products segment in Note 4.

 

In January 2010, the FASB issued ASU No. 2010-06—*Fair Value Measurements and Disclosure (“ASC Topic820”)—Improving Disclosures about Fair Value Measurements* (“ASU2010-06”). ASU 2010-06 amends ASC Topic 820 to add new requirements fordisclosures about transfers into and out of Levels 1 and 2 and separatedisclosures about purchases, sales, issuances and settlements relating toLevel 3 measurements. ASU 2010-06 also clarifies existing fair valuedisclosures about the level of disaggregation and about inputs and valuationtechniques used to measure fair value. We adopted ASU 2010-06 and have includedthe required disclosures in Note 5, with the exception of the requirementto provide disclosure of the Level 3 activity of purchases, sales,issuances and settlements on a gross basis, which will be effective for ourinterim and annual reporting periods beginning after December 15, 2010.

 

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**3.STRATEGIC TRANSACTIONS**

 

***The CNCIM Acquisition and Issuance of theAcquisition Shares***

 

OnMarch 22, 2010, we entered into the AcquisitionAgreement with Bounty and CNCIM. We completed the CNCIM Acquisition on June 9,2010 (the “Closing Date”) for total purchase consideration of$24.8 million consisting of (i) the issuance of 4,545,455 shares(at a Closing Date price of $4.50 per share) of our common stock, par value $0.001 per share (the “Acquisition Shares”),(ii) deferred payments totaling $7.5 million in cash payable in fiveequal annual installments beginning on December 9, 2010 (with a ClosingDate fair value of $6.0 million) and (iii) an adjustment related to theissuance of the Convertible Notes (as defined below). Calculation of thepurchase consideration in accordance with ASC Topic 805 — *BusinessCombinations* (“ASC Topic 805”) is as follows:

 
| ** **                                                                    | ** ** | **(In thousands, except  share and per share  information)** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Shares issued                                                                 |       | 4,545,455                                                    |       |
| Multiplied by Closing Date share price                                        |       | $                                                            | 4.50       | (1) |
| Value of shares                                                               |       | $                                                            | 20,455     |   |
| Fair value of deferred payments to the seller                                 |       | 5,962                                                        |       |
| Less: excess of par value over estimated fair  value of the Convertible Notes |       | (1,623)                                                      | (2)        |
| Total purchase consideration                                                  |       | $                                                            | 24,794     |   |

 

----

(1)                                  Represents theclosing price of our common stock on the Closing Date.

 

(2)                                 Represents a reduction ofthe purchase consideration because the par value of the Convertible Notes (as definedbelow) of $25.0 million exceeded the fair value of the Convertible Notes of$23.4 million as of the Closing Date.  Asthe CNCIM Acquisition and the issuance of the Convertible Notes are consideredlinked transactions, the Convertible Notes are initially recorded at theirClosing Date fair value with the difference between fair value and parallocated to the purchase consideration.

 

Thefollowing is a summary of the recognized amounts of assets acquired andliabilities assumed as a result of the CNCIM Acquisition:

 
| ** **                                                                         | ** ** | **(In thousands)** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------|------------|
| Cash                                                                               |       | $                  | 2,470      |   |
| Investment advisory fee receivables                                                |       | 868                |       |
| Equipment and improvements                                                         |       | 148                |       |
| Other receivables                                                                  |       | 139                |       |
| Accrued and other liabilities                                                      |       | (306               | )          |
| Identifiable intangible assets                                                     |       | 11,065             |       |
| Excess of purchase consideration over identifiable  net assets acquired - goodwill |       | 10,410             |       |
|                                                                               |       | $                  | 24,794     |   |

 

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Inaccordance with ASC Topic 805, the fair values of the assets acquired andliabilities assumed were estimated by management. Management received theassistance of an independent valuation firm. The identifiable intangible assets acquired by asset class are asfollows:

 
| ** **                      | ** ** | **Closing Date  Estimated Fair  Value** | ** ** | **Estimated Average Remaining  Useful Life** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
| ** **                      | ** ** | **(In thousands)**                      | ** ** | **(In years)**                               | ** ** |
| **Intangible asset class:**     |       |                                    |       |                                         |       |
| Investment management contracts |       | $                                       | 10,900     |                                         | 8.35       |   |
| Non-compete agreements          |       | 165                                     |       | 4.67                                         |       |
|                            |       | $                                       | 11,065     |                                         |       |   |

 

Thefair value of the intangible assets related to the CNCIM CDO investmentmanagement contracts was determined utilizing an excess earnings approach basedon the expected cash flows from the CDOs. The intangible assets related to themanagement contracts will be amortized based on a ratio of expected discountedcash flows from the contracts over the expected remaining term of thecontracts. The fair value of the intangible assets associated with thenon-compete agreements was determined using a lost cash flows analysis and willbe amortized straight-line over the term of the agreements. Amortizationexpense for the three and six months ended June 30, 2010 related to theintangible assets acquired was $0.2 million.

 

Thefollowing table presents expected remaining amortization expense of theidentifiable intangible assets acquired:

 
| ** ** | ** ** | **(In thousands)** | ** ** |
|------------|------------|--------------------|------------|
|       |       |               |       |
| 2010       |       | $                  | 1,152      |   |
| 2011       |       | 2,300              |       |
| 2012       |       | 2,230              |       |
| 2013       |       | 2,021              |       |
| 2014       |       | 1,366              |       |
| Thereafter |       | 1,803              |       |
|       |       | $                  | 10,872     |   |

 

Goodwillof $10.4 million is the excess of the total purchase consideration over theidentifiable tangible and intangible assets acquired in the CNCIM Acquisition.Goodwill relates to (i) the additional strategic opportunities that webelieve will be available to us as a result of the recapitalization of our debtand our increased assets under management, (ii) improvements in ourcapital structure resulting from the Trust Preferred Exchange and the SeniorNotes Discharge (each as defined below) and (iii) the expected synergiesfrom the CNCIM Acquisition. Goodwill is recorded within our InvestmentManagement segment.  For tax purposes,goodwill recognized was $16.5 million and will be amortized over 15 years.

 

Inaccordance with ASC Topic 805, we have expensed CNCIM Acquisition-relatedexpenses (other than those related to stock issuance and debt issuance) asincurred.  For the three and six monthsended June 30, 2010, we recorded expenses related to the CNCIM Acquisitionand associated transactions of $2.6 million and $4.0 million, respectively,within strategic transactions expenses in the condensed consolidated statementsof operations.  Stock issuance costs of$1.1 million were recorded as a reduction to additional paid-in capital inaccordance with ASC Topic 505 — *Equity.*

 

***The Convertible Notes Agreement andIssuance of the Conversion Shares***

 

OnMarch 22, 2010, in connection with entering into the AcquisitionAgreement, we entered into a Senior Subordinated Convertible Notes Agreement(the “Convertible Notes Agreement”)with Bounty pursuant to which Bounty agreed to purchase for cash,$25.0 million in aggregate principal amount of our senior subordinatedconvertible notes (the “ConvertibleNotes”), convertible into 4,132,231 shares of common stock (as suchamount may be adjusted in certain events or increased in connection with the paymentof interest-in-kind (“PIK Interest”)) (the “Conversion Shares”) at an initial conversion price of $6.05 pershare, subject to adjustment.  TheConvertible Notes were issued to Bounty simultaneously with the closing of theCNCIM Acquisition and will mature on December 9, 2017. Interest on theConvertible Notes is payable to the holders of the Convertible Notes quarterlyin arrears on each January 1, April 1, July 1 andOctober 1, beginning on July 1, 2010. We will pay interest in cash ata per annum rate starting at 8% on 

 

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theClosing Date and increasing incrementally to 11% on June 9, 2014;provided, that we may, in our sole discretion and upon notice to the holders ofthe Convertible Notes, elect to pay up to 50% of the interest payment due toany holder of the Convertible Notes in PIK Interest, subject to certainconditions.

 

Weevaluated the terms and conditions of the conversion feature contained in theConvertible Notes, and certain of the antidilution provisions of the conversionfeature cause it to be deemed an embedded derivative instrument (the “EmbeddedDerivative”) under the provision of ASC Topic 815—*Derivatives and Hedging*. Theseantidilution provisions prevent the conversion feature from qualifying as beingindexed to our common stock. The Convertible Notes are recorded as twocomponents: (i) the Embedded Derivative initially recorded on the ClosingDate as a $6.9 million derivative liability and, (ii) long term debtinitially recorded on the Closing Date at $16.5 million. At each subsequentbalance sheet date, the Embedded Derivative will be marked to fair value, andthe change in fair value will be recorded in the condensed consolidatedstatement of operations within net gain (loss) on investments, loans,derivatives and liabilities. As of June 30, 2010, the Embedded Derivativewas valued at $10.2 million, resulting in a $3.3 million loss during the threemonths ended June 30, 2010 recorded in the condensed consolidatedstatement of operations as net gain (loss) on investments, loans, derivativesand liabilities. The total Closing Date fair value of the two components was$23.4 million. The $1.6 million difference between the $25.0 million principalamount of the Convertible Notes and the $23.4 million Closing Date total fairvalue associated with the Convertible Notes was treated as a reduction ofpurchase consideration in conjunction with the CNCIM Acquisition. We did notelect the fair value option for the long term debt component of the ConvertibleNotes. The difference between the $16.5 million Closing Date fair value of thecomponent of the Convertible Notes recorded as long term debt and the $25.0 millionprincipal amount of the Convertible Notes will be accreted to earnings usingthe effective yield method of recognizing interest expense. Debt issuance costsof $0.5 million were recorded within prepaid and other assets and will be amortizedinto expense over the term of the Convertible Notes in accordance with ASCTopic 470—*Debt*.

 

***The Senior Notes Discharge***

 

OnMarch 22, 2010, DFR and Deerfield entered into a Payment Agreement andRelease (the “Senior Notes DischargeAgreement”) with the holders of the Series A Senior Secured Notesissued by Deerfield (the “Series ANotes”) and the holders of the Series B Senior Secured Notes issuedby Deerfield (the “Series B Notes”and, together with the Series A Notes, the “Senior Notes”), pursuant to which we agreed with the holders ofthe Senior Notes to discharge all of the approximately $48.8 million inaggregate principal amount of Series A Notes then outstanding atapproximately 64.1% of the principal amount thereof plus accrued interest, andall of the approximately $25.1 million in aggregate principal amount ofthe Series B Notes previously outstanding at approximately 94.5% of theprincipal amount thereof plus accrued interest, or an aggregate discount ofapproximately 25.6% from the face amount of the Senior Notes plus accruedinterest (the “Senior Notes Discharge”).  We used the proceeds of the issuance of theConvertible Notes together with other available funds to complete the SeniorNotes Discharge on June 9, 2010.  Werecorded a $17.4 million gain on the condensed consolidated statement ofoperations related to the Senior Notes Discharge. As a result of theconsummation of the Senior Notes Discharge, all obligations and liabilities ofDFR and Deerfield under the Senior Notes were released, and the intercreditoragreement related to the Senior Notes was terminated.

 

***The DPLC Restructuring***

 

OnMarch 21, 2010, we entered into a Termination Agreement (the “Termination Agreement”) with PegasusDeerfield (AIV), LLC (“PegasusDeerfield”), PGS Management, LLC (“PM”, and together with Pegasus Deerfield, the “Pegasus Parties”), DPLC, DCM, DPLC GP, Deerfield LoanManager LLC (“DLM” andtogether with DFR, DCM and DLM, the “DeerfieldParties”) and Jonathan Trutter, pursuant to which (i) the PegasusParties waived certain rights with respect to the stock issuances associatedwith the CNCIM Acquisition and (ii) the Deerfield Parties and the PegasusParties terminated or amended certain provisions of agreements related to DPLCand cancelled warrants to purchase three million shares of our common stock,which comprises all of the warrants previously issued to the Pegasus Parties(the “DPLC Restructuring”).Pursuant to the Termination Agreement, we granted Pegasus Deerfield and certainof its associates warrants to purchase an aggregate of 250,000 shares ofour common stock at an exercise price of $4.25 per share (the “DPLCRestructuring Warrants”). See Note 14 for further discussion of the DPLCRestructuring Warrants.  Pursuant to theTermination Agreement, DPLC GP and DPLC released all partners of DPLC fromtheir unfunded capital commitments to DPLC as of the date of the TerminationAgreement. Effective as of March 31, 2010, DPLC made distributions of$9.0 million to Pegasus Deerfield and an amount equal to his entire capitalaccount balance to Jonathan Trutter. DPLC GP also withdrew an amount equalto the entire portion of its capital account attributable to DLM’s investmentin DPLC GP and distributed such amount to DLM, our wholly-ownedsubsidiary. During the three months ended June 30, 2010, DPLC has madeadditional distributions to Pegasus Deerfield of $3.8 million. PegasusDeerfield has notified us that they intend to withdraw their entire remainingcapital account balance.

 

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***Unaudited Pro Forma Financial Information***

 

Duringthe three and six months ended June 30, 2010, we recognized net revenuesof $0.2 million and net loss attributable to DFR of $0.3 million related toCNCIM. In addition, for the three and six months ended June 30, 2010, werecorded a net loss of $0.8 million related to the consolidation of the fourCNCIM CDOs.  This was comprised of netrevenues of $2.7 million, expenses of $0.2 million and net losses of $3.3million in net other income (expense) and gain (loss). The following unauditedpro forma condensed combined financial information gives effect to thefollowing transactions as if they had been completed as of the beginning of theperiods presented: (1) the CNCIM Acquisition and issuance of theAcquisition Shares; (2) the issuance of the Convertible Notes; (3) theSenior Notes Discharge; (4) the Trust Preferred Exchange (as definedbelow); and (5) the DPLC Restructuring. This unaudited pro forma combinedfinancial information is presented for illustrative purposes only and is notnecessarily indicative of the operating results that would have occurred if theCNCIM Acquisition had been consummated during the period or as of the dates forwhich the pro forma data is presented, nor is it necessarily indicative offuture operating results of DFR. The pro forma combined financial informationfor the three and six months ended June 30, 2010 does not give effect tothe application of ASC Topic 810 for the period prior to the CNCIM Acquisitionas it relates to the four CNCIM CDOs.

 
| ** **                                         | ** ** | **Three months ended June 30,**          | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                                         | ** ** | **2010**                                      | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                         | ** ** | **(In thousands, except for per share data)** | ** ** |
| Total net revenue                                  |       | $                                             | 34,402     |                               | $          | 6,530 |   | $ | 59,487 |   | $ | 19,341 |   |
| Net income (loss)                                  |       | $                                             | (3,234     | )                                  | $          | 54,939 |   | $ | (3,909 | ) | $ | 68,082 |   |
| Net income attributable to Deerfield Capital Corp. |       | $                                             | 7,079      |                               | $          | 54,939 |   | $ | 10,248 |   | $ | 68,082 |   |
| Net income attributable to Deerfield Capital Corp. |       |                                          |       |                               |       |   |   |   |   |
| per share - basic                                  |       | $                                             | 0.62       |                               | $          | 4.87 |   | $ | 0.91 |   | $ | 6.05 |   |
| Net income attributable to Deerfield Capital Corp. |       |                                          |       |                               |       |   |   |   |   |
| per share - diluted                                |       | $                                             | 0.48       |                               | $          | 3.60 |   | $ | 0.72 |   | $ | 4.48 |   |

 

**4.CONSOLIDATED INVESTMENT PRODUCTS**

 

Beginning January 1, 2010, as a result of the adoption of theamendments to ASC Topic 810, we consolidated seven CDOs creating ourConsolidated Investment Products segment. In conjunction with the CNCIMAcquisition, as of the Closing Date, we also consolidated the four CNCIM CDOsin accordance with ASC Topic 810. As a result, we have consolidatednon-recourse assets of $4.0 billion and non-recourse liabilities of $3.6billion into our condensed consolidated financial statements as of June 30,2010 related to the CIP CDOs. We have determined that, although the juniortranches of the CIP CDOs have certain characteristics of equity, they should berecorded as debt on our balance sheet, as the subordinated notes have a statedmaturity indicating a date on which they are mandatorily redeemable. The preferenceshares of the CIP CDOs are also classified as debt on our balance sheet, sinceredemption is required only upon liquidation or termination of the CLO and notupon liquidation or termination of DFR or DCM.

 

The assets of the CIP CDOs are held solely as collateral to satisfy theobligations of the CIP CDOs. We have no right to the benefits from, nor do webear the risks associated with, the assets held by the CIP CDOs beyond ourminimal direct investments in, and management fees generated from, the CIPCDOs. If the CIP CDOs were to liquidate, the assets would not be available tothe general creditors of DFR, and as a result, we do not consider them to beour assets. Additionally, the investors in the CIP CDOs have no recourse to ourgeneral credit for the debt issued by the CIP CDOs. We therefore do notconsider this debt to be an obligation of ours.

 

For the three and six months ended June 30, 2010, the net loss of$10.3 million and $14.2 million, respectively, recorded in our condensedconsolidated financial statements was not indicative of the cash flowdistributions received from the CIP CDOs of $3.7 million and $7.3 million forthe three and six months ended June 30, 2010, respectively. For the threemonths ended June 30, 2010, the $3.7 million received from the CIP CDOsconsisted of management fees of $3.5 million, equity distributions of $0.1million and interest on our debt investments of $0.1 million. For the sixmonths ended June 30, 2010, the $7.3 million received from the CIP CDOsconsisted of management fees of $7.0 million, equity distributions of $0.2million and interest on our debt investments of $0.1 million. We consolidatedassets of $4.0 billion, liabilities of $3.6 billion and equity of $0.4 billionrelated to the CIP CDOs as of June 30, 2010 despite the fact that theassets of the CIP CDOs are not available to us, nor are we obligated under thedebt issued by the CIP CDOs. Upon consolidation, we eliminated management feereceivables of $1.7 million as of June 30, 2010 and management fee revenueof $3.3 million and $6.9 million related to the CIP CDOs for the three and sixmonths ended June 30, 2010, respectively.

 

We have included other required disclosures related to our ConsolidatedInvestment Products segment in Notes 2, 5, 8, 13 and 17.

 

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**5. FAIRVALUE OF FINANCIAL INSTRUMENTS**

 

Effective January 1, 2008, we adopted ASC Topic 820—*Fair Value Measurements and Disclosures* (“ASCTopic 820”). ASC Topic 820 defines fair value, establishes a framework used tomeasure fair value and enhances disclosure requirements for fair valuemeasurements. In accordance with ASC Topic 820, we have categorized ourfinancial instruments carried at fair value, based on the priority of thevaluation technique, into a three-level fair value hierarchy. The valuationhierarchy is based upon the transparency of the inputs to the valuation of theasset or liability as of the measurement date. A financial instrument’scategorization within the valuation hierarchy is based on the lowest level ofinput that is significant to the fair value measurement. The three levels aredefined as follows:

 

*Level 1*—inputs to the valuation methodologyare quoted prices (unadjusted) for identical assets or liabilities in activemarkets.

 

The types of assets included in Level 1 generally are equitysecurities or derivatives listed on an active exchange. We held no Level 1securities as of June 30, 2010.

 

*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.

 

Our assets and liabilities that are generally included in this categoryare Agency RMBS (as defined below), loans classified as either investments atfair value or loans held for sale where asset valuations are provided by independentpricing services, corporate bonds, long term debt and interest ratederivatives. Agency RMBS are backed by mortgage loans and are guaranteed as toprincipal and interest by federally chartered entities such as the FederalNational Mortgage Association (“Fannie Mae”) or the Federal Home Loan MortgageCorporation (“Freddie Mac”) and, in the case of the Government NationalMortgage Association (“Ginnie Mae”), the U.S. government. We refer to RMBSguaranteed or issued by Fannie Mae, Freddie Mac and Ginnie Mae as “Agency RMBS.”

 

*Level 3*—inputs to the valuationmethodology include significant unobservable inputs to the fair valuemeasurement. This includes situations where there is little, if any, marketactivity for the asset or liability.

 

Our assets and liabilities that are generally included in this categoryare non-Agency RMBS, corporate bonds, loans classified as either investments atfair value or loans held for sale where asset valuations are not provided byindependent pricing services, warrants, the Embedded Derivative, and long termdebt held in our Consolidated Investment Products segment. Level 3 alsoincludes loans held for investment in periods when an impairment charge istaken.

 

Our full valuation methodology and ASC Topic 820 accounting policy arediscussed in the notes to the Consolidated Financial Statements included in our2009 10-K.  There were no significantchanges in our valuation methodologies during the three and six months ended June 30,2010.

 

Wehave recorded all assets and liabilities in our Consolidated InvestmentProducts segment at fair value. We have not elected the fair value option forDFR MM CLO, which is included in our Principal Investing Segment, and as such,the assets and liabilities of DFR MM CLO are not recorded at fair value. Theamendments to ASC Topic 810 indicate that assets and liabilities ofconsolidated VIEs should be recorded at their carrying value as of the datethat we became the primary beneficiary of the VIEs, provided such applicationis practicable.  We have determined it isnot practicable to initially record the CIP CDOs at their carrying value asthey have never previously been required to satisfy GAAP or other reportingrequirements.  In connection with theadoption of the amendments to ASC Topic 810, we have elected and applied thefair value option under ASC Topic 825—*Financial Instruments*(“ASCTopic 825”) to measure, on an entity-by-entity basis, all of the eligibleassets and liabilities of the CIP CDOs at fair value subsequent to the date ofinitial adoption of the amendments to ASC Topic 810, as we have also determinedthat measurement of the notes issued by the CIP CDOs at fair value bettercorrelates with the fair value of the assets held by the CIP CDOs, which areheld to provide the cash flows for the note obligations of the CIP CDOs.

 

The following is a description of the valuation methodologies used forinstruments measured at fair value, including the general classification ofsuch instruments pursuant to the valuation hierarchy described below based ontheir classification in the condensed consolidated balance sheet. Management,from time to time, may make adjustments to the valuation methodologiesdescribed below under certain market conditions. Management maintains aconsistent policy and process for identifying when and how such adjustmentsshould be made. To the extent that a significant fair value adjustment is madeby management, the valuation classification would generally be considered aLevel 3 within the fair value hierarchy.

 

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***Investments at Fair Value***

 

Investments at fair value include RMBS, loans and other investmentsheld in DPLC and our Consolidated Investment Products segment, corporate bondsheld in DFR MM CLO, beneficial interests in CDOs and contingent liabilitiesrelated to CDOs. The fair value for RMBS generally represents a modeledvaluation, which includes spreads and prepayment rates which are observable inthe market. Agency RMBS are classified as Level 2 within the fair valuehierarchy. The continuing illiquidity in the non-Agency RMBS markets haslimited the availability of market data which is included in the valuationmodels. Non-Agency RMBS are valued using model pricing that management believeswould be used by market participants and classified as Level 3 within thefair value hierarchy given this limited availability of observable market data.Loans and other investments held in DPLC and our Consolidated InvestmentProducts segment and corporate bonds held in DFR MM CLO are generally priced ata composite of the mid-point in the bid-ask spread of dealer quotes or based onthe composite price of a different tranche of the same security if dealerquotes are unavailable for the specific tranche we own. Loans and otherinvestments held in DPLC and our Consolidated Investment Products segment andcorporate bonds held in DFR MM CLO priced in this manner are classified asLevel 2 within the fair value hierarchy. Where no such quotes areavailable, the price may be based on an internally developed model usingcomposite or other comparable market data which could include unobservablemarket inputs. Loans and other investments held in DPLC and our ConsolidatedInvestment Products segment priced in this manner are classified asLevel 3 within the fair value hierarchy. Beneficial interests in CDOs andcontingent liabilities related to CDOs are valued by management via internalmodels and as such are also classified as Level 3 within the fair valuehierarchy.

 

***Derivative assets and liabilities***

 

The derivatives held by us generally represent instruments traded inthe over-the-counter market and are valued using internally developed market-standardmodels. The inputs to the valuation models for the interest rate swaps and capsrepresent observable market data available at commonly quoted intervals for thefull terms of the contracts. All interest rate derivatives are classified asLevel 2 within the fair value hierarchy. The valuation models for warrantsmay contain a significant level of unobservable inputs and are classified asLevel 3 within the fair value hierarchy. The Embedded Derivative is valuedby valuing the Convertible Notes and subsequently valuing the Convertible Noteseliminating the conversion right.  Thedifference represents the value of the Embedded Derivative.  The valuation of the Embedded Derivative iscompleted using a binomial tree model which may contain a significant level ofunobservable inputs and is classified as Level 3 within the fair valuehierarchy.

 

***Loans held for sale***

 

Loans held for sale are carried at the lower of cost or fair value. Ifthe fair value of a loan is less than its cost basis, a valuation adjustment isrecognized in the condensed consolidated statements of operations, and the loan’scarrying value is adjusted accordingly. The valuation adjustment may berecovered if the fair value increases, which is also recognized in thecondensed consolidated financial statements. Loans held for sale are generallypriced at a composite of the mid-point in the bid-ask spread of dealer quotesor based on the composite price of a different tranche of the same security ifdealer quotes are unavailable for the specific tranche we own. As of June 30,2010, we classify loans held for sale priced in this manner as Level 2within the fair value hierarchy. Where no such quotes are available, price maybe based on an internally developed model using composite or other comparablemarket data which could include unobservable market inputs. Loans held for salepriced in this manner are classified as Level 3 within the fair valuehierarchy.

 

***Long Term Debt held in ourConsolidated Investment Products Segment***

 

Long term debt held in our Consolidated Investment Products segmentincludes the noncontrolling interest portion of the debt, includingsubordinated notes and preference shares of the CIP CDOs.  The fair value for long term debt held in ourConsolidated Investment Products segment generally represents a modeledvaluation that utilizes inputs that are both observable and unobservable in themarket. Long term debt held in our Consolidated Investment Products segmentpriced in this manner is classified as Level 2 within the fair valuehierarchy.  The preferred shares of CDOswithin the long term debt held in our Consolidated Investment Products segmentare valued by management by considering, among other things, available brokerquotes. If a broker quote is unavailable, the preferred shares of CDOs arevalued using internally developed models that utilize composite or othercomparable market data management believes would be used by marketparticipants, which could include unobservable market inputs. Long term debtheld in our Consolidated Investment Products segment priced in this manner isclassified as Level 3 within the fair value hierarchy.

 

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***Assets and liabilities measured at fairvalue on a recurring basis***

 

The following table presents the financial instruments carried at fairvalue on a recurring basis, by caption in the condensed consolidated balancesheet and by level within the ASC Topic 820 valuation hierarchy, as of June 30,2010, for our Principal Investing and Investment Management segments:

 
| ** **                             | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| ** **                             | ** ** | **(In thousands)** | ** ** |
| Investments at fair value              |       |               |       |        |       |        |       |               |       |
| RMBS                                   |       | $                  | —     |        | $          | 304,145     |       | $                  | 1,635      |   | $ | 305,780 |   |
| Loans                                  |       | —             |       | 2,964       |       | 634         |       | 3,598              |       |
| Other                                  |       | —             |       | 5,951       |       | 4,388       |       | 10,339             |       |
| Derivative assets                      |       | —             |       | —      |       | 29          |       | 29                 |       |
| Total financial instrument assets      |       | $                  | —     |        | $          | 313,060     |       | $                  | 6,686      |   | $ | 319,746 |   |
|                                   |       |               |       |        |       |        |       |               |       |
| Derivative liabilities                 |       | $                  | —     |        | $          | 225         |       | $                  | 10,156     |   | $ | 10,381 |   |
| Accrued and other liabilities          |       | —             |       | —      |       | 260         |       | 260                |       |
| Total financial instrument liabilities |       | $                  | —     |        | $          | 225         |       | $                  | 10,416     |   | $ | 10,641 |   |

 

The following table presents the financial instruments carried at fairvalue on a recurring basis, by caption in the condensed consolidated balancesheet and by level within the ASC Topic 820 valuation hierarchy, as of June 30,2010, for our Consolidated Investment Products segment:

 
| ** **                             | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| ** **                             | ** ** | **(In thousands)** | ** ** |
| Investments at fair value              |       |               |       |        |       |        |       |               |       |
| Loans                                  |       | $                  | —     |        | $          | 3,534,902   |       | $                  | 18,873     |   | $ | 3,553,775 |   |
| Corporate bonds                        |       | —             |       | 195,949     |       | 13,293      |       | 209,242            |       |
| Other                                  |       | —             |       | 6,713       |       | 11,862      |       | 18,575             |       |
| Derivative assets                      |       |               |       | —      |       | 27          |       | 27                 |       |
| Total financial instrument assets      |       | $                  | —     |        | $          | 3,737,564   |       | $                  | 44,055     |   | $ | 3,781,619 |   |
|                                   |       |               |       |        |       |        |       |               |       |
| Long term debt                         |       | $                  | —     |        | $          | 3,365,727   |       | $                  | 128,683    |   | $ | 3,494,410 |   |
| Derivative liabilities                 |       | —             |       | 5,709       |       | —      |       | 5,709              |       |
| Total financial instrument liabilities |       | $                  | —     |        | $          | 3,371,436   |       | $                  | 128,683    |   | $ | 3,500,119 |   |

 

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

 

The table below includes a rollforward of the balance sheet amounts forthe three months ended June 30, 2010 (including the change in fair value)for financial instruments classified within Level 3 of the valuationhierarchy for our Principal Investing and Investment Management segments:

 
| ** **                             | ** ** | ** **                                                         | ** ** | ** **              | ** ** | ** **               | ** ** | ** **         | ** ** | ** **              | ** ** | **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**          | ** ** |
| ** **                             | ** ** | **April 1,  2010**                                            | ** ** | **Gains  (Losses) (1)** | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** ** | **June 30,  2010** | ** ** | **at  June 30, 2010 (1)** | ** ** |
|                                   |       | **(In  thousands)**                                                |       |
| Investments  at fair value             |       |                                                               |       |                    |       |                     |       |               |       |                    |       |                           |       |
| RMBS                                   |       | $                                                                  | 2,452      |                    | $          | (384                     | )          | $                  | (433       | )                       | $          | —                         |       | $ | 1,635 |   | $ | 3,107 |   |
| Loans                                  |       | 912                                                                |       | (1                      | )          | (277                     | )          | —             |       | 634                     |       | (1                             | )          |
| Other                                  |       | 4,707                                                              |       | (319                    | )          | —                   |       | —             |       | 4,388                   |       | (319                           | )          |
| Derivative  assets                     |       | 26                                                                 |       | 3                       |       | —                   |       | —             |       | 29                      |       | 3                              |       |
| Total  financial instrument assets     |       | $                                                                  | 8,097      |                    | $          | (701                     | )          | $                  | (710       | )                       | $          | —                         |       | $ | 6,686 |   | $ | 2,790 |   |
|                                   |       |                                                               |       |                    |       |                     |       |               |       |                    |       |                           |       |
| Derivative  liabilities                |       | $                                                                  | —     |                    | $          | 3,267                    |       | $                  | 6,889      |                    | $          | —                         |       | $ | 10,156 |   | $ | 3,267 |   |
| Accrued  and other liabilities         |       | 312                                                                |       | 4                       |       | (56                      | )          | —             |       | 260                     |       | 4                              |       |
| Total  financial instrument liabilties |       | $                                                                  | 312        |                    | $          | 3,271                    |       | $                  | 6,833      |                    | $          | —                         |       | $ | 10,416 |   | $ | 3,271 |   |

 

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(1)                                  Net realizedand unrealized gains (losses) on investments at fair value are reported withinnet gain (loss) on investments, loans, derivatives and liabilities in thecondensed consolidated statement of operations.

 

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The table below includes a rollforward of the balance sheet amounts forthe six months ended June 30, 2010 (including the change in fair value)for financial instruments classified within Level 3 of the valuationhierarchy for our Principal Investing and Investment Management segments:

 
| ** **                              | ** ** | ** **                                                         | ** ** | ** **              | ** ** | ** **               | ** ** | ** **         | ** ** | ** **              | ** ** | **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,  2010**                                          | ** ** | **Gains  (Losses) (1)** | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** ** | **June 30,  2010** | ** ** | **at  June 30, 2010 (1)** | ** ** |
|                                    |       | **(In  thousands)**                                                |       |
| Investments  at fair value              |       |                                                               |       |                    |       |                     |       |               |       |                    |       |                           |       |
| RMBS                                    |       | $                                                                  | 2,631      |                    | $          | (87                      | )          | $                  | (909       | )                       | $          | —                         |       | $ | 1,635 |   | $ | 3,798 |   |
| Loans                                   |       | 990                                                                |       | (10                     | )          | (346                     | )          | —             |       | 634                     |       | (10                            | )          |
| Other                                   |       | 2,597                                                              |       | 1,791                   |       | —                   |       | —             |       | 4,388                   |       | 1,791                          |       |
| Derivative  assets                      |       | 74                                                                 |       | (45                     | )          | —                   |       | —             |       | 29                      |       | (45                            | )          |
| Total  financial instrument assets      |       | $                                                                  | 6,292      |                    | $          | 1,649                    |       | $                  | (1,255     | )                       | $          | —                         |       | $ | 6,686 |   | $ | 5,534 |   |
|                                    |       |                                                               |       |                    |       |                     |       |               |       |                    |       |                           |       |
| Derivative  liabilities                 |       | $                                                                  | —     |                    | $          | 3,267                    |       | $                  | 6,889      |                    | $          | —                         |       | $ | 10,156 |   | $ | 3,267 |   |
| Accrued  and other liabilities          |       | 364                                                                |       | 10                      |       | (114                     | )          | —             |       | 260                     |       | 10                             |       |
| Total  financial instrument liabilities |       | $                                                                  | 364        |                    | $          | 3,277                    |       | $                  | 6,775      |                    | $          | —                         |       | $ | 10,416 |   | $ | 3,277 |   |

 

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(1)                                  Net realizedand unrealized gains (losses) on investments at fair value are reported withinnet gain (loss) on investments, loans, derivatives and liabilities in thecondensed consolidated statement of operations.

 

The table below includes a rollforward of the balance sheet amounts forthe three months ended June 30, 2010 (including the change in fair value)for financial instruments classified within Level 3 of the valuation hierarchyfor our Consolidated Investment Products segment:

 
| ** **                         | ** ** | ** **                                                         | ** ** | ** **                  | ** ** | ** **              | ** ** | ** **               | ** ** | ** **         | ** ** | ** **              | ** ** | **Changes  in Unrealized**     | ** ** |
|------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|--------------------|------------|-------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **Fair  Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains  (Losses)**         | ** ** |
| ** **                         | ** ** | **Estimated**                                                      | ** ** | **Fair  Value of CIP CDOs** | ** ** | **Net  Realized/**      | ** ** | **Purchases,  (Sales),** | ** ** | **Net  Transfers** | ** ** | **Estimated**           | ** ** | **Related  to Financial**      | ** ** |
| ** **                         | ** ** | **Fair  Value**                                                    | ** ** | **Consolidated  as of**     | ** ** | **Unrealized**          | ** ** | **Issuances  and**       | ** ** | **In  (Out)**      | ** ** | **Fair  Value**         | ** ** | **Instruments  Held**          | ** ** |
| ** **                         | ** ** | **April 1,  2010**                                            | ** ** | **June 9,  2010**      | ** ** | **Gains  (Losses) (1)** | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** ** | **June 30,  2010** | ** ** | **at  June 30, 2010 (1)** | ** ** |
|                               |       | **(In  thousands)**                                                |       |
| Investments  at fair value         |       |                                                               |       |                        |       |                    |       |                     |       |               |       |                    |       |                           |       |
| Loans                              |       | $                                                                  | 23,026     |                        | $          | 1,497                   |       | $                        | 67         |               | $          | 1,948                   |       | $                              | (7,665     | )(2) | $ | 18,873 |   | $ | 55 |   |
| Corporate  bonds                   |       | 9,774                                                              |       | 3,390                       |       | 129                     |       | —                   |       | —             |       | 13,293                  |       | (496                           | )          |
| Other                              |       | 107                                                                |       | 11,641                      |       | 114                     |       | —                   |       | —             |       | 11,862                  |       | 114                            |       |
| Derivative  assets                 |       | 25                                                                 |       | 10                          |       | (8                      | )          | —                   |       | —             |       | 27                      |       | (8                             | )          |
| Total  financial instrument assets |       | $                                                                  | 32,932     |                        | $          | 16,538                  |       | $                        | 302        |               | $          | 1,948                   |       | $                              | (7,665     | ) | $ | 44,055 |   | $ | (335 | ) |
|                               |       |                                                               |       |                        |       |                    |       |                     |       |               |       |                    |       |                           |       |
| Long  term debt                    |       | $                                                                  | 80,163     |                        | $          | 62,622                  |       | $                        | (14,102    | )                  | $          | —                  |       | $                              | —     |   | $ | 128,683 |   | $ | (14,102 | ) |

 

----

(1)                                  Net realizedand unrealized gains (losses) on investments at fair value are reported withinnet gain (loss) on investments, loans, derivatives and liabilities in thecondensed consolidated statement of operations.

 

(2)                                  The nettransfers out of Level 3 represent certain loans which were valued viainternally developed models as of March 31, 2010 and priced at a compositeof the mid-point in the bid-ask spread of dealer quotes as of June 30,2010.

 

The table below includes arollforward of the balance sheet amounts for the six months ended June 30,2010 (including the change in fair value) for financial instruments classifiedwithin Level 3 of the valuation hierarchy for our Consolidated InvestmentProducts segment:

 
|                           |       |                                                               |       |                        |       |                    |       |                     |       |               |       |                    |       |                           |       |   |   |    |   |   |   |   |
|--------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|--------------------------|------------|--------------------|------------|-------------------------|------------|--------------------------------|------------|--------|--------|---------|--------|--------|--------|--------|
| ** **                     | ** ** | ** **                                                         | ** ** | ** **                  | ** ** | ** **              | ** ** | ** **               | ** ** | ** **         | ** ** | ** **              | ** ** | **Changes  in Unrealized**     | ** ** |
| ** **                     | ** ** | **Fair  Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains  (Losses)**         | ** ** |
| ** **                     | ** ** | **Estimated**                                                      | ** ** | **Fair  Value of CIP CDOs** | ** ** | **Net  Realized/**      | ** ** | **Purchases,  (Sales),** | ** ** | **Net  Transfers** | ** ** | **Estimated**           | ** ** | **Related  to Financial**      | ** ** |
| ** **                     | ** ** | **Fair  Value**                                                    | ** ** | **Consolidated  as of**     | ** ** | **Unrealized**          | ** ** | **Issuances  and**       | ** ** | **In  (Out)**      | ** ** | **Fair  Value**         | ** ** | **Instruments  Held**          | ** ** |
| ** **                     | ** ** | **January 1,  2010**                                          | ** ** | **June 9,  2010**      | ** ** | **Gains  (Losses) (1)** | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** ** | **June 30,  2010** | ** ** | **at  June 30, 2010 (1)** | ** ** |
|                           | ** ** | **(In  thousands)**                                                | ** ** |
| Investmentsatfairvalue         |       |                                                               |       |                        |       |                    |       |                     |       |               |       |                    |       |                           |       |
| Loans                          |       | $                                                                  | 19,080     |                        | $          | 1,497                   |       | $                        | 423        |               | $          | 5,538                   |       | $                              | (7,665     | )(2)   | $      | 18,873  |   | $      | 253    |   |
| Corporate  bonds               |       | 12,890                                                             |       | 3,390                       |       | 1,039                   |       | (4,026                   | )          | —             |       | 13,293                  |       | (223                           | )          |
| Other                          |       | 477                                                                |       | 11,641                      |       | 120                     |       | —                   |       | (376               | )(3)       | 11,862                  |       | 132                            |       |
| Derivative  assets             |       | 15                                                                 |       | 10                          |       | 2                       |       | —                   |       | —             |       | 27                      |       | 2                              |       |
| Totalfinancialinstrumentassets |       | $                                                                  | 32,462     |                        | $          | 16,538                  |       | $                        | 1,584      |               | $          | 1,512                   |       | $                              | (8,041     | )      | $      | 44,055  |   | $      | 164    |   |
|                           |       |                                                               |       |                        |       |                    |       |                     |       |               |       |                    |       |                           |       |
| Long  term debt                |       | $                                                                  | 45,414     |                        | $          | 62,622                  |       | $                        | 20,647     |               | $          | —                  |       | $                              | —     |   | $      | 128,683 |   | $      | 20,647 |   |

 

----

(1)                                  Net realizedand unrealized gains (losses) on investments at fair value are reported withinnet gain (loss) on investments, loans, derivatives and liabilities in thecondensed consolidated statement of operations.

 

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(2)                                  The nettransfers out of Level 3 include certain loans which were valued via internallydeveloped models as of January 1, 2010 and priced at a composite of themid-point in the bid-ask spread of dealer quotes as of June 30, 2010.

 

(3)                                  The nettransfers out of Level 3 include certain other investments which were valuedvia a single dealer quote as of January 1, 2010 and priced at a compositeof the mid-point in the bid-ask spread of dealer quotes as of June 30,2010.

 

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

 

Certain assets are measured at fair value on a nonrecurring basis,meaning that the instruments are measured at fair value only in certaincircumstances (for example, when held at the lower of cost or fair value). Thefollowing table presents the assets carried on the condensed consolidatedbalance sheet by caption and by level within the ASC Topic 820 valuationhierarchy for which a nonrecurring change in fair value was recorded during thethree and six months ended June 30, 2010 for our Principal Investing andInvestment Management segments:

 
| ** **                                                   | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying  Value** | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **(In thousands)** | ** ** |
| Loans held for sale                                          |       | $                  | —     |        | $          | —      |       | $                   | 109        |   | $ | 109 |   |
| Loans held for investment, net of allowance for  loan losses |       | —             |       | —      |       | 1,237       |       | 1,237               |       |
| Total assets at fair value on a nonrecurring basis           |       | $                  | —     |        | $          | —      |       | $                   | 1,346      |   | $ | 1,346 |   |

 

In the table above, “Loans held for sale” includes changes in fairvalue of loans which are carried on the condensed consolidated balance sheet atthe lower of cost or fair value, and “Loans held for investment” representsloans for which a provision for loan losses was recorded during the three andsix months ended June 30, 2010.

 

Thefollowing table presents the total change in value of financial assets forwhich a fair value adjustment was included in the condensed consolidatedfinancial statements during the three and six months ended June 30, 2010for our Principal Investing and Investment Management segments:

 
| ** **                           | ** ** | **Three months ended** | ** ** | **Six months ended**   | ** ** |
|--------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **June 30, 2010** | ** ** | **June 30, 2010** | ** ** |
| ** **                           | ** ** | **(In thousands)**     | ** ** |
| Loans held for sale (1)              |       | $                      | (7         | )                      | $          | (20 | ) |
| Loans held for investment (2)        |       | (309                   | )          | (3,583                 | )          |
| Total nonrecurring fair value losses |       | $                      | (316       | )                      | $          | (3,603 | ) |

 

----

(1)                                  Changes in thefair value of loans held for sale are reported within net gain (loss) oninvestments, loans, derivatives and liabilities in the condensed consolidatedstatements of operations.

 

(2)                                  Impairmentcharges to loans held for investment are reported within provision for loanlosses in the condensed consolidated statements of operations.

 

ASC Topic 820 requires disclosure of the fair value of financialinstruments for which it is practical to estimate. Estimated fair valuespresented below are calculated in accordance with ASC Topic 820. With respectto securities for which the fair value option was not elected, quoted marketprices, if available, are utilized as estimates of fair values. In the absenceof available quoted market prices, fair values have been derived based on ourassumptions, the estimated amount and timing of future cash flows and estimateddiscount rates. Different assumptions could significantly affect theseestimates.

 

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The carrying amounts and estimated fair values of our financialinstruments as of June 30, 2010 for our Principal Investing and InvestmentManagement segments, for which the disclosure of fair values is required, wereas follows:

 
| ** **                                            | ** ** | **As of June 30, 2010** | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|
| ** **                                            | ** ** | ** **                   | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **Carrying**                 | ** ** | **Fair** | ** ** |
| ** **                                            | ** ** | **Value**                    | ** ** | **Value** | ** ** |
| ** **                                            | ** ** | **(In thousands)**           | ** ** |
| Financial assets:                                     |       |                         |       |   |   |
| Cash and cash equivalents (1)                         |       | $                            | 42,963     |   | $ | 42,963 |   |
| Restricted cash and cash equivalents (1)              |       | 10,456                       |       | 10,456 |   |
| Investments at fair value (2)                         |       | 319,717                      |       | 319,717 |   |
| Other investments (3)                                 |       | 1,412                        |       | 1,412 |   |
| Derivative assets (2)                                 |       | 29                           |       | 29 |   |
| Loans held for sale (2)                               |       | 109                          |       | 109 |   |
| Loans, net of allowance for loan losses  (2) (3) |       | 268,527                      |       | 247,574 |   |
| Investment advisory fee receivables (1)               |       | 1,226                        |       | 1,226 |   |
|                                                  |       |                         |       |   |   |
| Financial liabilities:                                |       |                         |       |   |   |
| Repurchase agreements (1)                             |       | 282,246                      |       | 282,246 |   |
| Derivative liabilities (2)                            |       | 10,381                       |       | 10,381 |   |
| Accrued and other liabilities (2)                     |       | 260                          |       | 260 |   |
| Long term debt:                                       |       |                         |       |   |   |
| Convertible notes (4)                                 |       | 16,522                       |       | 16,729 |   |
| Subordinated debt and securities (4) (5)         |       | 120,775                      |       | 30,370 |   |
| DFR MM CLO (4)                                        |       | 217,296                      |       | 177,477 |   |
|                                                       |            |                              |            |  |  |  |  |

 

----

(1)                                  Carryingamounts approximate the fair value due to the short term nature of theseinstruments.

 

(2)                                  The estimatedfair values were determined in accordance with ASC Topic 820.

 

(3)                                  It was notpracticable to estimate the fair value of certain loans and other investmentsbecause they are not traded in an active market; therefore, the carrying valuehas been used as an approximation of fair value for loans with a carrying valueof $58.8 million and other investments with a carrying value of$1.4 million as of June 30, 2010. If an independent pricing servicecan not provide fair value estimates for a given loan, we may determine estimatedfair value based on some or all of the following: (a) current financialinformation of the borrowing company and performance against its operatingplan; (b) changes in the fair value of collateral supporting the loan;(c) changes to the market for the borrowing company’s service or productand (d) present value of projected future cash flows.

 

(4)                                  The estimatedfair values were calculated utilizing the guidance from ASC Topic 820. Weutilized comparable market data and internal and external models to calculatethe estimated fair value of the long term debt.

 

(5)                                  Subordinateddebt and securities include both our trust preferred securities and our juniorsubordinated notes.

 

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Thecarrying amounts and estimated fair values of our financial instruments in ourConsolidated Investment Products segment as of June 30, 2010 for which thedisclosure of fair values is required were as follows:

 
| ** **                               | ** ** | **As of June 30, 2010** | ** ** |
|------------------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | ** **                   | ** ** | **Estimated** | ** ** |
| ** **                               | ** ** | **Carrying**                 | ** ** | **Fair** | ** ** |
| ** **                               | ** ** | **Value**                    | ** ** | **Value** | ** ** |
| ** **                               | ** ** | **(In thousands)**           | ** ** |
| Financial assets:                        |       |                         |       |   |   |
| Restricted cash and cash equivalents (1) |       | $                            | 141,746    |   | $ | 141,746 |   |
| Investments at fair value (2)            |       | 3,781,592                    |       | 3,781,592 |   |
| Derivative assets (2)                    |       | 27                           |       | 27 |   |
|                                     |       |                         |       |   |   |
| Financial liabilities:                   |       |                         |       |   |   |
| Derivative liabilities (2)               |       | 5,709                        |       | 5,709 |   |
| Long term debt (2)                       |       | 3,494,410                    |       | 3,494,410 |   |
|                                          |            |                              |            |  |  |  |  |

 

----

(1)                                  Carryingamounts approximate the fair value due to the short term nature of theseinstruments.

 

(2)                                  The estimatedfair values were determined in accordance with ASC Topic 820.

 

The following table presents the realized and unrealized gains (losses)on investments at fair value as reported within net gain (loss) on investments,loans, derivatives and liabilities in our condensed consolidated statements ofoperations for the three and six months ended June 30, 2010:

 
| ** **                | ** ** | **For the  three months ended June 30,** | ** ** | **For the  six months ended June 30,** | ** ** |
|---------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                | ** ** | **2010**                                      | ** ** | **2009**                                    | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                | ** ** | **(In thousands)**                       | ** ** | **(In thousands)**                     | ** ** |
| Realized gains (losses)   |       | $                                             | 5,055      |                                        | $          | (352 | ) | $ | 14,779 |   | $ | (348 | ) |
| Unrealized gains (losses) |       | (48,806                                       | )          | 1,525                                       |       | 14,502 |   | 6,659 |   |
| Total gains (losses)      |       | $                                             | (43,751    | )                                           | $          | 1,173 |   | $ | 29,281 |   | $ | 6,311 |   |

 

**6.OTHER INVESTMENTS**

 

As of June 30, 2010, we held certain other investments carried atcost less any adjustments for other-than-temporary impairment of$1.4 million. These investments consist of equity securities in theentities established in connection with the issuance of our trust preferredsecurities of $0.8 million and other common and preferred equitysecurities that are not traded in an active market with an original cost andcarrying value of $0.6 million as of June 30, 2010. We previouslyheld $3.7 million of equity securities in the entities established in connectionwith the issuance of the trust preferred securities; however, on March 4,2010, $2.9 million of equity securities were cancelled in connection with theTrust Preferred Exchange as described in Note 13.

 

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**7. LOANSHELD FOR INVESTMENTAND LOANS HELD FOR SALE**

 

The following summarizes our loans held for sale and loans held forinvestment as of June 30, 2010:

 
| ** **                       | ** ** | **Carrying Value** | ** ** |
|----------------------------------|------------|--------------------|------------|
| ** **                       | ** ** | **Loans Held**     | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Type of Loan**                 | ** ** | **for Sale (1)**   | ** ** | **for Investment** | ** ** | **Total** | ** ** |
| ** **                       | ** ** | **(In thousands)** | ** ** |
| Corporate leveraged loans:       |       |               |       |   |   |   |   |
| Loans held in DFR MM CLO (2)     |       | $                  | —     |   | $ | 272,093 |   | $ | 272,093 |   |
| Other corporate leveraged loans  |       | 109                |       | — |   | 109 |   |
| Commercial real estate loans (3) |       | —             |       | 9,489 |   | 9,489 |   |
|                             |       | $                  | 109        |   | 281,582 |   | 281,691 |   |
| Allowance for loan losses        |       |               |       | (13,055 | ) | (13,055 | ) |
|                             |       |               |       | $ | 268,527 |   | $ | 268,636 |   |

 

----

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

 

(2)                                  Loans held inDFR MM CLO are reported gross of $5.6 million of allowance for loan losses asof June 30, 2010.

 

(3)                                  Commercial realestate loans are reported gross of $7.4 million of allowance for loanlosses as of June 30, 2010.

 

The following summarizes our allowance for loan losses at June 30,2010:

 
| ** **                   | ** ** | **Number**   | ** ** | **Par**            | ** ** | **Allowance**       | ** ** |
|------------------------------|------------|--------------|------------|--------------------|------------|---------------------|------------|
| **Type of Loan**             | ** ** | **of Loans** | ** ** | **Value**          | ** ** | **for Loan Losses** | ** ** |
| ** **                   | ** ** | ** **   | ** ** | **(In thousands)** | ** ** |
| Loans held in DFR MM CLO     |       | 4            |       | $                  | 9,798      |                | $          | (5,647 | ) |
| Commercial real estate loans |       | 3            |       | 8,058              |       | (7,408              | )          |
| Total                        |       | 7            |       | $                  | 17,856     |                | $          | (13,055 | ) |

 

As of June 30, 2010, our loans held for sale and loans held forinvestment totaled $268.6 million, net of allowance for loan losses. Loansclassified as held for sale and carried at the lower of cost or estimated fairvalue totaled $0.1 million, net of a valuation allowance of$1.0 million as of June 30, 2010. Loans classified as held forinvestment were carried at amortized cost of $281.6 million, less anallowance for loan losses of $13.1 million as of June 30, 2010. Forthe three and six months ended June 30, 2010, the average net carryingvalue of impaired loans was $4.2 million.

 

As of June 30, 2010, we held certain loans that allow the borrowerto satisfy interest accruals by increasing the outstanding principal balance ofthe loan. For the three and six months ended June 30, 2010, interestreceivables were satisfied through increases to the loans’ outstandingprincipal balances in the amount of $0.3 million and $0.7 million,respectively.

 

Loans held in DFR MM CLO are considered to be held for investment andare reported at amortized cost with an allowance for loan losses, if necessary,unless we decide to sell one of these loans, in which case the loan istransferred to loans held for sale and carried at the lower of cost or estimatedfair value.

 

As of June 30, 2010, our commercial real estate loans consisted offour loans classified as held for investment totaling $9.5 million less anallowance for loan losses of $7.4 million. We recognized $0.1 million ininterest income on one of these loans for the six months ended June 30,2010.

 

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The following summarizes the activity within the allowance for loanlosses for the six months ended June 30, 2010 and 2009:

 
| ** **                                  | ** ** | **Allowance for Loan Losses** | ** ** |
|---------------------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **2010**                      | ** ** | **2009** | ** ** |
| ** **                                  | ** ** | **(In thousands)**            | ** ** |
| Allowance for loan losses at January 1 |       | $                             | 15,889     |   | $ | 19,979 |   |
| Provision for loan losses                   |       | 4,485                         |       | 11,226 |   |
| Charge-offs                                 |       | (7,311                        | )          | (2,616 | ) |
| Recoveries                                  |       | (8                            | )          | — |   |
| Allowance for loan losses at June 30   |       | $                             | 13,055     |   | $ | 28,589 |   |

 

We did not recognize $0.9 million and $1.8 million, respectively, ofinterest income earned, but not yet received, on loans held for investment forthe three months and six months ended June 30, 2010 as a result of theplacement of these loans on non-accrual status. In addition, we did notrecognize $0.3 million and $1.0 million, respectively, of interest incomeearned, but not yet received, on loans held for sale for the three and sixmonths ended June 30, 2009 as a result of the placement of these loans onnon-accrual status. Our loans held for investment, loans held for sale andloans classified as investments at fair value are diversified over manyindustries, and, as such, we do not believe we have any significantconcentration risk associated with the composition of the loan portfolio.

 

**8.DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES**

 

Derivative instruments are carried at fair value as discussed inNote 5.  The following table is asummary of our derivative instruments as of June 30, 2010 for ourPrincipal Investing segment:

 
| ** **          | ** ** | **Number of** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|---------------------|------------|---------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **          | ** ** | **Contracts** | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **          | ** ** | ** **    | ** ** | **(In thousands)** | ** ** |
| Interest rate swap  |       | 1             |       | $                  | 10,000     |       | $          | —          |       | $                 | (207       | ) | $ | (207 | ) |
| Interest rate cap   |       | 1             |       | 40,000             |       | —     |       | (18             | )          | (18               | )          |
| Warrants            |       | 3             |       | n/a                |       | 29         |       | —          |       | 29                |       |
| Embedded Derivative |       | 1             |       | n/a                |       | —     |       | (10,156         | )          | (10,156           | )          |
|                |       | 6             |       | $                  | 50,000     |       | $          | 29              |       | $                 | (10,381    | ) | $ | (10,352 | ) |

 

----

n/a—notapplicable

 

The following table is a summary of our derivative instruments as of June 30,2010 for our Consolidated Investment Products segment:

 
| ** **         | ** ** | **Number of** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|--------------------|------------|---------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **         | ** ** | **Contracts** | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **         | ** ** | ** **    | ** ** | **(In thousands)** | ** ** |
| Interest rate swap |       | 1             |       | 123,000            |       | $          | —     |            | $          | (5,709            | )          | $ | (5,709 | ) |
| Warrants           |       | 4             |       | n/a                |       | 27         |       | —          |       | 27                |       |
|               |       | 5             |       | $                  | 123,000    |       | $          | 27              |       | $                 | (5,709     | ) | $ | (5,682 | ) |
|                    |            |               |            |                    |            |            |            |                 |            |                   |            |  |  |  |  |

 

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The following table is a summary of the net loss (gain) on derivativesincluded in net (loss) gain on investments, loans, derivatives and liabilitiesin the condensed consolidated statements of operations:

 
| ** **                     | ** ** | **For the three months ended June 30,** | ** ** | **For the six months ended June 30,** | ** ** |
|--------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2010**                                     | ** ** | **2009**                                   | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                     | ** ** | **(In thousands)**                           | ** ** | **(In thousands)**                         | ** ** |
| Interest rate swaps            |       | $                                            | 59         |                                       | $          | 2,939 |   | $ | (569 | ) | $ | 2,766 |   |
| Credit default swaps           |       | —                                       |       | —                                     |       | — |   | (119 | ) |
| Interest rate floors and caps  |       | —                                       |       | 1                                          |       | — |   | 1 |   |
| Warrants                       |       | (5                                           | )          | 41                                         |       | (43 | ) | (71 | ) |
| Embedded Derivative            |       | (3,267                                       | )          | —                                     |       | (3,267 | ) | — |   |
| Net gain (loss) on derivatives |       | $                                            | (3,213     | )                                          | $          | 2,981 |   | $ | (3,879 | ) | $ | 2,577 |   |

 

***Interest Rate Swaps***

 

In general, when a fixed-rate or hybrid adjustable-rate RMBS is fundedby a short term borrowing, our Principal Investing segment may enter into aninterest rate swap agreement that effectively fixes a portion of the borrowingcosts for a period close to the anticipated weighted-average life of thefixed-rate portion of the related RMBS. This strategy is designed to protect aportion of our portfolio from increased funding costs due to rising interestrates because the borrowing costs are not fixed for the duration of thefixed-rate period of the related RMBS. With respect to our ConsolidatedInvestment Products segment, interest rate swaps may be entered into by a CDOto protect it from a mismatch between any fixed interest rates on its assetsand the floating interest rates on its debt.

 

We did not enter into any interest rate swaps during the three or sixmonths ended June 30, 2010. The weighted average fixed rate payable on theinterest rate swaps in our Principal Investing and Consolidated InvestmentProducts segments as of June 30, 2010 was 5.83%.

 

***Interest Rate Cap***

 

Our interest rate cap is structured such that we will receive paymentsbased on the spread in rates if the three-month London Interbank Offered Rate (“LIBOR”)rate increases above a certain agreed upon contractual rate, and we will makepayments based on a nominal fixed interest rate. This interest rate cap wasentered into to manage interest rate exposure in DFR MM CLO.

 

***Embedded Derivative***

 

Our Convertible Notes contain a conversion feature with certainantidilution provisions that cause the conversion feature to be deemed anembedded derivative instrument under the provision of ASC Topic 815. SeeNote 3 for additional discussion concerning the Convertible Notes and theEmbedded Derivative.

 

***Warrants***

 

We hold warrants in both our Principal Investing and ConsolidatedInvestment Products segments to purchase equity interests in companies withrespect to which we or the CIP CDOs are, or were, also a debt holder. Thesewarrants were typically issued in connection with renegotiations and amendmentsof the loan agreements related to debt holdings of our Principal Investing andConsolidated Investment Products segments.

 

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**9. NET GAIN(LOSS) ON INVESTMENTS, LOANS, DERIVATIVES AND LIABILITIES**

 

The following table is a summary of the components of our net gain(loss) on investments, loans, derivatives and liabilities:

 
| ** **                                                          | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                          | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                          | ** ** | **(In thousands)**                   | ** ** |
| ** **                                                          | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss on available-for-sale securities                           |       | $                                    | —     |                               | $          | — |   | $ | — |   | $ | (31 | ) |
| Net gain (loss) on investments at fair value                        |       | (43,751                              | )          | 1,173                              |       | 29,281 |   | 6,311 |   |
| Net gain (loss) on liabilities at fair value                        |       | 14,802                               |       | —                             |       | (73,054 | ) | — |   |
| Net gain on loans                                                   |       | 4,237                                |       | 24,876                             |       | 6,991 |   | 30,691 |   |
| Net gain (loss) on derivatives                                      |       | (3,213                               | )          | 2,981                              |       | (3,879 | ) | 2,577 |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities |       | $                                    | (27,925    | )                                  | $          | 29,030 |   | $ | (40,661 | ) | $ | 39,548 |   |

 

**10.EQUIPMENT AND IMPROVEMENTS**

 

On November 27, 2009, we entered into an amendment to our originallease agreement dated July 11, 2005 (as amended, the “Lease”). Pursuant tothe amendment, we vacated our original premises on April 30, 2010 andrelocated to new office space in the same building.

 

The new term of the Lease will expire on February 28, 2021. As aresult of our relocation, our annual rent expense under the Lease will bereduced by approximately $1.3 million. In addition, the amount of theletter of credit constituting our security deposit under the Lease was reducedfrom approximately $2.3 million to approximately $1.3 million. Theamendment also provides for a further reduction of the amount of the letter ofcredit to $0.5 million on September 30, 2010 upon the satisfaction ofcertain conditions.

 

In connection with the amendment, we recognized a non-cash accelerationof depreciation and amortization expense related to certain leaseholdimprovements and equipment on the original premises as a result of a shorterestimated life for the use of those assets. The total impact of theacceleration of the depreciation and amortization expense was approximately$6.9 million, which we expensed ratably from the date the amendment wassigned (November 27, 2009) to the date on which we vacated the originalpremises (April 30, 2010). The impact of the accelerated depreciation forthe three and six months ended June 30, 2010 was approximately$1.4 million and $5.5 million, respectively. During the three and sixmonths ended June 30, 2010, we also invested $1.0 million and $1.3million, respectively, in additions to leasehold improvements, equipment, andfurniture and fixtures related to the new premises.

 

**11.REPURCHASE AGREEMENTS**

 

Repurchase agreements are short term borrowings from financialinstitutions that bear interest at rates that have historically moved in closerelationship to the one-month, two-month or three-month LIBOR. As of June 30,2010, we had repurchase agreements outstanding with two counterparties in theamount of $282.2 million with a weighted-average borrowing rate of 0.33%and remaining weighted average maturity of 22 days. During the six months endedJune 30, 2010, repurchase agreement liabilities decreased by$9.2 million, primarily as a result of net RMBS sales and paydowns, whichresulted in associated repurchase agreement reductions. As of June 30,2010, the fair value of securities pledged minus repurchase agreementliabilities and related accrued interest payable was $11.0 million. At June 30,2010, 88.3% of our repurchase agreement liabilities were concentrated with onecounterparty. See Note 12 for additional discussion concerning securitiesreceived and pledged as collateral.

 

**12.SECURITIES RECEIVED AND PLEDGED AS COLLATERAL**

 

To the extent that we receive securities as collateral in connectionwith derivative and repurchase agreement transactions, we are generallypermitted to sell or repledge these securities. As of June 30, 2010, wedid not have any securities held as collateral. We also pledge our own assetsto collateralize our repurchase agreements and in connection with derivativetransactions. These securities owned and pledged, where the counterparty hasthe right by contract or custom to sell or repledge the financial instruments,were approximately $293.3 million as of June 30, 2010 and consistedof securities pledged as initial collateral on repurchase agreements. Inaddition, as of June 30, 2010, we had $0.8 million of cash withcounterparties as collateral on derivatives, which is included in Due frombroker on the condensed consolidated balance sheet.

 

In July 2010, our largest repurchase agreement counterparty agreedto remove the requirement that we maintain a minimum of $20.0 million ofcash and certain eligible securities in the custody of such counterparty inorder to maintain our current repurchase agreement margin percentages on ourAgency RMBS.

 

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**13. LONGTERM DEBT**

 

The following table summarizes our long term debt as of June 30,2010:

 
| ** **                           | ** ** | ** **         | ** ** | **Current**               | ** ** |
|--------------------------------------|------------|--------------------|------------|---------------------------|------------|
| ** **                           | ** ** | **Carrying**       | ** ** | **Weighted Average** | ** ** |
| ** **                           | ** ** | **Value**          | ** ** | **Borrowing Rate**        | ** ** |
| ** **                           | ** ** | **(In thousands)** | ** ** | ** **                | ** ** |
| **Recourse:**                        | ** ** | ** **         | ** ** | ** **                | ** ** |
| Trust Preferred Securities           |       | $                  | 25,775     |                      | 3.84       | % |
| Junior Subordinated Debt             |       | 95,000             |       | 1.00                      | %          |
| Convertible Notes (1)                |       | 16,522             |       | 8.00                      | %          |
| Total Recourse                       |       | 137,297            |       | 2.38                      | %          |
| **Non-Recourse:**                    |       |               |       |                      |       |
| DFR MM CLO (2)                       |       | 217,296            |       | 1.02                      | %          |
| Consolidated Investment Products (3) |       | 3,494,410          |       | 0.95                      | %          |
| Total Non-Recourse                   |       | 3,711,706          |       | 0.95                      | %          |
| Total long term debt                 |       | $                  | 3,849,003  |                      | 1.00       | % |

 

----

(1)          The Convertible Notesprincipal outstanding of $25.0 million is presented net of an $8.5 milliondiscount. The Convertible Notes currently pay interest at the 8.00% statedrate; however, including the discount, the effective rate of interest is18.14%.

 

(2)          Excludes $19.0 millionof DFR MM CLO debt that is owned by us and eliminated upon consolidation. Hadthis debt been included, the weighted-average borrowing rate would have been1.29% as of June 30, 2010.

 

(3)          Long term debt of the CIPCDOs is recorded at fair value in accordance with ASC Topic 820.  This includes the fair value of thepreference shares issued by the CIP CDOs in the carrying value, however, thepreference shares do not have a stated interest rate and are therefore excludedfrom the calculation of the weighted average rate. The par value of the CIP CDOslong term debt (including preference shares) was $4.2 billion.

 

*Recourse Debt*

 

Recoursedebt refers to debt that is our general obligation.

 

*Junior Subordinated Debt and Trust Preferred Securities*

 

OnMarch 4, 2010, we entered into an exchangeagreement with the holders of our trust preferred securities to exchange$95.0 million of the $120.0 million aggregate outstanding principalamount of trust preferred securities previously issued by our threewholly-owned indirect subsidiaries, Deerfield Capital Trust I, DeerfieldCapital Trust II and Deerfield Capital Trust III, for$95.0 million aggregate outstanding principal amount of juniorsubordinated notes (the “JuniorSubordinated Debt”) issued by us (the “Trust Preferred Exchange”). The Trust Preferred Exchange wascompleted on March 4, 2010. An aggregate of $25.0 million inprincipal amount of trust preferred securities issued by Deerfield CapitalTrust I was not exchanged and remains outstanding and is subject to theterms and covenants, including the net worth covenant, set forth in the amendedtrust preferred indenture and described in our 2009 10-K.

 

TheJunior Subordinated Debt is governed by a junior subordinated indenture (the “Junior Subordinated Debt Indenture”),dated March 4, 2010, between us and The Bank of New York Mellon TrustCompany, National Association, as trustee. Pursuant to the Junior SubordinatedDebt Indenture, the Junior Subordinated Debt bears interest at a fixed rate of1.00% per annum from the date of issuance through April 30, 2015 as aresult of the CNCIM Acquisition and the related strategic transactions, whichcollectively qualified as a Credit Enhancing Transaction (as defined in theJunior Subordinated Debt Indenture). Thereafter, the Junior Subordinated Debtwill be subject to a variable interest rate equal to LIBOR plus 2.58% perannum, until maturity on October 30, 2035.

 

The Junior Subordinated Debt Indenture contains certain restrictivecovenants including, among other things, (i) a covenant that requires allasset management activities to be conducted by DFR and its subsidiaries, andwhich permits us to sell equity and material assets of DCM only if all assetmanagement fees and proceeds from equity and asset sales are subject to thelimits on restricted payments set forth in the Junior Subordinated DebtIndenture, (ii) a debt covenant that permits DFR and DCM to incurindebtedness only if the proceeds of such indebtedness are subject to the limitson restricted payments set forth in the Junior

 

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SubordinatedDebt Indenture and (iii) a restricted payments covenant that restricts ourability to pay dividends or make distributions in respect of our equity securities,subject to a number of exceptions and conditions. Unlike the indentures for thetrust preferred securities, the Junior Subordinated Debt Indenture does notcontain a covenant requiring us to maintain a minimum net worth.

 

*Convertible Notes*

 

Seethe “TheConvertible Notes Agreement and Issuance of the Conversion Shares” discussionin Note 3 for a description of the Convertible Notes.

 

TheConvertible Notes Agreement contains events of default customary for agreementsof its type (with customary grace periods, as applicable) and provides that,upon the occurrence of an event of default arising from certain events ofbankruptcy or insolvency with respect to us and our material subsidiaries, alloutstanding Convertible Notes will become due and payable immediately withoutfurther action or notice. If any other type of event of default occurs and iscontinuing, then the holders of at least 33-1/3% in principal amount of thethen outstanding Convertible Notes may declare all of the outstanding ConvertibleNotes to be due and payable immediately.

 

TheConvertible Notes Agreement contains customary covenants, including thefollowing: (i) that we will not, and will not permit any of oursubsidiaries to, incur any indebtedness that is contractually subordinated inright of payment to other indebtedness of ours unless such indebtedness is alsocontractually subordinated in right of payment to the Convertible Notes onsubstantially similar terms; (ii) that we will not consolidate or mergewith or into another person or sell, transfer or otherwise dispose of all orsubstantially all of our assets to another person unless certain conditions aresatisfied; (iii) that, upon a change of control, we will offer torepurchase all or any part of the Convertible Notes of each holder ofConvertible Notes at a purchase price in cash equal to 100% of the aggregateprincipal amount of the Convertible Notes repurchased, plus accrued and unpaidinterest; and (iv) that we will use commercially reasonable efforts tokeep the Conversion Shares listed on the NASDAQ Stock Market or anothersecurities exchange on which our common stock is listed or quoted.

 

*Senior Notes*

 

We used the proceeds of the issuance of theConvertible Notes together with other available funds to complete the SeniorNotes Discharge on June 9, 2010 as discussed in Note 3. We recordeda $17.4 million gain on the condensed consolidated statement of operationsrelated to the Senior Notes Discharge.

 

*Non-Recourse Debt*

 

Non-recoursedebt refers to debt with recourse only to specific assets pledged as collateralto the lenders, such as the debt issued by the CIP CDOs and DFR MM CLO. Thecreditors of non-recourse debt have no recourse to our other assets. None ofour non-recourse debt is subject to potential margin calls for additionalpledges of cash or assets.

 

*DFR MMCLO*

 

Theholders of the debt securities of DFR MM CLO have recourse only to its assets,which had a carrying value of $285.5 million as of June 30, 2010.

 

*ConsolidatedInvestment Products*

 

During the three and six months ended June 30,2010, the CIP CDOs paid down $62.2 million and $105.6 million, respectively, oftheir outstanding debt. The carrying value of the assets held in the CIPCDOs, which are the only assets to which the CIP CDOs debt holders have recoursefor repayment, was $4.0 billion as of June 30, 2010.

 

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**14. STOCKHOLDERS’ EQUITY**

 

***Common Stock***

 

On June 9, 2010, we issued 4,545,455 shares ofcommon stock to Bounty in connection with the CNCIM Acquisition as discussed inNote 3. In addition, the Convertible Notes issued to Bounty are convertibleinto 4,132,231 shares of common stock (as such amount may be adjusted incertain events or increased in connection with the payment of PIK interest atan initial conversion price of $6.05 per share, subject to adjustment).

 

***Performance Shares***

 

Duringthe three months ended June 30, 2010, we granted 11,111 restricted stockunits (the “Performance Shares”) to each of the eight non-employee directors ofour Board as a component of their compensation. We recorded $400,000 inexpense within other general and administrative expense on the condensedconsolidated statement of operations during the three months endedJune 30, 2010 related to these grants.  Each of the PerformanceShares represents the right to receive one share of our common stock onJune 16, 2013, subject to forfeiture and acceleration upon the occurrenceof certain specified events. The number of Performance Shares granted to eachnon-employee director is subject to adjustment for dividends or otherdistributions paid between June 16, 2010 and June 16, 2013 and mayalso be adjusted, as determined by the Board, in connection with any stockdividends, stock splits, subdivisions or consolidations of shares (includingreverse stock splits) or similar changes in our capitalization.

 

Thefollowing table summarizes our Performance Shares activity for the six months endedJune 30, 2010:

 
| Performance shares as of January 1, 2010 |   | 308,164 |   |
|-----------------------------------------------|--------|---------|--------|
| Granted                                       |   | 88,888  |   |
| Performance shares as of June 30, 2010   |   | 397,052 |   |

 

***Restricted Stock Grants***

 

As of January 1, 2010,we had one nonvested restricted stock grant outstanding related to 433 sharesof our common stock.  All of the 433shares associated with the restricted stock grant vested during the six monthsended June 30, 2010, and we no longer have any outstanding restrictedstock grants.

 

***Warrants***

 

On April 14, 2009, we announced the formation of DPLC, ourinvestment venture with Pegasus. In connection with the formation of DPLC, weissued to Pegasus Deerfield, an affiliate of Pegasus, (i) a five-yearwarrant to purchase 2,500,000 shares of our common stock at an exercise priceof $4.25 per share (“Warrant A”) and (ii) a five-year warrant to purchase500,000 shares of our common stock at an exercise price of $10.00 per share (“WarrantB” and, together with Warrant A, the “Warrants”). On March 21, 2010, weentered into the Termination Agreement with the Pegasus Parties, the DeerfieldParties and Jonathan Trutter, our CEO, pursuant to which, among other things,the Deerfield Parties and the Pegasus Parties agreed to cancel the Warrants. Wealso granted certain of the Pegasus Parties and their affiliates the DPLCRestructuring Warrants, which are fully vested warrants to purchase 250,000shares of our common stock at an exercise price of $4.25 per share. For the sixmonths ended June 30, 2010, we recognized $0.5 million of warrant expenserelated to the DPLC Restructuring Warrants in other general and administrativeexpense in the condensed consolidated statement of operations. See Note 3 formore details regarding the DPLC Restructuring.

 

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**15.COMPUTATION OF NET INCOME (LOSS) PER SHARE**

 

The following table presents the calculation of basic and diluted netincome (loss) per share:

 
| ** **                                                                             | ** ** | **Three months ended June 30,**      | ** ** | **Six months ended June 30,**        | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                             | ** ** | **2010**                                  | ** ** | **2009**                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                             | ** ** | **(In thousands, except per share data)** | ** ** | **(In thousands, except per share data)** | ** ** |
|                                                                                   |       |                                      |       |                                      |       |   |   |   |   |
| **Net income**                                                                         |       | $                                         | 7,386      |                                      | $          | 49,906 |   | $ | 4,086 |   | $ | 61,445 |   |
| Net loss attributable to noncontrolling interest  and Consolidated investment Products |       | 10,471                                    |       | 2,960                                     |       | 13,634 |   | 2,960 |   |
| **Net income attributable to  Deerfield Capital Corp.**                                |       | $                                         | 17,857     |                                      | $          | 52,866 |   | $ | 17,720 |   | $ | 64,405 |   |
|                                                                                   |       |                                      |       |                                      |       |   |   |   |   |
| Weighted average shares used in basic calculation                                      |       | 7,884                                     |       | 6,731                                     |       | 7,327 |   | 6,717 |   |
| Diluive effect of:                                                                     |       |                                      |       |                                      |       |   |   |   |   |
| Warrants                                                                               |       | 60                                        |       | —                                    |       | 34 |   | — |   |
| Weighted average shares used in diluted  calculation                                   |       | 7,944                                     |       | 6,731                                     |       | 7,361 |   | 6,717 |   |
|                                                                                   |       |                                      |       |                                      |       |   |   |   |   |
| **Net income attributable to  Deerfield Capital Corp. per share - basic**              |       | $                                         | 2.26       |                                      | $          | 7.85 |   | $ | 2.42 |   | $ | 9.59 |   |
|                                                                                   |       |                                      |       |                                      |       |   |   |   |   |
| **Net income attributable to  Deerfield Capital Corp. per share - diluted**            |       | $                                         | 2.25       |                                      | $          | 7.85 |   | $ | 2.41 |   | $ | 9.59 |   |

 

For the three and six months ended June 30, 2010, the 4,132,231Conversion Shares related to the Convertible Notes were excluded from the calculationof diluted net income per share because their effect was anti-dilutive underthe if-converted method. For the three and six months ended June 30, 2010,the 250,000 DPLC Restructuring Warrants issued and vested on March 22,2010 in connection with the Termination Agreement were included in thecalculation of diluted net income per share because their effect was dilutiveunder the treasury stock method.

 

For the three and six months ended June 30, 2010 and 2009,Performance Shares were included in both weighted average shares calculationsbut were not included in shares outstanding. For the three and six months endedJune 30, 2009, restricted stock grants for 433 shares of our common stockwere not included in the calculation of diluted net income (loss) per sharebecause their effect was anti-dilutive under the treasury stock method.

 

**16. INCOMETAXES**

 

We record deferred income taxes in accordance with ASC Topic 740 *— Income Taxes*(“ASC Topic 740”). We record deferred taxassets and liabilities for the future tax consequences attributable todifferences between the GAAP carrying amounts and their respective income taxbases. As required by ASC Topic 740, DFR evaluated the likelihood of realizingtax benefits in future periods, which requires the recognition of a valuationallowance to reduce any deferred tax assets to an amount that is more likelythan not to be realized. As of June 30, 2010, we continued to record afull valuation allowance on our net deferred tax assets.

 

The issuance of the Acquisition Shares resultedin an ownership change as defined in Sections 382 and 383 of the InternalRevenue Code of 1986, as amended (the “Code”) (“Ownership Change”). Generally,there is an Ownership Change if, at any time, one or more 5% shareholders (asdefined in the Code) have aggregate increases in their ownership of more than50 percentage points looking back over the relevant testing period, whichcan occur as a result of acquisitions and certain dispositions of common stockby our 5% shareholders. As a result of the occurrence of the Ownership Change,our ability to use our net operating losses (“NOLs”), net capital losses (“NCLs”)and certain recognized built-in losses to reduce our taxable income in futureyears is generally limited to an annual amount (the “Section 382Limitation”) equal to the fair market value of our common stock immediatelyprior to the Ownership Change, subject to certain adjustments, multiplied bythe long term tax-exempt interest rate, which for the month of June was4.01%.  NOLs and NCLs that exceed theSection 382 Limitation in any year will continue to be allowed ascarryforwards for the remainder of the carryforward period; however, if thecarryforward period for any NOL or NCL expires before that loss is fullyutilized, the unused portion will provide no future benefit.

 

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We are continuing to evaluate the effects of the Ownership Change onour gross deferred tax assets. As of December 31, 2009, we had NOLs ofapproximately $209.0 million. Due to the Ownership Change and the Section 382Limitation, the maximum amount of NOLs that is expected to be available priorto expiration is approximately $22.0 million without regard to capital lossesthat were carried forward. As of December 31, 2009, we also had NCLs ofapproximately $422.8 million. Due to the Ownership Change and the Section 382Limitation, the maximum amount of NCLs that is expected to be available priorto expiration is approximately $5.5 million. Consequently, we expect to reducedeferred tax assets related to our NOLs and NCLs by approximately $242.0million. There could also be further reductions in deferred tax assets related tocertain built-in losses. The reductions discussed above and any futurereductions of deferred tax assets will have a corresponding reduction in thevaluation allowance, and as such, will have no effect on our financialstatements.

 

For the three and six months ended June 30, 2010, our InvestmentManagement segment recorded de minimis income tax expense related to DeerfieldCapital Management (Europe) Limited.

 

**17. SEGMENT REPORTING**

 

Our business consists of three reportable segments: InvestmentManagement, Principal Investing and Consolidated Investment Products. Weevaluate the performance of our Investment Management and Principal Investingsegments (“DFR Operations”) based on segment results, expenses and revenues. Weseparately evaluate our Consolidated Investment Products segment based on itsresults, expenses and revenues, as our Consolidated Investment Products segmentexclusively consists of the CIP CDOs. The results for all segments also includedirect and allocated expenses and revenues. The following table provides abreakdown of our condensed consolidated statements of operations intosegment-based components. DFR Operations for the three and six months ended June 30,2010 is comparable to our consolidated GAAP results for periods prior to January 1,2010.

 

The following summarizes the financial information concerning ourreportable segments (as described in Note 1):

 
| ** **                                                     | ** ** | **For the three months ended June, 2010**          | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                     | ** ** | **Investment  Management (1)**                     | ** ** | **Principal  Investing (1)** | ** ** | **DFR Operations** | ** ** | **Consolidated  Investment  Products** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                 | ** ** |
|                                                           |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                                |       | $                                                  | 208        |   | $ | 8,817 |   | $ | 9,025 |   | $ | 28,423 |   | $ | (265 | )(2) | $ | 37,183 |   |
| Interest expense                                               |       | 1,025                                              |       | 1,595 |   | 2,620 |   | 5,917 |   | (265 | )(2) | 8,272 |   |
| Net interest income (expense)                                  |       | (817                                               | )          | 7,222 |   | 6,405 |   | 22,506 |   | — |   | 28,911 |   |
| Provision for loan losses                                      |       | —                                             |       | 291 |   | 291 |   | — |   | — |   | 291 |   |
| Net interest income (expense) after provision for  loan losses |       | (817                                               | )          | 6,931 |   | 6,114 |   | 22,506 |   | — |   | 28,620 |   |
| Investment advisory fees                                       |       | 7,045                                              |       | — |   | 7,045 |   | — |   | (3,263 | )(3) | 3,782 |   |
| Total net revenues                                             |       | $                                                  | 6,228      |   | $ | 6,931 |   | $ | 13,159 |   | $ | 22,506 |   | $ | (3,263 | ) | $ | 32,402 |   |
| Depreciation and amortization                                  |       | $                                                  | 3,025      |   | $ | — |   | $ | 3,025 |   | $ | — |   | $ | — |   | $ | 3,025 |   |
| Income tax expense                                             |       | $                                                  | 2          |   | $ | — |   | $ | 2 |   | $ | — |   | $ | — |   | $ | 2 |   |
| Net income (loss)                                              |       | $                                                  | 14,624     |   | $ | 3,075 |   | $ | 17,699 |   | $ | (10,313 | ) | $ | — |   | $ | 7,386 |   |
|                                                           |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| ** **                                                     | ** ** | **For  the three months ended June 30, 2009** | ** ** |   |   |   |   |   |   |
| ** **                                                     | ** ** | **Investment  Management (1)**                     | ** ** | **Principal  Investing (1)** | ** ** | **DFR Operations** | ** ** |   |   |   |   |   |   |
| ** **                                                     | ** ** | **(In  thousands)**                                | ** ** |   |   |   |   |   |   |
|                                                           |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                                |       | $                                                  | 16         |   | $ | 14,082 |   | $ | 14,098 |   |   |   |   |   |   |   |
| Interest expense                                               |       | 1,314                                              |       | 4,352 |   | 5,666 |   |   |   |   |   |   |   |
| Net interest income (expense)                                  |       | (1,298                                             | )          | 9,730 |   | 8,432 |   |   |   |   |   |   |   |
| Provision for loan losses                                      |       | —                                             |       | 9,119 |   | 9,119 |   |   |   |   |   |   |   |
| Net interest income (expense) after provision for  loan losses |       | (1,298                                             | )          | 611 |   | (687 | ) |   |   |   |   |   |   |
| Investment advisory fees                                       |       | 4,009                                              |       | — |   | 4,009 |   |   |   |   |   |   |   |
| Total net revenues                                             |       | $                                                  | 2,711      |   | $ | 611 |   | $ | 3,322 |   |   |   |   |   |   |   |
| Depreciation and amortization                                  |       | $                                                  | 1,629      |   | $ | — |   | $ | 1,629 |   |   |   |   |   |   |   |
| Income tax expense                                             |       | $                                                  | 10         |   | $ | 150 |   | $ | 160 |   |   |   |   |   |   |   |
| Net income (loss)                                              |       | $                                                  | (3,401     | ) | $ | 53,307 |   | $ | 49,906 |   |   |   |   |   |   |   |

 

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| ** **                                                     | ** ** | **For the six months ended June 30, 2010**  | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                     | ** ** | **Investment  Management (1)**              | ** ** | **Principal  Investing (1)** | ** ** | **DFR Operations** | ** ** | **Consolidated  Investment  Products** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                               | ** ** |
|                                                           |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                                |       | $                                                | 214        |   | $ | 16,086 |   | $ | 16,300 |   | $ | 52,709 |   | $ | (324 | )(2) | $ | 68,685 |   |
| Interest expense                                               |       | 2,238                                            |       | 3,380 |   | 5,618 |   | 10,672 |   | (324 | )(2) | 15,966 |   |
| Net interest income (expense)                                  |       | (2,024                                           | )          | 12,706 |   | 10,682 |   | 42,037 |   | — |   | 52,719 |   |
| Provision for loan losses                                      |       | —                                           |       | 4,477 |   | 4,477 |   | — |   | — |   | 4,477 |   |
| Net interest income (expense) after provision for  loan losses |       | (2,024                                           | )          | 8,229 |   | 6,205 |   | 42,037 |   | — |   | 48,242 |   |
| Investment advisory fees                                       |       | 13,547                                           |       | — |   | 13,547 |   | — |   | (6,869 | )(3) | 6,678 |   |
| Total net revenues                                             |       | $                                                | 11,523     |   | $ | 8,229 |   | $ | 19,752 |   | $ | 42,037 |   | $ | (6,869 | ) | $ | 54,920 |   |
| Depreciation and amortization                                  |       | $                                                | 8,763      |   | $ | — |   | $ | 8,763 |   | $ | — |   | $ | — |   | $ | 8,763 |   |
| Income tax expense                                             |       | $                                                | 2          |   | $ | — |   | $ | 2 |   | $ | — |   | $ | — |   | $ | 2 |   |
| Net income (loss)                                              |       | $                                                | 11,176     |   | $ | 7,067 |   | $ | 18,243 |   | $ | (14,157 | ) | $ | — |   | $ | 4,086 |   |
|                                                           |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| ** **                                                     | ** ** | **As of June 30, 2010**                     | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                               | ** ** |
| Identifiable assets                                            |       | $                                                | 677,811    |   | $ | 57,398 |   | $ | 735,209 |   | $ | 3,961,970 |   | $ | (5,477 | )(4) | $ | 4,691,702 |   |
|                                                           |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| ** **                                                     | ** ** | **For  the six months ended June 30, 2009** | ** ** |   |   |   |   |   |   |
| ** **                                                     | ** ** | **Investment  Management (1)**              | ** ** | **Principal  Investing (1)** | ** ** | **Consolidated** | ** ** |   |   |   |   |   |   |
| ** **                                                     | ** ** | **(In  thousands)**                              | ** ** |   |   |   |   |   |   |
|                                                           |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| Interest income                                                |       | $                                                | 62         |   | $ | 27,818 |   | $ | 27,880 |   |   |   |   |   |   |   |
| Interest expense                                               |       | 2,658                                            |       | 10,007 |   | 12,665 |   |   |   |   |   |   |   |
| Net interest income (expense)                                  |       | (2,596                                           | )          | 17,811 |   | 15,215 |   |   |   |   |   |   |   |
| Provision for loan losses                                      |       | —                                           |       | 11,226 |   | 11,226 |   |   |   |   |   |   |   |
| Net interest income (expense) after provision for  loan losses |       | (2,596                                           | )          | 6,585 |   | 3,989 |   |   |   |   |   |   |   |
| Investment advisory fees                                       |       | 8,746                                            |       | — |   | 8,746 |   |   |   |   |   |   |   |
| Total net revenues                                             |       | $                                                | 6,150      |   | $ | 6,585 |   | $ | 12,735 |   |   |   |   |   |   |   |
| Depreciation and amortization                                  |       | $                                                | 3,264      |   | $ | — |   | $ | 3,264 |   |   |   |   |   |   |   |
| Income tax expense                                             |       | $                                                | 28         |   | $ | 150 |   | $ | 178 |   |   |   |   |   |   |   |
| Net income (loss)                                              |       | $                                                | (6,788     | ) | $ | 68,233 |   | $ | 61,445 |   |   |   |   |   |   |   |
|                                                           |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| ** **                                                     | ** ** | **As  of June 30, 2009**                    | ** ** |   |   |   |   |   |   |
| ** **                                                     | ** ** | **(In  thousands)**                              | ** ** |   |   |   |   |   |   |
| Identifiable assets                                            |       | $                                                | 47,806     |   | $ | 686,834 |   | $ | 734,640 |   |   |   |   |   |   |   |

 

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(1)                                  Excludesintercompany investment advisory fee revenues of our Investment Managementsegment and corresponding intercompany management fee expense for our PrincipalInvesting segment related to the management agreement between the two segmentsof $0.6 million and $1.3 million for the three and six months ended June 30,2010, respectively, and $1.4 million and $2.9 million for the three and sixmonths ended June 30, 2009, respectively.

 

(2)                                  Primarilyrepresents interest income and the corresponding interest expense earned by ourPrincipal Investing segment on its investment in our Consolidated InvestmentProducts segment debt.

 

(3)                                  Primarilyrepresents internal fees charged to our Consolidated Investment Productssegment by our Investment Management segment for investment advisory services.

 

(4)                                  Primarilyrepresents the elimination of Investment Management segment and PrincipalInvesting segment investments in CIP CDOs of $3.7 million and the receivablefor fees charged to our Consolidated Investment Products segment by ourInvestment Management segment which have not yet been paid by our ConsolidatedInvestment Products segment of $1.7 million.

 

Our Principal Investing segment results of operations include thefinancial results of DFR MM CLO and DPLC for the three and six monthsended June 30, 2010 and 2009.

 

**18.COMMITMENTS AND CONTINGENCIES**

 

***Legal Proceedings***

 

As previously reported, in connection with the investigation by the SECof certain mortgage securities transactions effected by DCM on behalf of DFR in2005 and 2006, and the accounting for those transactions, DFR received a “Wellsnotice” from the staff of the SEC on June 7, 2010 stating that the staffwill recommend that the SEC bring an enforcement proceeding against DFR forpossible violations of certain securities laws. On July 16, 2010, DFRsubmitted a response to the “Wells notice” presenting its position on theissues raised in the “Wells notice” and requesting that the SEC reject thestaff’s recommendation that it bring an enforcement proceeding against DFR. TheSEC has not yet determined whether it will commence enforcement proceedingsagainst DFR.

 

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As a result of the SEC’s investigation, DFR has determined that it isappropriate to establish a reserve of $1.3 million for the quarter ended June 30,2010 included in Other, net in the condensed consolidated statements ofoperations, which represents its current best estimate of the probable lossassociated with the resolution of this matter based, in part, on DFR’sdiscussions with the SEC concerning the issues raised in the “Wells notice.”  There can be, however, no assurance that theamount reserved will be sufficient, and DFR cannot predict when or how thismatter will be resolved.

 

In the ordinary course of business, we may be subject to legal andregulatory proceedings that are generally incidental to our ongoing operations.While there can be no assurance of the ultimate disposition of suchproceedings, we do not believe their disposition will have a material adverseeffect on our condensed consolidated financial statements.

 

***2010 Interim Chairman CompensationAgreement***

 

On March 22, 2010, we entered into a letter agreement (“2010Rothschild Compensation Agreement”) with Peter H. Rothschild setting forth thefees payable to him for his services as Interim Chairman of the Board for theyear ending December 31, 2010. Mr. Rothschild has been a member ofthe Board since December 2004 and the Interim Chairman of the Board sinceApril 19, 2007. The 2010 Rothschild Compensation Agreement provides for abase fee during 2010 of $41,667 per month and an expense reimbursement of$10,000 per month for expenses relating to office space, information technologyand other items which Mr. Rothschild pays to his firm which provides himwith office space and related infrastructure. This agreement is subject tocancellation at any time at the discretion of the compensation committee of theBoard (the “Compensation Committee”) as well as the occurrence of certainspecified events. The 2010 Rothschild Compensation Agreement also provides fortwo discretionary fees, a “Capital Transaction Success Fee” not to exceed$1,000,000 and a “Non-Capital Transaction Success Fee” not to exceed $500,000,which may be paid if certain specified conditions are met. During the threemonths ended June 30, 2010, Mr. Rothschild received a discretionaryfee of $550,000 in connection with the consummation of the CNCIM Acquisition.

 

***Other Commitments and Contingencies***

 

We had unfunded investment commitments on bank loans of$2.4 million as of June 30, 2010. The timing and amount of additionalfunding on these bank loans are at the discretion of the borrower, to theextent the borrower satisfies certain requirements and provides certaindocumentation. Subsequent to June 30, 2010, the unfunded commitments onbank loans was reduced to $0.7 million as a result of a modification of theloan agreement.

 

**19. SUBSEQUENT EVENTS**

 

In connection with the preparation of the condensed consolidatedfinancial statements, we evaluated subsequent events after the balance sheetdate of June 30, 2010. There have been no significant subsequent eventssince June 30, 2010 that would require adjustment to or additionaldisclosure in these financial statements.

 

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**ITEM 2.****             ****MANAGEMENT’SDISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Youshould read the following discussion together with our condensed consolidatedfinancial statements and notes thereto included in*“Part I — Item 1. Financial Statements”* of thisQuarterly Report on Form 10-Q (the “Quarterly Report”). Unless otherwisenoted or the context otherwise requires, we refer to Deerfield Capital Corp. as“DFR,” to DFR and its subsidiaries as “we,” “us,” “our” or “our company,” toDeerfield & Company LLC, one of our indirect wholly-ownedsubsidiaries, as “Deerfield” and to Deerfield Capital Management LLC, anotherof our indirect wholly-owned subsidiaries, as “DCM.”

 

**Overview**

 

We are a Maryland corporation with an Investment Management segmentthat manages approximately $10.1 billion of client assets as ofJuly 1, 2010, including bank loans and other corporate debt, residentialmortgage-backed securities (“RMBS”), government securities and asset-backedsecurities (“ABS”). Certain of these client assets, which we are required toconsolidate, constitute our Consolidated Investment Products segment.  In addition, through our Principal Investingsegment, we manage our own assets, which are comprised primarily of fixedincome investments, including bank loans and other corporate debt and RMBS, andtotaled $592.4 million as of June 30, 2010.

 

On March 22, 2010, we entered into an Acquisition and InvestmentAgreement (the “Acquisition Agreement”)with Bounty Investments, LLC (“Bounty”) and Columbus Nova Credit InvestmentsManagement, LLC (“CNCIM”), pursuant to which we agreed to acquire all of theoutstanding equity interests of CNCIM from Bounty (the “CNCIM Acquisition”). The CNCIM Acquisitionwas completed on June 9, 2010 (the “Closing Date”). CNCIM is an investmentmanager specializing in bank loans that currently manages four collateralizeddebt obligations (the “CNCIM CDOs”). See “*Strategic Transactions”*laterin this section for additional information regarding the CNCIM Acquisition andassociated transactions.

 

***Our Business***

 

We operate in three businesssegments: Investment Management, Principal Investing and ConsolidatedInvestment Products. Our Investment Management segment involves earninginvestment advisory fees for managing a variety of investment productsincluding collateralized debt obligations (“CDOs”), separately managed accountsand other investment vehicles. Our Principal Investing segment involvesmaintaining an investment portfolio comprised primarily of bank loans and othercorporate debt and Agency RMBS (as defined below). Agency RMBS are backed bymortgage loans and are guaranteed as to principal and interest by federallychartered entities such as the Federal National Mortgage Association (“FannieMae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and, in thecase of the Government National Mortgage Association (“Ginnie Mae”), the U.S.government. We refer to RMBS guaranteed or issued by the Fannie Mae, FreddieMac and Ginnie Mae as “Agency RMBS.” Our Agency RMBS portfolio consists ofFannie Mae and Freddie Mac securities. We refer to our investments in seniorsecured loans (first lien and second lien term loans), senior subordinated debtfacilities and other junior securities as “Corporate Loans.”  We provide investment management services to11 CDOs (the “CIP CDOs”) that are consolidated as Variable Interest Entities (“VIEs”)consistent with Financial Accounting Standards Board (“FASB”) Accounting StandardsCodification (the “Codification”) Topic 810—*Consolidation*(“ASCTopic 810”) as amended by Accounting Standards Update (“ASU”) 2009-17 (“ASU2009-17”). The CIP CDOs constitute our Consolidated Investment Productssegment. Our Consolidated Investment Products segment excludes DFR MiddleMarket CLO Ltd. (“DFR MM CLO”), which is included in our PrincipalInvesting segment because we own all of its preference shares.

 

*Investment Management Segment*

 

Our Investment Management segment is operated through DCM and itswholly-owned subsidiary, CNCIM. Unless otherwise noted or the context otherwiserequires, references to DCM’s investment management activities include theactivities of CNCIM. DCM manages investment accounts for various types ofclients, including CDOs, separately managed accounts (separate, non-pooledaccounts established by clients) and other investment vehicles. Except for theseparately managed accounts, these clients are collective investment vehiclesthat pool the capital contributions of multiple investors, which are typicallyfinancial institutions, such as insurance companies and banks, employeebenefits plans and “funds of funds” (investment funds that in turn allocatetheir assets to a variety of other investment funds). Our teams that managethese accounts are supported by various other groups within DCM, such as riskmanagement, systems, accounting, operations and legal. DCM enters into aninvestment management agreement with each client, pursuant to which the clientgrants DCM certain discretion to purchase and sell securities and otherfinancial instruments.

 

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Our primary source of revenue from our Investment Management segment isthe investment advisory fees paid by the accounts we manage. These feestypically consist of management fees based on the account’s assets and, in somecases, performance fees based on the profits we generate for the account.

 

***Assets Under Management***

 

As of July 1, 2010, DCM’s total assets under management (“AUM”)was approximately $10.1 billion, held in 31 CDOs, six separately managedaccounts and one other investment vehicle.

 

The following table summarizes the AUM for each of our productcategories:

 
| ** **                      | ** ** | **As of July 1, 2010** | ** ** |
|---------------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **Number of**               | ** ** | ** ** | ** ** |
| ** **                      | ** ** | **Accounts**                | ** ** | **AUM** | ** ** |
| ** **                      | ** ** | ** **                  | ** ** | **(In thousands)** | ** ** |
| CDOs (1):                       |       |                        |       |   |   |
| CLOs                            |       | 16                          |       | $ | 5,582,085 |   |
| Asset-backed securities         |       | 11                          |       | 3,605,426 |   |
| Corporate bonds                 |       | 4                           |       | 602,830 |   |
| Total CDOs                      |       | 31                          |       | 9,790,341 |   |
| Separately managed accounts (2) |       | 6                           |       | 320,666 |   |
| Other investment vehicle (3)    |       | 1                           |       | 5,997 |   |
| Total AUM (4)                   |       |                        |       | $ | 10,117,004 |   |

 

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(1)                                  CDO AUM numbersgenerally reflect the aggregate principal or notional balance of the collateraland, in some cases, the cash balance held by the CDOs and are as of the date ofthe last trustee report received for each CDO prior to July 1, 2010. TheAUM for our Euro-denominated CDOs has been converted into U.S. dollars usingthe spot rate of exchange as of the respective AUM date.

 

(2)                                  AUM for certainof the separately managed accounts is a multiple of the capital actuallyinvested in such account. Management fees for these accounts are paid on thishigher AUM amount.

 

(3)                                  Otherinvestment vehicle AUM represents the AUM of Deerfield Pegasus Loan Capital LP(“DPLC”).

 

(4)                                  Included inTotal AUM for July 1, 2010 is $275.6 million related to DFR MM CLO.DCM manages DFR MM CLO but is not contractually entitled to receive anymanagement fees so long as all of the preference shares are held by DeerfieldCapital LLC (“DC LLC”) or an affiliate thereof.

 

*PrincipalInvesting Segment*

 

Income from our Principal Investing segment is influenced by fourfactors: (i) the difference between the interest income we earn on ourinvestment portfolio and the cost of our borrowings net of hedges, if any,(ii) the net recognized gains and losses, if any, on our investmentportfolio, (iii) provision for loan losses, if any, and (iv) thevolume or aggregate amount of such investments. We use leverage to seek toenhance our returns, which can also magnify losses. The cost of borrowings tofinance our investments comprises a significant portion of our operatingexpenses.

 

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The following table is a summary of our Principal Investing segment byasset class:

 
| ** **                         | ** ** | **June 30, 2010** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **Carrying**           | ** ** | **% of Total** | ** ** |
| **Principal Investing**            | ** ** | **Value**              | ** ** | **Investments** | ** ** |
| ** **                         | ** ** | **(In thousands)**     | ** ** | ** ** | ** ** |
|                               |       |                   |       |   |   |
| RMBS (1)                           |       | $                      | 305,780    |   | 50.5 | % |
| Corporate Loans:                   |       |                   |       |   |   |
| Loans held in DFR MM CLO (2)       |       | 272,093                |       | 44.9 | % |
| Other corporate leveraged loans    |       | 109                    |       | 0.0 | % |
| Loans held in DPLC (3)             |       | 3,598                  |       | 0.6 | % |
| Commercial real estate loans (4)   |       | 9,489                  |       | 1.6 | % |
| Corporate bonds held in DFR MM CLO |       | 5,951                  |       | 1.0 | % |
| Equity securities                  |       | 1,412                  |       | 0.2 | % |
| Other investments (5)              |       | 7,057                  |       | 1.2 | % |
| **Total Investments**              |       | 605,489                |       | 100.0 | % |
| Allowance for loan losses          |       | (13,055                | )          |   |   |
| **Net Investments**                |       | $                      | 592,434    |   |   |   |

 

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(1)                                  RMBS are eitherAgency RMBS or non-Agency RMBS. As of June 30, 2010, non-Agency RMBSrepresented $1.6 million.

 

(2)                                  Loans held inDFR MM CLO are reported gross of a $5.6 million allowance for loan losses as ofJune 30, 2010.

 

(3)                                  Loans held inDPLC are syndicated bank loans.  Weelected to record these loans at fair value in accordance with ASC Topic 825—*Financial Instruments*(“ASC Topic 825”).

 

(4)                                  Commercial realestate loans are reported gross of a $7.4 million allowance for loan losses asof June 30, 2010.

 

(5)                                  Otherinvestments include $2.7 million of investments in the CIP CDOs that areeliminated upon consolidation.

 

*ConsolidatedInvestment Products*

 

Our Consolidated Investment Products segment was established onJanuary 1, 2010 in accordance with the amendments to the consolidationguidance in ASC Topic 810. We provide investment management services to the CIPCDOs and earn contractually-negotiated management fees for providing thoseservices. In addition to the seven CIP CDOs that we consolidated into theConsolidated Investment Products segment effective January 1, 2010, inconjunction with the CNCIM Acquisition, we consolidated the four CNCIM CDOs asof the Closing Date into this segment. Management fees vary by contract andperformance of the products, but typically include senior fees, subordinatedfees and incentive fees.

 

The following table is a summary of our Consolidated InvestmentProducts segment by asset class:

 
| ** **                           | ** ** | **June 30, 2010** | ** ** |
|--------------------------------------|------------|------------------------|------------|
| ** **                           | ** ** | **Carrying**           | ** ** | **% of Total** | ** ** |
| **Consolidated Investment Products** | ** ** | **Value**              | ** ** | **Investments** | ** ** |
| ** **                           | ** ** | **(In thousands)**     | ** ** | ** ** | ** ** |
|                                 |       |                   |       |   |   |
| Loans                                |       | $                      | 3,553,775  |   | 94.0 | % |
| Corporate bonds                      |       | 209,242                |       | 5.5 | % |
| Other investments                    |       | 18,575                 |       | 0.5 | % |
| **Total Investments**                |       | $                      | 3,781,592  |   | 100.0 | % |

 

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**OurStrategy**

 

Our strategy to achieve growth centers on four areas:(i) the acquisition of existing CDO contracts from other managers,(ii) the internal development of new product offerings relying onexisting capabilities, (iii) the introduction of new productsresulting from acquisitions of and ventures with external managers and(iv) the creation of new collateralized loan obligation (“CLO”) structuresas the market environment improves and the economics for new issuances becomeattractive to investors.

 

On June 9, 2010, we completed the CNCIM Acquisition and severalother strategic transactions which, provided a significant increase in our AUM,are expected to provide a significant increase in our investment advisory feeincome, eliminated our near-term debt maturities, reduced our total debt andremoved a number of restrictive debt covenants to which we were subject. Webelieve these transactions will result in opportunities for us to grow bothorganically and via acquisitions that may not have otherwise been available tous. See “*Strategic Transactions”*later in thissection for more details.

 

We are focused on growing our Investment Management segment bylaunching new investment products that we believe will diversify our revenuestreams and take advantage of our core competencies of credit analysis andasset management. We intend to make investments in certain of these newinvestment products. We believe that the growth of fee-based income through themanagement of alternative investment products will provide the most attractiverisk-adjusted return on capital.

 

We are also focused on managing our Principal Investing segment byopportunistically redeploying our capital into other fee-based strategies. Inthe near term, we expect to continue to hold our RMBS portfolio both for theincome it provides and as a source of liquidity.

 

**Strategic Transactions**

 

***The CNCIM Acquisition and Issuance of theAcquisition Shares***

 

OnMarch 22, 2010, we entered into the AcquisitionAgreement with Bounty and CNCIM. We completed the CNCIM Acquisition onthe Closing Date for total purchase consideration of $24.8 millionconsisting of (i) the issuance of 4,545,455 shares (at a Closing Dateprice of $4.50 per share) of our commonstock, par value $0.001 per share (the “Acquisition Shares”), (ii) deferred payments totaling$7.5 million in cash payable in five equal annual installments beginningon December 9, 2010 (with a Closing Date fair value of $6.0 million) and (iii) anadjustment related to the issuance of the Convertible Notes (as defined below).Calculation of the purchase consideration in accordance with ASC Topic 805 — *Business Combinations* (“ASC Topic 805”) is as follows:

 
| ** **                                                                    | ** ** | **(In thousands, except  share and per share  information)** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Shares issued                                                                 |       | 4,545,455                                                    |       |
| Multiplied by Closing Date share price                                        |       | $                                                            | 4.50       | (1) |
| Value of shares                                                               |       | $                                                            | 20,455     |   |
| Fair value of deferred payments to the seller                                 |       | 5,962                                                        |       |
| Less: excess of par value over estimated fair  value of the Convertible Notes |       | (1,623                                                       | )(2)       |
| Total purchase consideration                                                  |       | $                                                            | 24,794     |   |

 

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(1)                                  Represents theclosing price of our common stock on the Closing Date.

 

(2)                                 Represents a reduction ofthe purchase consideration because the par value of the Convertible Notes (asdefined below) of $25.0 million exceeded the fair value of the ConvertibleNotes of $23.4 million as of the Closing Date. As the CNCIM Acquisition and theissuance of the Convertible Notes are considered linked transactions, theConvertible Notes are initially recorded at their Closing Date fair value withthe difference between fair value and par allocated to the purchaseconsideration.

 

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Thefollowing is a summary of the recognized amounts of assets acquired andliabilities assumed as a result of the CNCIM Acquisition:

 
| ** **                                                                         | ** ** | **(In thousands)** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------|------------|
| Cash                                                                               |       | $                  | 2,470      |   |
| Investment advisory fee receivables                                                |       | 868                |       |
| Equipment and improvements                                                         |       | 148                |       |
| Other receivables                                                                  |       | 139                |       |
| Accrued and other liabilities                                                      |       | (306               | )          |
| Identifiable intangible assets                                                     |       | 11,065             |       |
| Excess of purchase consideration over identifiable  net assets acquired - goodwill |       | 10,410             |       |
|                                                                               |       | $                  | 24,794     |   |

 

Inaccordance with ASC Topic 805, the fair values of the assets acquired andliabilities assumed were estimated by management.  Management received the assistance of anindependent valuation firm.  Theidentifiable intangible assets acquired by asset class are as follows:

 
| ** **                      | ** ** | **Closing Date  Estimated Fair  Value** | ** ** | **Estimated Average Remaining  Useful Life** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
| ** **                      | ** ** | **(In thousands)**                      | ** ** | **(In years)**                               | ** ** |
| **Intangible asset class:**     |       |                                    |       |                                         |       |
| Investment management contracts |       | $                                       | 10,900     |                                         | 8.35       |   |
| Non-compete agreements          |       | 165                                     |       | 4.67                                         |       |
|                            |       | $                                       | 11,065     |                                         |       |   |

 

Thefair value of the intangible assets related to the CNCIM CDO investmentmanagement contracts was determined utilizing an excess earnings approach basedon the expected cash flows from the CDOs. The intangible assets related to themanagement contracts will be amortized based on a ratio of expected discountedcash flows from the contracts over the expected remaining term of thecontracts.  The fair value of theintangible assets associated with the non-compete agreements was determinedusing a lost cash flows analysis and will be amortized straight-line over theterm of the agreements. Goodwill of $10.4 million is the excess of the totalpurchase consideration over the identifiable tangible and intangible assetsacquired in the CNCIM Acquisition. Goodwill relates to (i) the additionalstrategic opportunities that we believe will be available to us as a result ofthe recapitalization of our debt and our increased assets under management, (ii) improvementsin our capital structure resulting from the Trust Preferred Exchange and theSenior Notes Discharge (each as defined below) and (iii) the expectedsynergies from the CNCIM Acquisition.

 

Inaccordance with ASC Topic 805, we have expensed CNCIM Acquisition-related expenses(other than those related to stock issuance and debt issuance) asincurred.  For the three and six monthsended June 30, 2010, we recorded expenses related to the CNCIM Acquisitionand associated transactions of $2.6 million and $4.0 million, respectively,within strategic transactions expenses in the condensed consolidated statementsof operations.  Stock issuance costs of$1.1 million were recorded as a reduction to additional paid-in capital inaccordance with ASC Topic 505 — *Equity.*

 

***The Convertible Notes Agreement andIssuance of the Conversion Shares***

 

OnMarch 22, 2010, in connection with entering into the AcquisitionAgreement, we entered into a Senior Subordinated Convertible Notes Agreement(the “Convertible Notes Agreement”)with Bounty pursuant to which Bounty agreed to purchase for cash,$25.0 million in aggregate principal amount of our senior subordinatedconvertible notes (the “ConvertibleNotes”), convertible into 4,132,231 shares of common stock (as suchamount may be adjusted in certain events or increased in connection with thepayment of interest-in-kind (“PIK Interest”)) (the “Conversion Shares”) at an initial conversion price of $6.05 pershare, subject to adjustment.  TheConvertible Notes were issued to Bounty simultaneously with the closing of theCNCIM Acquisition and will mature on December 9, 2017. Interest on theConvertible Notes is payable to the holders of the Convertible Notes quarterlyin arrears on each January 1, April 1, July 1 andOctober 1, beginning on July 1, 2010. We will pay interest in cash ata per annum rate starting at 8% on the Closing Date and increasingincrementally to 11% on June 9, 2014; provided, that we may, in our solediscretion and upon notice to the holders of the Convertible Notes, elect topay up to 50% of the interest payment due to any holder of the ConvertibleNotes in PIK Interest, subject to certain conditions.

 

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We evaluated the terms and conditions of the conversion featurecontained in the Convertible Notes, and certain of the antidilution provisionsof the conversion feature cause it to be deemed an embedded derivativeinstrument (the “Embedded Derivative”) under the provisions of ASCTopic 815—*Derivatives and Hedging*.These antidilution provisions prevent the conversion feature from qualifying asbeing indexed to our common stock. The Convertible Notes are recorded as twocomponents: (i) the Embedded Derivative initially recorded on the ClosingDate as a $6.9 million derivative liability and, (ii) long term debtinitially recorded on the Closing Date at $16.5 million. At each subsequentbalance sheet date, the Embedded Derivative will be marked to fair value andthe change in fair value will be recorded in the condensed consolidatedstatement of operations within net gain (loss) on investments, loans,derivatives and liabilities. As of June 30, 2010, the Embedded Derivativewas valued at $10.2 million, resulting in a $3.3 million loss during the threemonths ended June 30, 2010 recorded in the condensed consolidatedstatement of operations as net gain (loss) on investments, loans, derivativesand liabilities. The total Closing Date fair value of the two components was$23.4 million. The $1.6 million difference between the $25.0 million principalamount of the Convertible Notes and the $23.4 million Closing Date total fairvalue associated with the Convertible Notes was treated as a reduction of purchaseconsideration in conjunction with the CNCIM Acquisition. We did not elect thefair value option for the long term debt component of the Convertible Notes.The difference between the $16.5 million Closing Date fair value of theConvertible Notes recorded as long term debt and the $25.0 millionprincipal amount of the Convertible Notes will be accreted to earnings usingthe effective yield method of recognizing interest expense. Debt issuance costsof $0.5 million were recorded within prepaid and other assets and will beamortized into expense over the term of the Convertible Notes in accordancewith ASC Topic 470—*Debt*.

 

***The Senior Notes Discharge***

 

OnMarch 22, 2010, DFR and Deerfield entered into a Payment Agreement andRelease (the “Senior Notes DischargeAgreement”) with the holders of the Series A Senior Secured Notesissued by Deerfield (the “Series ANotes”) and the holders of the Series B Senior Secured Notes issuedby Deerfield (the “Series B Notes”and, together with the Series A Notes, the “Senior Notes”), pursuant to which we agreed with the holders ofthe Senior Notes to discharge all of the approximately $48.8 million inaggregate principal amount of Series A Notes then outstanding atapproximately 64.1% of the principal amount thereof plus accrued interest, andall of the approximately $25.1 million in aggregate principal amount ofthe Series B Notes previously outstanding at approximately 94.5% of theprincipal amount thereof plus accrued interest, or an aggregate discount of approximately25.6% from the face amount of the Senior Notes plus accrued interest (the “Senior Notes Discharge”).  We used the proceeds of the issuance of theConvertible Notes together with other available funds to complete the SeniorNotes Discharge on June 9, 2010.  Werecorded a $17.4 million gain on the condensed consolidated statement ofoperations related to the Senior Notes Discharge. As a result of theconsummation of the Senior Notes Discharge, all obligations and liabilities ofDFR and Deerfield under the Senior Notes were released, and the intercreditoragreement related to the Senior Notes was terminated.

 

***The DPLC Restructuring***

 

OnMarch 21, 2010, we entered into a Termination Agreement (the “Termination Agreement”) with PegasusDeerfield (AIV), LLC (“PegasusDeerfield”), PGS Management, LLC (“PM”, and together with Pegasus Deerfield, the “Pegasus Parties”), DPLC, DCM, DPLC GP, Deerfield LoanManager LLC (“DLM” andtogether with DFR, DCM and DLM, the “DeerfieldParties”) and Jonathan Trutter, pursuant to which (i) the PegasusParties waived certain rights with respect to the stock issuances associatedwith the CNCIM Acquisition and (ii) the Deerfield Parties and the PegasusParties terminated or amended certain provisions of agreements related to DPLCand cancelled warrants to purchase three million shares of our common stock,which comprises all of the warrants previously issued to the Pegasus Parties(the “DPLC Restructuring”).Pursuant to the Termination Agreement, we granted Pegasus Deerfield and certainof its associates warrants to purchase an aggregate of 250,000 shares ofour common stock at an exercise price of $4.25 per share (the “DPLCRestructuring Warrants”). For the six months ended June 30, 2010, werecognized $0.5 million of warrant expense related to the DPLC RestructuringWarrants in other general and administrative expense in the condensedconsolidated statement of operations. Pursuant to the Termination Agreement,DPLC GP and DPLC released all partners of DPLC from their unfunded capitalcommitments to DPLC as of the date of the Termination Agreement. Effective asof March 31, 2010, DPLC made distributions of $9.0 million to PegasusDeerfield and an amount equal to his entire capital account balance to JonathanTrutter. DPLC GP also withdrew an amount equal to the entire portion ofits capital account attributable to DLM’s investment in DPLC GP anddistributed such amount to DLM, our wholly-owned subsidiary. During the threemonths ended June 30, 2010, DPLC has made additional distributions to PegasusDeerfield of $3.8 million. Pegasus Deerfield has notified us that they intendto withdraw their entire remaining capital account balance.

 

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**Trends**

 

We have identified the following trends and factors that may affect ourbusiness:

 

*Credit market dislocation.*  The well-publicized disruptions in thefinancial markets that began in 2007 and escalated throughout 2008significantly diminished through the second half of 2009 and into the firstquarter of 2010. The numerous programs implemented by the U.S. government aimedat stabilizing credit markets and improving overall financial system liquidityinitially showed signs of having the desired effect. Among the signs ofreturning stability and confidence in financial markets was a strong increasein equity markets with the Dow Jones Industrial Average and theS&P 500 advancing by 29% and 27%, respectively, from June 30,2009 until March 31, 2010. However, during the second quarter of 2010,equity markets experienced a sharp correction with the Dow Jones IndustrialAverage falling from a high of 11,205 at April 26, 2010 to 9,774 at June 30,2010.  This decline was attributed toescalating credit concerns with respect to certain sovereign European debtissuers and fears of another slowdown in the U.S. economy. These two concernswere the primary forces behind a “flight to quality” shift in portfolios thatdrove yields on U.S. Treasury notes and bonds noticeably lower and causedcredit spreads to widen. For instance, the yield on the 10 year U.S. Treasurynote, which had fluctuated narrowly around an average of 3.70% during the firstquarter of 2010, fell to a yield of 2.93% at June 30, 2010.  The trailing 100 day volatility on the10 year U.S. Treasury bond also rose from 22.7%, as of March 31,2010, to 28.89%, as of June 30, 2010. We cannot predict the long-term effect that the numerous programs put inplace by the U.S. government will have on financial markets or our business,but we have observed that the liquidity provided by the government via thenumerous programs has begun to make it easier for us to obtain credit from newcounterparties as discussed below.

 

*Financial Reform*.  Thedislocations referred to above caused widespread damage to the economy,significant loss of jobs and necessitated numerous bailout programs to moderatethe negative impacts of the recent economic downturn. The U.S. federalgovernment expressed interest in undertaking financial reforms intended toprevent a recurrence of the 2008-2009 disruptions and in July 2010, theDodd-Frank Wall Street Reform and Consumer Protection Act was signed into law.We are already registered as an investment adviser with the Securities andExchange Commission (“SEC”) and, as a result, have no reason at present tobelieve the law will impact our business or strategy in any significant way.

 

*Liquidity.*  A significant portion of the investments inour Principal Investing portfolio are financed. We depend on a variety offinancial institutions to provide that financing. Historically, we havefinanced our RMBS portfolio using repurchase agreements. Events in 2008 causedmany financial institutions to change their credit standards and generallyreduced the amount of repurchase agreements available to borrowers, resultingin a decrease in overall market liquidity. This trend reduced the number offinancial institutions with which we conduct repurchase financings and, in 2008,prompted us to sell a significant portion of our RMBS portfolio at a time whenwe would not otherwise have chosen to do so. Improving market conditions andour performance have allowed us to add some new capacity in repurchasefinancing during the third quarter of 2010 by executing new agreements with twofirms.

 

*Corporate credit performance.*  Corporate default rates increased duringearly 2009 as the U.S. economy weakened and financial markets deteriorated.Although there is risk of further economic declines resulting in anothercyclical increase in corporate defaults over the coming months, the second halfof 2009 and the first six months of 2010 showed a reduction in corporatedefaults. If the stimulus packages are not effective in promoting growth, it ispossible that recent signs of improvement may give way to renewed economicweakness. A further weakening of the U.S. economy likely would result infurther increases in corporate default rates. Such increases likely wouldfurther reduce the returns associated with certain of our investments,particularly the Corporate Loans held in both our Principal Investing portfolioand in certain of the vehicles managed within our Investment Managementsegment. Increases in defaults also could cause us to trigger, or prolong theeffects of triggering, certain structural provisions in the CDOs that we haveinvestments in and manage. These structural provisions include, but are notlimited to, overcollateralization requirements that are meant to protectinvestors from deterioration in the credit quality of the underlying collateralpool.

 

*Credit spreads.*  Beginning in the second half of 2007, creditmarkets experienced significantly higher yields and wider spreads versusTreasury securities. For example, the yield spread on the Barclay’s High YieldBond Index (the “BHY Index”) increased from 295 basis points over Treasuries atJune 30, 2007 to a peak of 1830 basis points in November of 2008.This widening of credit spreads resulted in a decline over that period in the fairvalue for most of our investments and in the securities we manage. The secondhalf of 2009 saw a dramatic narrowing of credit spreads, as evidenced by thespread on the BHY Index falling from 945 basis points over Treasuries as ofJune 30, 2009 to 570 basis points as of March 31, 2010.  More recently, however, the average spread onthe BHY Index widened to 700 basis points over Treasuries as of June 30,2010, reflecting a more cautious view on the pace of economic recovery in theU.S. and credit concerns in Europe.

 

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*Yield curve.*  In the first quarter of 2010, the yield curvewas relatively stable, with the spread between 6 month U.S. Treasury bills and10 year U.S. Treasury notes narrowing by only 5 basis points from 3.65% atDecember 31, 2009 to 3.60% at March 31, 2010. In the second quarterof 2010, the yield curve flattened dramatically with the spread between 6 monthU.S. Treasury bills and 10 year U.S. Treasury notes declining to 2.71%.  This decline in the spread occurred almostentirely as a result of a decline in the yield of the 10 year U.S. Treasurynote which fell from 3.83% at March 31, 2010 to 2.93% at June 30,2010.  Since our earnings are derived inpart from the difference between the interest income we earn on our investmentportfolio and the cost of our borrowings net of hedges, if any, changes in theyield curve can impact our earnings. In that regard, we generally expect ourearnings to increase with a steeper yield curve, because we borrow at shortterm rate and hold investments paying interest at intermediate to long termrates; however, if short term yields rise in relation to intermediate termyields (a flattening of the yield curve), we would likely experience areduction in net interest income.

 

*CDO financing and management.*  The reduction in liquidity and widening ofcredit spreads resulted in significant downward pressure on the fair values ofassets typically held in and financed by CDOs in 2009. These decreased fairvalues, along with increased default rates on assets held in CDOs andsignificant rating agency downgrades of the collateral underlying certain ofour CDOs, caused our CDOs to trigger certain of their structural provisions andreduced our management fees and our AUM. During the first six months of 2010,we have seen increases in fair values of assets in certain of our portfolios.As a result, most of our CLOs have returned to compliance with theirovercollateralization tests, and we have begun to recoup some of our deferredsubordinated management fees from those CLOs and expect those CLOs to payfuture subordinated management fees on a current basis. See “*Results of Operations—Investment ManagementSegment—CDOs*” for further information.

 

*Valuation of investments.*  Fewer financing options and tighter lendingstandards had the widespread effect of forcing investors to offer for sale asignificant amount of investment assets under distressed market 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.

 

**Critical Accounting Policies**

 

Our financial statements are prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”). Theseaccounting principles require us to make some complex and subjective judgmentsand estimates. Our most critical accounting policies involve judgments andestimates that could affect our reported assets and liabilities, as well as ourreported revenues and expenses. We believe that all of the judgments andestimates inherent in our financial statements were reasonable, based uponinformation available to us. We rely on management’s experience and analysis ofhistorical and current market data in order to arrive at what we believe to bereasonable estimates. Under varying conditions, we could report materiallydifferent amounts arising under these critical 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 — Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations*” in our Annual Report on Form 10-K for the fiscalyear ended December 31, 2009, as filed with the SEC on March 23, 2010(our “2009 10-K”). There have been no material changes to the criticalaccounting policies disclosed in our 2009 10-K except as indicated below.

 

*Recent Accounting Updates*

 

InJune 2009, the FASB issued SFAS No. 167, *Amendments to FASB Interpretation No. 46(R) *(“SFASNo. 167”). In December 2009, the FASB issued ASU 2009-17 to revisethe Codification to include SFAS No. 167 within ASC Topic 810. InFebruary 2010, the FASB issued ASU 2010-10, *Amendments for Certain Investment Funds*(“ASU 2010-10”), to defer theeffective date of the amendments to the consolidation requirements of ASC Topic810 resulting from the issuance of ASU 2009-17 for reporting entities withinterests in entities with all the attributes of an investment company butspecifically excluding interests in securitization entities. This statementrequires an enterprise to perform an analysis to determine whether theenterprise’s variable interest or interests give it a controlling financialinterest in a VIE. The amendments to ASC Topic 810 also amendFIN 46(R) to eliminate the quantitative approach to determining theprimary beneficiary of a VIE and require ongoing reassessments of VIE status.We adopted the amendments to ASC Topic 810 on January 1, 2010 and createdour Consolidated Investment Products segment.

 

OurConsolidated Investment Products segment consists of the CIP CDOs. The impactof consolidating the CIP CDOs into our condensed consolidated balance sheet asof June 30, 2010 is an increase to total assets of $4.0 billion, anincrease in total liabilities of $3.6 billion and an increase in totalstockholders’ equity of $401.7 million, including a cumulative effect from theadoption of the amendments to ASC Topic 810 of $244.9 million as ofJanuary 1, 2010 and a cumulative effect from the adoption of ASC Topic 810for the CNCIM CDOs, consolidated effective June 9, 2010, of $186.0million. The impact of consolidating the CIP CDOs into our

 

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condensedconsolidated statement of operations for the three months ended June 30,2010 was an increase in total revenues of $22.5 million, an increase in totalexpense of $3.8 million, a decrease in net other income (expense) and gain(loss) of $29.0 million and a decrease in net income of $10.3 million. Theimpact of consolidating the CIP CDOs into our condensed consolidated statementof operations for the six months ended June 30, 2010 was an increase intotal revenues of $42.0 million, an increase in total expense of $8.1 million,a decrease in net other income (expense) and gain (loss) of $48.1 million and adecrease in net income of $14.2 million. There was no effect on the income (loss) attributable to DFR as a resultof the adoption of the amendments to ASC Topic 810.

 

In January 2010, the FASB issued ASU No. 2010-06—*Fair Value Measurements and Disclosure (“ASC Topic820”)—Improving Disclosures about Fair Value Measurements* (“ASU2010-06”). ASU 2010-06 amends ASC Topic 820 to add new requirements fordisclosures about transfers into and out of Levels 1 and 2 and separatedisclosures about purchases, sales, issuances and settlements relating toLevel 3 measurements. ASU 2010-06 also clarifies existing fair valuedisclosures about the level of disaggregation and about inputs and valuationtechniques used to measure fair value. We adopted ASU 2010-06 and have includedthe required disclosures in the notes to the condensed consolidated financialstatements, with the exception of the requirement to provide disclosure of theLevel 3 activity of purchases, sales, issuances and settlements on a grossbasis, which will be effective for our interim and annual reporting periodsbeginning after December 15, 2010.

 

**FinancialCondition**

 

The following table summarizes the carrying value of our investmentportfolio by balance sheet classification as of June 30, 2010 for ourPrincipal Investing and Investment Management segments:

 
| ** **                         | ** ** | **Investments at** | ** ** | **Other**       | ** ** | **Loans Held**   | ** ** | **Loans Held**     | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------------|------------|-----------------|------------|------------------|------------|--------------------|------------|------------|------------|
| ** **                         | ** ** | **Fair Value**     | ** ** | **Investments** | ** ** | **For Sale (1)** | ** ** | **For Investment** | ** ** | **Total**  | ** ** |
| **Security Description**           | ** ** | **(In thousands)** | ** ** |
| RMBS                               |       | $                  | 305,780    |            | $          | —           |       | $                  | —     |       | $          | — |   | $ | 305,780 |   |
| Corporate Loans:                   |       |               |       |            |       |             |       |               |       |       |       |
| Loans held in DFR MM CLO           |       | —             |       | —          |       | —           |       | 272,093            |       | 272,093    |       |
| Other corporate leveraged loans    |       | —             |       | —          |       | 109              |       | —             |       | 109        |       |
| Loans held in DPLC                 |       | 3,598              |       | —          |       | —           |       | —             |       | 3,598      |       |
| Commercial real estate loans       |       | —             |       | —          |       | —           |       | 9,489              |       | 9,489      |       |
| Corporate bonds held in DFR MM CLO |       | 5,951              |       | —          |       | —           |       | —             |       | 5,951      |       |
| Equity securities                  |       | —             |       | 1,412           |       | —           |       | —             |       | 1,412      |       |
| Other investments (2)              |       | 8,052              |       | —          |       | —           |       | —             |       | 8,052      |       |
| Total invested assets              |       | $                  | 323,381    |            | $          | 1,412            |       | $                  | 109        |       | 281,582    |   | 606,484 |   |
|                               |       |               |       |            |       |             |       |               |       |       |       |
| Allowance for loan losses          |       |               |       |            |       |             |       | (13,055            | )          | (13,055    | )          |
|                               |       |               |       |            |       |             |       |               |       |       |       |
|                               |       |               |       |            |       |             |       | $                  | 268,527    |       | $          | 593,429 |   |

 

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

 

(2)                                  Otherinvestments include $3.7 million of investments in the CIP CDOs that areeliminated upon consolidation.

 

***Residential Mortgage-Backed Securities***

 

For the three and six months ended June 30, 2010, we had netpurchases of RMBS of $26.8 million and $69.8 million, respectively.  Our RMBS portfolio also experienced netincreases in the fair value of RMBS holdings of $3.7 million and $2.8 millionfor the three and six months ended June 30, 2010, respectively. Thisactivity was partially offset by RMBS principal paydowns of $24.8 millionand $68.0 million for the three and six months ended June 30, 2010,respectively, $2.0 million and $0.6 million of realized losses during the threeand six months ended June 30, 2010, respectively, and amortization of $0.9million and $3.3 million for the three and six months ended June 30, 2010,respectively. Consequently, the fair value of our Agency RMBS increased from$302.5 million as of December 31, 2009 to a fair value of$304.2 million at June 30, 2010, while our non-Agency RMBS decreasedfrom $2.6 million as of December 31, 2009 to $1.6 million at June 30,2010.  This resulted in a total netincrease to RMBS of $0.7 million from December 31, 2009 to June 30,2010.

 

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As of June 30, 2010, our RMBS portfolio had a net amortized costof 104.94% of its par value. As of June 30, 2010 we had unamortized netpremium of $14.9 million included in the cost basis of our RMBS portfolio.As of June 30, 2010 the current weighted average life of the portfolio,which represents the average number of years for which each dollar of unpaidprincipal remains outstanding was 4.6 years.

 

Net portfolio duration, which is the difference between the duration ofour RMBS portfolio and the duration of our associated repurchase agreements,adjusted for the effects of our interest rate swap portfolio, was zero based onmodel-driven modified duration results. In order to fully assess the possibleimpact of a change in interest rates on the RMBS portfolio, we also analyze notonly the duration, but also the portfolio’s leverage and spread risk. Ourprimary means of measuring and managing spread risk in our RMBS portfolio is tocompute and monitor the dollar value of a 1 basis point change (the “DV01”)in the option adjusted spread at which our securities trade in relation tosimilar duration treasury obligations.

 

The following table details our RMBS holdings as of June 30, 2010:

 
| ** **                       | ** ** | ** **              | ** ** | ** **     | ** ** | **Weighted Average** | ** ** |
|----------------------------------|------------|-------------------------|------------|----------------|------------|----------------------|------------|
| ** **                       | ** ** | ** **              | ** ** | ** **     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | **Contractual** | ** ** | **Constant** | ** ** | ** ** | ** ** |
| ** **                       | ** ** | **Par**                 | ** ** | **Estimated**  | ** ** | ** **           | ** ** | **Months to** | ** ** | **Yield to** | ** ** | **Maturity** | ** ** | **Prepayment** | ** ** | **Modified** | ** ** |
| ** **                       | ** ** | **Amount**              | ** ** | **Fair Value** | ** ** | **Coupon**           | ** ** | **Reset (1)** | ** ** | **Maturity** | ** ** | **(Month/Year)** | ** ** | **Rate (2)** | ** ** | **Duration (3)** | ** ** |
| **Security Description**    | ** ** | **(In thousands)** | ** ** | ** **     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hybrid Adjustable Rate RMBS:     |       |                    | ** ** | ** **     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Rate reset in 1 year or less     |       | $                       | 35,318     |           | $          | 36,800               |       | 4.70 | % | 7 |   | 2.3 | % | 07/35 |   | 11.9 | % | 0.5 | % |
| Rate reset in 1 to 3 years       |       | 86,760                  |       | 90,971         |       | 5.37                 | %          | 22 |   | 2.3 | % | 04/36 |   | 14.9 | % | 0.4 | % |
| Rate reset in 3 to 5 years       |       | 71,352                  |       | 76,670         |       | 5.45                 | %          | 46 |   | 1.9 | % | 09/36 |   | 20.6 | % | -1.0 | % |
| Rate reset in 5 to 7 years       |       | 74,365                  |       | 67,953         |       | 5.45                 | %          | 70 |   | 2.4 | % | 05/37 |   | 25.4 | % | -0.4 | % |
| Rate reset in 7 to 10 years      |       | 28,368                  |       | 30,749         |       | 5.51                 | %          | 89 |   | 2.6 | % | 05/38 |   | 19.6 | % | 0.6 | % |
| Fixed Rate RMBS:                 |       |                    |       |           |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| 30 year                          |       | 5,143                   |       | 2,637          |       | 5.88                 | %          | n/a |   | 3.1 | % | 08/34 |   | 22.5 | % | 2.8 | % |
| Total hybrid and fixed rate RMBS |       | $                       | 301,306    |           | $          | 305,780              |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                  |            |                         |            |                |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  Representsnumber of months before conversion to floating rate.

 

(2)                                  Constantprepayment rate 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)                                  Modifiedduration represents the approximate percentage change in fair value per 100basis point change in interest rates.

 

n/a—not applicable

 

Actual maturities of RMBS are generally shorter than stated contractualmaturities as they are affected by the contractual lives of the underlyingmortgages, normal monthly amortization of principal and voluntary prepaymentsof principal. The stated contractual final maturity of the mortgage loansunderlying our portfolio of RMBS ranges up to 30 years from date ofissuance, but the expected maturity is subject to change based on the actualand estimated prepayments of the underlying loans.

 

The constant prepayment rate (“CPR”) attempts to predict the averageannualized percentage rate of principal prepayments over the remaining life ofthe security. As interest rates rise, the rate of refinancing typicallydeclines, which we believe may result in lower rates of prepayment and, as aresult, a lower portfolio CPR. CPR also may be influenced by defaults in themortgage loans underlying the RMBS that we hold. The agencies that guaranteetimely payment of principal and interest to RMBS holders may periodicallychoose to buy such delinquent mortgage loans from the pool by repaying theoutstanding principal balance on the loan thereby increasing unscheduledrepayments of principal and increasing CPR. Therefore, during periods of highdelinquencies and defaults in the mortgages underlying our RMBS, we would alsoexpect increases in prepayments and CPR. Furthermore, during the first quarterof 2010, Fannie Mae and Freddie Mac announced and began to carry out plans tobuy “substantially” all mortgages held in RMBS pools issued under theirrespective programs that were delinquent by 120 days or more. This actionhad the effect of increasing the near-term CPR on our RMBS.

 

As of June 30, 2010, the mortgages underlying our hybridadjustable-rate RMBS had fixed interest rates for a weighted average period ofapproximately 44 months after which time the interest rates reset andbecome adjustable. The average length of time until contractual maturity ofthose mortgages was approximately 26 years as of June 30, 2010.

 

After the reset date, interest rates on our hybrid adjustable-rate RMBSfloat based on spreads over various London Interbank Offered Rate (“LIBOR”) andU.S. Treasury indices. These interest rates are subject to caps that limitthe amount the applicable

 

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interestrate can increase during any year, known as an annual cap, and through thematurity of the applicable security, known as a lifetime cap. As of June 30,2010, the weighted average lifetime rate cap for the portfolio was 10.5%, theweighted average maximum increase in the first year that the rates areadjustable (“initial cap”) was 4.9%, and the weighted average maximum annualincrease for years subsequent to the first year was 2.0%.

 

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

 

As of June 30, 2010, DFR MM CLO had $280.8 millionof investments in loans outstanding, with a carrying value of$272.1 million, which is included in loans held for investment on thecondensed consolidated balance sheet, reduced by an allowance for loan lossesof $5.6 million. As of June 30, 2010, DFR MM CLO hadrestricted cash and cash equivalents of $8.2 million, which are generallyutilized to purchase additional loans and pay distributions to debt and equityholders, and $217.3 million of notes payable to third party investors,which is included in our long term debt. As of June 30, 2010, the weightedaverage coupon on the loan portfolio was 6.42%, and the weighted averagecontractual maturity of the loan portfolio was 4.1 years.DFR MM CLO is a bankruptcy remote entity, and, although weconsolidate 100% of the assets and liabilities of DFR MM CLO, our maximumexposure to loss on our investment in DFR MM CLO is limited to ourinitial investment of $69.0 million. As of June 30, 2010, we havereceived distributions from DFR MM CLO equal to $34.8 millionsince its inception.

 

The following table summarizes the carrying value of theDFR MM CLO loan portfolio:

 
| ** **                | ** ** | **June 30,**  | ** ** |
|---------------------------|------------|--------------------|------------|
| **Type of Loan**          | ** ** | **2010**           | ** ** |
| ** **                | ** ** | **(In thousands)** | ** ** |
| First lien secured (1)    |       | $                  | 149,543    |   |
| Second lien secured (2)   |       | 108,822            |       |
| Mezzanine                 |       | 13,728             |       |
| ** **                |       | 272,093            |       |
| Allowance for loan losses |       | (5,647             | )          |
| ** **                |       | $                  | 266,446    |   |

 

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(1)                                  Presented grossof a $1.2 million allowance for loan losses as of June 30, 2010.

 

(2)                                  Presented grossof a $4.4 million allowance for loan losses as of June 30, 2010.

 

***Derivatives and Hedging***

 

The following table summarizes the derivative instruments in ourPrincipal Investing segment as of June 30, 2010:

 
| ** **                      | ** ** | **Number of** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|---------------------------------|------------|---------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **                      | ** ** | **Conracts**  | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **                      | ** ** | ** **    | ** ** | **(In thousands)** | ** ** |
| ** **                      | ** ** | ** **    | ** ** | ** **         | ** ** | ** ** | ** ** | ** **      | ** ** | ** **        | ** ** |
| Interest rate swaps             |       | 1             |       | $                  | 10,000     |       | $          | —          |       | $                 | (207       | ) | $ | (207 | ) |
| Interest rate cap in DFR MM CLO |       | 1             |       | 40,000             |       | —     |       | (18             | )          | (18               | )          |
| Warrants                        |       | 3             |       | n/a                |       | 29         |       | —          |       | 29                |       |
| Embedded Derivative             |       | 1             |       | n/a                |       | —     |       | (10,156         | )          | (10,156           | )          |
|                            |       | 6             |       | $                  | 50,000     |       | $          | 29              |       | $                 | (10,381    | ) | $ | (10,352 | ) |

 

----

n/a—notapplicable

 

Our Convertible Notes contain a conversion feature, including certainantidilution provisions which cause it to be deemed an embedded derivativeinstrument under the provisions of ASC Topic 815. These antidilutionprovisions prevent the conversion feature from qualifying as being indexed toour common stock. As a result, the fair value of the Embedded Derivative wasrecorded as a $6.9 million derivative liability on the Closing Date. At eachsubsequent balance sheet date, the Embedded Derivative will be marked to fairvalue with the change in fair value being recorded in the condensedconsolidated statement of operations as net gain (loss) on

 

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investments,loans, derivatives and liabilities.  Asof June 30, 2010, the Embedded Derivative was valued at $10.2 million,resulting in a $3.3 million loss during the three months ended June 30,2010 recorded in the condensed consolidated statement of operations as net gain(loss) on investments, loans, derivatives and liabilities.

 

***Consolidated Investment Products Segment***

 

Investmentsin our Consolidated Investment Products segment include loans, corporate bondsand other investments recorded at fair value. The assets of our Consolidated Investment Products segment are heldsolely as collateral to satisfy the obligations of the CIP CDOs. We have noright to the benefits from, nor do we bear the risks associated with, theassets held by the CIP CDOs beyond our minimal direct investments in, andmanagement fees generated from, the CIP CDOs.

 

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**Results ofOperations**

 

The following section provides a comparative discussion of our consolidatedresults of operations as of and for the three and six months ended June 30,2010 and June 30, 2009.

 

***Summary***

 

The following table summarizes selected historical consolidatedfinancial information:

 
| ** **                                                                             | ** ** | **Three months ended June 30,**                  | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                             | ** ** | **2010**                                              | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                             | ** ** | **(Dollars in thousands, except for per share data)** | ** ** |
| ** **                                                                             | ** ** | ** **                                            | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Condensed Consolidated Statements  of Operations Data:**                             |       |                                                  |       |                               |       |   |   |   |   |
| Net revenues                                                                           |       | 32,402                                                |       | 3,322                              |       | 54,920 |   | 12,735 |   |
| Total expenses                                                                         |       | 11,029                                                |       | 11,989                             |       | 23,693 |   | 20,314 |   |
| Net other income (expense) and gain (loss)                                             |       | (13,985                                               | )          | 58,733                             |       | (27,139 | ) | 69,202 |   |
| Net income                                                                             |       | 7,386                                                 |       | 49,906                             |       | 4,086 |   | 61,445 |   |
| Net loss attributable to noncontrolling interest  and Consolidated Investment Products |       | 10,471                                                |       | 2,960                              |       | 13,634 |   | 2,960 |   |
| Net income attributable to Deerfield Capital Corp.                                     |       | 17,857                                                |       | 52,866                             |       | 17,720 |   | 64,405 |   |
| Net income attributable to Deerfield Capital Corp.  per share - diluted                |       | 2.25                                                  |       | 7.85                               |       | 2.41 |   | 9.59 |   |
| Core earnings (1)                                                                      |       | 6,405                                                 |       | 5,532                              |       | 10,860 |   | 10,559 |   |
| Core earnings per share - diluted (2)                                                  |       | 0.74                                                  |       | 0.82                               |       | 1.41 |   | 1.57 |   |

 
| ** **                                      | ** ** | **As of June 30,**    | ** ** | **As of December 31,** | ** ** |   |   |   |   |
|-------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|--------|--------|--------|--------|
| ** **                                      | ** ** | **2010**                   | ** ** | **2009**                    | ** ** |   |   |   |   |
| ** **                                      |       | **(Dollars in thousands)** |       |                        |       |   |   |
| **Condensed Consolidated Balance  Sheet Data:** |       |                       |       |                        |       |   |   |   |   |
| Residential mortgage-backed securities          |       | 305,780                    |       | 305,174                     |       |   |   |   |   |
| Assets in Consolidated Investment Products      |       | 3,961,970                  |       | —                      |       |   |   |   |   |
| Total assets                                    |       | 4,691,702                  |       | 720,222                     |       |   |   |   |   |
| Repurchase agreements                           |       | 282,246                    |       | 291,463                     |       |   |   |   |   |
| Long term debt:                                 |       |                       |       |                        |       |   |   |   |   |
| Recourse:                                       |       |                       |       |                        |       |   |   |   |   |
| Trust preferred securities                      |       | 25,775                     |       | 123,717                     |       |   |   |   |   |
| Junior subordinated debt                        |       | 95,000                     |       | —                      |       |   |   |   |   |
| Convertible notes                               |       | 16,522                     |       | —                      |       |   |   |   |   |
| Senior Notes                                    |       | —                     |       | 72,315                      |       |   |   |   |   |
| Non-Recourse:                                   |       |                       |       |                        |       |   |   |   |   |
| DFR MM CLO                                      |       | 217,296                    |       | 217,297                     |       |   |   |   |   |
| Consolidated Investment Products                |       | 3,494,410                  |       | —                      |       |   |   |   |   |
| Total stockholders’ equity                 |       | 434,170                    |       | 6,860                       |       |   |   |   |   |
|                                            |       |                       |       |                        |       |   |   |   |   |
| **AUM:**                                        |       |                       |       |                        |       |   |   |   |   |
| Investment Management segment (3) (4)      |       | 10,117,004                 |       | 9,193,908                   |       |   |   |   |   |
| Principal Investing segment (4) (5)        |       | 592,434                    |       | 593,562                     |       |   |   |   |   |

 

----

(1)                                  Core earningsrepresents a non-GAAP financial measure. Please see the *“Reconciliationof Non-GAAP Financial Measures”* below for a reconciliation betweenthe comparable GAAP measure and a discussion of the importance placed on thismeasure by management.

 

(2)                                  For the threeand six months ended June 30, 2010, we utilized the fully-diluted sharenumber of 8,943,181 and 7,862,680, respectively, which includes the dilutiveimpact of the DPLC Restructuring Warrants and the Convertible Notes. Inaddition, interest expense on the Convertible Notes of $0.2 million was addedback to core earnings for the three and six months ended June 30, 2010 tocalculate diluted earnings per share under the if-converted method.

 

(3)                                  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. Included in InvestmentManagement segment AUM is $275.6 million and $288.5 million relatedto DFR MM CLO for July 1, 2010 and January 1,

 

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2010, respectively. DCM manages DFR MM CLO, but is not contractuallyentitled to receive any management fees therefrom for so long as all of itspreference shares are held by DC LLC or an affiliate thereof.

 

(4)                                  AUM for DFR MMCLO and DPLC are included in both Investment Management segment AUM andPrincipal Investing segment AUM for July 1, 2010 and 2009.

 

(5)                                  AUM for ourPrincipal Investing segment is reflected net of allowance for loan losses of$13.1 million and $15.9 million as of June 30, 2010 and December 31,2009, respectively.

 

**Reconciliationof Non-GAAP Financial Measures**

 

We believe that core earnings, a non-GAAP financial measure, is auseful metric for evaluating and analyzing our performance. The calculation ofcore earnings, which we use to compare our own financial results from period toperiod, eliminates the impact of certain non-cash items, non-recurring items,special charges and income tax. The core earnings provided herein may not becomparable to similar measures presented by other companies, as it is anon-GAAP financial measure and may therefore be defined differently by othercompanies. Core earnings includes the earnings from DFR MM CLO for both thethree and six months ended June 30, 2010 and June 30, 2009, andMarket Square CLO Ltd. (“Market Square CLO”) (until we sold all of ourpreference shares in and deconsolidated Market Square CLO as of June 30,2009) but is not necessarily indicative of cash flows received from DFR MM CLOand Market Square CLO.

 

**CoreEarnings**

 

The table below provides a reconciliation between net income and coreearnings:

 
| ** **                                                                      | ** ** | **Three months ended June 30,**                   | ** ** | **Six months ended June 30,**                     | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2010**                                               | ** ** | **2009**                                               | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                      | ** ** | **(In thousands, except share and per share amounts)** | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| ** **                                                                      | ** ** | ** **                                             | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                      |       | $                                                      | 7,386      |                                                   | $          | 49,906 |   | $ | 4,086 |   | $ | 61,445 |   |
| Adjusting items:                                                                | ** ** | ** **                                             |       |                                                   | ** ** | ** ** |   |   |   |
| Provision for loan losses                                                       |       | 291                                                    |       | 9,119                                                  |       | 4,477 |   | 11,226 |   |
| Depreciation and amortization                                                   |       | 3,025                                                  |       | 1,629                                                  |       | 8,763 |   | 3,264 |   |
| Impairment of intangible assets                                                 |       | —                                                 |       | 126                                                    |       | 168 |   | 126 |   |
| Net other income (expense) and gain (loss) (1)                                  |       | 14,430                                                 |       | (58,733                                                | )          | 27,139 |   | (69,202 | ) |
| Income tax expense                                                              |       | 2                                                      |       | 160                                                    |       | 2 |   | 178 |   |
| Noncontrolling interest and Consolidated  Investment Products core earnings (2) |       | (18,729                                                | )          | 3,297                                                  |       | (34,304 | ) | 3,297 |   |
| Warrant expense                                                                 |       | —                                                 |       | —                                                 |       | 529 |   | — |   |
| Cost savings initiatives                                                        |       | —                                                 |       | 28                                                     |       | — |   | 225 |   |
| Core earnings                                                                   |       | $                                                      | 6,405      |                                                   | $          | 5,532 |   | $ | 10,860 |   | $ | 10,559 |   |
|                                                                            |       |                                                   |       |                                                   |       |   |   |   |   |
| Core earnings per share - diluted                                               |       | $                                                      | 0.74       |                                                   | $          | 0.82 |   | $ | 1.41 |   | $ | 1.57 |   |
| Weighted-average number of shares outstanding -  diluted (3)                    |       | 8,943,181                                              |       | 6,730,655                                              |       | 7,862,680 |   | 6,716,570 |   |

 

----

(1)                                  The coreearnings adjustment for net other income (expense) and gain (loss) includes$0.4 million in strategic transaction expenses related to the three monthsended March 31, 2010, which should have been included as an adjustment tocore earnings in that period. Additionally, core earnings for the six monthsended June 30, 2010 exclude $0.4 million of loss on investments at fairvalue that should have been an adjustment to core earnings in that period.

 

(2)                                  Noncontrollinginterest and Consolidated Investment Products core earnings is comprised of (i) theportion of net interest income and expenses of DPLC that are attributable tothird party investors in DPLC, calculated using each investor’s ownershippercentage in DPLC during the measurement period, and (ii) the portion ofnet interest income and expenses of the CIP CDOs that are consolidated but areattributable to third party investors in the CIP CDOs.

 

(3)                                  For the threeand six months ended June 30, 2010, we utilized the fully-diluted sharenumber of 8,943,181 and 7,862,680, respectively, in the computation of thediluted core earnings per share, which includes the dilutive impact of the DPLCRestructuring Warrants and the Convertible Notes. In addition, interest expenseon the Convertible Notes of $0.2 million was added back to core earnings forthe three and six months ended June 30, 2010 to calculate diluted earningsper share under the if-converted method.

 

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**Executive Summary of Results of Operations**

 

When we analyze our financial results, we focus on the combined resultsof our Investment Management and Principal Investing segments (“DFR Operations”).While we are required to include our Consolidated Investment Products segmentin our consolidated GAAP results, this segment does not have any economicimpact on our operations.

 

OurPrincipal Investing segment results of operations include the financial resultsof DFR MM CLO and DPLC for the three and six months ended June 30, 2010and June 30, 2009. Our Principal Investing segment results of operationsalso include the financial results of Market Square CLO for the three and sixmonths ended June 30, 2009. On June 30, 2009, we sold all of ourpreference shares in Market Square CLO to an unrelated third party in exchangefor an upfront payment and a delayed purchase price in the form of a right toreceive a portion of the future distributions, if any, on the preferenceshares. As a result of the sale, we determined we were no longer the primarybeneficiary of Market Square CLO and, therefore, deconsolidated Market SquareCLO.  As of January 1, 2010,however, the amendments to ASC Topic 810 required us to again consolidateMarket Square CLO, and it is now part of our Consolidated Investment Productssegment.

 

Our Consolidated Investment Products segment includes the results ofthe CIP CDOs, which, as of January 1, 2010, we consolidated in accordancewith the amendments to ASC Topic 810 and with respect to which we have electedfair value accounting. In conjunction with the CNCIM Acquisition, as of theClosing Date, we also consolidated the four CNCIM CDOs as CIP CDOs in accordancewith ASC Topic 810. The assets of the CIP CDOs are held solely as collateral tosatisfy the obligations of the CIP CDOs. We have no right to the benefits from,nor do we bear the risks associated with, the assets held by the CIP CDOs,beyond our minimal direct investments in, and management fees generated from,the CIP CDOs. If the CIP CDOs were to liquidate, the assets of the CIP CDOswould not be available to our general creditors, and as a result, we do notconsider them our assets. Additionally, the investors in the CIP CDOs have norecourse to the general credit of DFR for the debt issued by the CIP CDOs.Therefore, we do not consider this debt to be our obligation. When reviewingand analyzing our financial results, management excludes the impact of ourConsolidated Investment Products segment as this segment does not have anyeconomic impact on our operations.

 

Thefollowing tables provide a breakdown of our condensed consolidated statementsof operations into segment-based components and reconciles DFR Operations toGAAP. DFR Operations for the three and six months ended June 30, 2010 arecomparable to our consolidated GAAP results for periods prior to January 1,2010.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**SEGMENTCONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                                             | ** ** | **Three months ended June 30, 2010** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                             | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                             | ** ** | **Investment**                                                | ** ** | **Principal** | ** ** | ** ** | ** ** | **Investment** | ** ** | ** ** | ** ** | **GAAP** | ** ** |
| ** **                                                                             | ** ** | **Management**                                                | ** ** | **Investing** | ** ** | **DFR** | ** ** | **Products** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                                             | ** ** | **Segment (1)**                                          | ** ** | **Segment (1)** | ** ** | **Operations** | ** ** | **Segment** | ** ** | **Elimination** | ** ** | **DFR** | ** ** |
| ** **                                                                             | ** ** | **(In thousands)**                                       | ** ** |
| **Revenues**                                                                           | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest income                                                                        |       | $                                                             | 208        |   | $ | 8,817 |   | $ | 9,025 |   | $ | 28,423 |   | $ | (265 | ) | $ | 37,183 |   |
| Interest expense                                                                       |       | 1,025                                                         |       | 1,595 |   | 2,620 |   | 5,917 |   | (265 | ) | 8,272 |   |
| Net interest income                                                                    |       | (817                                                          | )          | 7,222 |   | 6,405 |   | 22,506 |   | — |   | 28,911 |   |
| Provision for loan losses                                                              |       | —                                                        |       | 291 |   | 291 |   | — |   | — |   | 291 |   |
| Net interest income (expense) after provision for  loan losses                         |       | (817                                                          | )          | 6,931 |   | 6,114 |   | 22,506 |   | — |   | 28,620 |   |
| Investment advisory fees                                                               |       | 7,045                                                         |       | — |   | 7,045 |   | — |   | (3,263 | ) | 3,782 |   |
| Total net revenues                                                                     |       | 6,228                                                         |       | 6,931 |   | 13,159 |   | 22,506 |   | (3,263 | ) | 32,402 |   |
|                                                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| **Expenses**                                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and benefits                                                              |       | 3,077                                                         |       | — |   | 3,077 |   | — |   | — |   | 3,077 |   |
| Professional services                                                                  |       | 190                                                           |       | 1,690 |   | 1,880 |   | 216 |   | — |   | 2,096 |   |
| Insurance expense                                                                      |       | 93                                                            |       | 608 |   | 701 |   | 51 |   | — |   | 752 |   |
| Other general and administrative expenses                                              |       | 488                                                           |       | 899 |   | 1,387 |   | 306 |   | — |   | 1,693 |   |
| Depreciation and amortization                                                          |       | 3,025                                                         |       | — |   | 3,025 |   | — |   | — |   | 3,025 |   |
| Occupancy                                                                              |       | 386                                                           |       | — |   | 386 |   | — |   | — |   | 386 |   |
| Investment advisory fees                                                               |       | —                                                        |       | — |   | — |   | 3,263 |   | (3,263 | ) | — |   |
| Total expenses                                                                         |       | 7,259                                                         |       | 3,197 |   | 10,456 |   | 3,836 |   | (3,263 | ) | 11,029 |   |
|                                                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| **Other Income (Expense) and Gain  (Loss)**                                            |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities                    |       | (954                                                          | )          | 2,294 |   | 1,340 |   | (29,265 | ) | — |   | (27,925 | ) |
| Strategic transactions expenses                                                        |       | (820                                                          | )          | (1,738 | ) | (2,558 | ) | — |   | — |   | (2,558 | ) |
| Net gain on the discharge of the Senior Notes                                          |       | 17,418                                                        |       | — |   | 17,418 |   | — |   | — |   | 17,418 |   |
| Other, net                                                                             |       | 13                                                            |       | (1,215 | ) | (1,202 | ) | 282 |   | — |   | (920 | ) |
| Net other income (expense) and gain (loss)                                             |       | 15,657                                                        |       | (659 | ) | 14,998 |   | (28,983 | ) | — |   | (13,985 | ) |
| Income (loss) before income tax expense                                                |       | 14,626                                                        |       | 3,075 |   | 17,701 |   | (10,313 | ) | — |   | 7,388 |   |
| Income tax expense                                                                     |       | 2                                                             |       | — |   | 2 |   | — |   | — |   | 2 |   |
|                                                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| **Net income (loss)**                                                                  |       | 14,624                                                        |       | 3,075 |   | 17,699 |   | (10,313 | ) | — |   | 7,386 |   |
| Net loss attributable to noncontrolling interest  and Consolidated Investment Products |       | —                                                        |       | 158 |   | 158 |   | 10,313 |   | — |   | 10,471 |   |
| **Net income attributable to  Deerfield Capital Corp.**                                |       | $                                                             | 14,624     |   | $ | 3,233 |   | $ | 17,857 |   | $ | — |   | $ | — |   | $ | 17,857 |   |
|                                                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| **Reconciliation of net income  (loss) and core earnings:**                            |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                             |       | $                                                             | 14,624     |   | $ | 3,075 |   | $ | 17,699 |   | $ | (10,313 | ) | $ | — |   | $ | 7,386 |   |
| Adjusting items:                                                                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Provision for loan losses                                                              |       | —                                                        |       | 291 |   | 291 |   | — |   | — |   | 291 |   |
| Depreciation and amortization                                                          |       | 3,025                                                         |       | — |   | 3,025 |   | — |   | — |   | 3,025 |   |
| Net other income (expense) and gain (loss) (2)                                         |       | (15,657                                                       | )          | 1,104 |   | (14,553 | ) | 28,983 |   | — |   | 14,430 |   |
| Income tax expense                                                                     |       | 2                                                             |       | — |   | 2 |   | — |   | — |   | 2 |   |
| Noncontrolling interest and Consolidated  Investment Products core earnings            |       | —                                                        |       | (59 | ) | (59 | ) | (18,670 | ) | — |   | (18,729 | ) |
| **Core Earnings**                                                                      |       | $                                                             | 1,994      |   | $ | 4,411 |   | $ | 6,405 |   | $ | — |   | $ | — |   | $ | 6,405 |   |

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**SEGMENTCONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                          | ** ** | **Three months ended June 30, 2009** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                          | ** ** | **Investment**                            | ** ** | **Principal** | ** ** | ** ** | ** ** |
| ** **                                                          | ** ** | **Management**                            | ** ** | **Investing** | ** ** | **DFR** | ** ** |
| ** **                                                          | ** ** | **Segment (1)**                           | ** ** | **Segment (1)** | ** ** | **Operations** | ** ** |
| ** **                                                          | ** ** | **(In thousands)**                        | ** ** |
| **Revenues**                                                        | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                     |       | $                                         | 16         |   | $ | 14,082 |   | $ | 14,098 |   |
| Interest expense                                                    |       | 1,314                                     |       | 4,352 |   | 5,666 |   |
| Net interest income                                                 |       | (1,298                                    | )          | 9,730 |   | 8,432 |   |
| Provision for loan losses                                           |       | —                                    |       | 9,119 |   | 9,119 |   |
| Net interest income (expense) after provision for  loan losses      |       | (1,298                                    | )          | 611 |   | (687 | ) |
| Investment advisory fees                                            |       | 4,009                                     |       | — |   | 4,009 |   |
| Total net revenues                                                  |       | 2,711                                     |       | 611 |   | 3,322 |   |
|                                                                |       |                                      |       |   |   |   |   |
| **Expenses**                                                        |       |                                      |       |   |   | ** ** |   |
| Compensation and benefits                                           |       | 3,029                                     |       | — |   | 3,029 |   |
| Professional services                                               |       | 140                                       |       | 588 |   | 728 |   |
| Insurance expense                                                   |       | 97                                        |       | 674 |   | 771 |   |
| Other general and administrative expenses                           |       | 530                                       |       | 4,284 |   | 4,814 |   |
| Depreciation and amortization                                       |       | 1,629                                     |       | — |   | 1,629 |   |
| Occupancy                                                           |       | 569                                       |       | — |   | 569 |   |
| Management and incentive fee expense to related  party              |       | —                                    |       | 295 |   | 295 |   |
| Cost savings initiatives                                            |       | 28                                        |       | — |   | 28 |   |
| Impairment of intangible assets                                     |       | 126                                       |       | — |   | 126 |   |
| Total expenses                                                      |       | 6,148                                     |       | 5,841 |   | 11,989 |   |
|                                                                |       |                                      |       |   |   |   |   |
| **Other Income (Expense) and Gain  (Loss)**                         |       |                                      |       |   |   | ** ** |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities |       | —                                    |       | 29,030 |   | 29,030 |   |
| Net gain on the deconsolidation of Market Square  CLO               |       | —                                    |       | 29,551 |   | 29,551 |   |
| Other, net                                                          |       | 46                                        |       | 106 |   | 152 |   |
| Net other income (expense) and gain (loss)                          |       | 46                                        |       | 58,687 |   | 58,733 |   |
| Income (loss) before income tax expense                             |       | (3,391                                    | )          | 53,457 |   | 50,066 |   |
| Income tax expense                                                  |       | 10                                        |       | 150 |   | 160 |   |
|                                                                |       |                                      |       |   |   |   |   |
| **Net income (loss)**                                               |       | (3,401                                    | )          | 53,307 |   | 49,906 |   |
| Net loss attributable to noncontrolling interest                    |       | —                                    |       | 2,960 |   | 2,960 |   |
| **Net income (loss) attributable to  Deerfield Capital Corp.**      |       | $                                         | (3,401     | ) | $ | 56,267 |   | $ | 52,866 |   |
| ** **                                                          | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Reconciliation of net income  (loss) and core earnings:**         |       |                                      |       |   |   |   |   |
| Net income (loss)                                                   |       | $                                         | (3,401     | ) | $ | 53,307 |   | $ | 49,906 |   |
| Adjusting items:                                                    |       |                                      |       |   |   |   |   |
| Provision for loan losses                                           |       | —                                    |       | 9,119 |   | 9,119 |   |
| Depreciation and amortization                                       |       | 1,629                                     |       | — |   | 1,629 |   |
| Impairment of intangible assets                                     |       | 126                                       |       | — |   | 126 |   |
| Net other income (expense) and gain (loss)                          |       | (46                                       | )          | (58,687 | ) | (58,733 | ) |
| Income tax expense                                                  |       | 10                                        |       | 150 |   | 160 |   |
| Noncontrolling interest core earnings                               |       | —                                    |       | 3,297 |   | 3,297 |   |
| Cost saving initiatives                                             |       | 28                                        |       | — |   | 28 |   |
| **Core Earnings**                                                   |       | $                                         | (1,654     | ) | $ | 7,186 |   | $ | 5,532 |   |

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

**SEGMENT CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                                                      | ** ** | **Six months ended June 30, 2010** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                      | ** ** | **Investment**                                              | ** ** | **Principal** | ** ** | ** ** | ** ** | **Investment** | ** ** | ** ** | ** ** | **GAAP** | ** ** |
| ** **                                                                                      | ** ** | **Management**                                              | ** ** | **Investing** | ** ** | **DFR** | ** ** | **Products** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                                                      | ** ** | **Segment (1)**                                        | ** ** | **Segment (1)** | ** ** | **Operations** | ** ** | **Segment** | ** ** | **Elimination** | ** ** | **DFR** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands)**                                     | ** ** |
| **Revenues**                                                                                    | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest income                                                                                 |       | $                                                           | 214        |   | $ | 16,086 |   | $ | 16,300 |   | $ | 52,709 |   | $ | (324 | ) | $ | 68,685 |   |
| Interest expense                                                                                |       | 2,238                                                       |       | 3,380 |   | 5,618 |   | 10,672 |   | (324 | ) | 15,966 |   |
| Net interest income                                                                             |       | (2,024                                                      | )          | 12,706 |   | 10,682 |   | 42,037 |   | — |   | 52,719 |   |
| Provision for loan losses                                                                       |       | —                                                      |       | 4,477 |   | 4,477 |   | — |   | — |   | 4,477 |   |
| Net interest income (expense) after provision for  loan losses                                  |       | (2,024                                                      | )          | 8,229 |   | 6,205 |   | 42,037 |   | — |   | 48,242 |   |
| Investment advisory fees                                                                        |       | 13,547                                                      |       | — |   | 13,547 |   | — |   | (6,869 | ) | 6,678 |   |
| Total net revenues                                                                              |       | 11,523                                                      |       | 8,229 |   | 19,752 |   | 42,037 |   | (6,869 | ) | 54,920 |   |
|                                                                                            |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| **Expenses**                                                                                    |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and benefits                                                                       |       | 5,918                                                       |       | — |   | 5,918 |   | — |   | — |   | 5,918 |   |
| Professional services                                                                           |       | 308                                                         |       | 2,033 |   | 2,341 |   | 579 |   | — |   | 2,920 |   |
| Insurance expense                                                                               |       | 184                                                         |       | 1,209 |   | 1,393 |   | 51 |   | — |   | 1,444 |   |
| Other general and administrative expenses                                                       |       | 902                                                         |       | 2,138 |   | 3,040 |   | 564 |   | — |   | 3,604 |   |
| Depreciation and amortization                                                                   |       | 8,763                                                       |       | — |   | 8,763 |   | — |   | — |   | 8,763 |   |
| Occupancy                                                                                       |       | 876                                                         |       | — |   | 876 |   | — |   | — |   | 876 |   |
| Investment advisory fees                                                                        |       | —                                                      |       | — |   | — |   | 6,869 |   | (6,869 | ) | — |   |
| Cost savings initiatives                                                                        |       | —                                                      |       | — |   | — |   | — |   | — |   | — |   |
| Impairment of intangible assets                                                                 |       | 168                                                         |       | — |   | 168 |   | — |   | — |   | 168 |   |
| Total expenses                                                                                  |       | 17,119                                                      |       | 5,380 |   | 22,499 |   | 8,063 |   | (6,869 | ) | 23,693 |   |
|                                                                                            |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| **Other Income (Expense) and Gain  (Loss)**                                                     |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities                             |       | 218                                                         |       | 8,342 |   | 8,560 |   | (49,221 | ) | — |   | (40,661 | ) |
| Strategic transactions expenses                                                                 |       | (855                                                        | )          | (3,167 | ) | (4,022 | ) | — |   | — |   | (4,022 | ) |
| Net gain on the discharge of  Series A & B Notes                                  |       | 17,418                                                      |       | — |   | 17,418 |   | — |   | — |   | 17,418 |   |
| Other, net                                                                                      |       | (7                                                          | )          | (957 | ) | (964 | ) | 1,090 |   | — |   | 126 |   |
| Net other income (expense) and gain (loss)                                                      |       | 16,774                                                      |       | 4,218 |   | 20,992 |   | (48,131 | ) | — |   | (27,139 | ) |
| Income (loss) before income tax expense                                                         |       | 11,178                                                      |       | 7,067 |   | 18,245 |   | (14,157 | ) | — |   | 4,088 |   |
| Income tax expense                                                                              |       | 2                                                           |       | — |   | 2 |   | — |   | — |   | 2 |   |
|                                                                                            |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| **Net income (loss)**                                                                           |       | 11,176                                                      |       | 7,067 |   | 18,243 |   | (14,157 | ) | — |   | 4,086 |   |
| Net (income) loss attributable to noncontrolling  interest and Consolidated Investment Products |       | —                                                      |       | (523 | ) | (523 | ) | 14,157 |   | — |   | 13,634 |   |
| **Net income attributable to  Deerfield Capital Corp.**                                         |       | $                                                           | 11,176     |   | $ | 6,544 |   | $ | 17,720 |   | $ | — |   | $ | — |   | $ | 17,720 |   |
|                                                                                            |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| **Reconciliation of net income  (loss) and core earnings:**                                     |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                               |       | $                                                           | 11,176     |   | $ | 7,067 |   | $ | 18,243 |   | $ | (14,157 | ) | $ | — |   | $ | 4,086 |   |
| Adjusting items:                                                                                |       |                                                        |       |   |   |   |   |   |   |   |   |   |   |
| Provision for loan losses                                                                       |       | —                                                      |       | 4,477 |   | 4,477 |   | — |   | — |   | 4,477 |   |
| Depreciation and amortization                                                                   |       | 8,763                                                       |       | — |   | 8,763 |   | — |   | — |   | 8,763 |   |
| Impairment of intangible assets                                                                 |       | 168                                                         |       | — |   | 168 |   | — |   | — |   | 168 |   |
| Net other income (expense) and gain (loss) (2)                                             |       | (16,774                                                     | )          | (4,218 | ) | (20,992 | ) | 48,131 |   | — |   | 27,139 |   |
| Income tax expense                                                                              |       | 2                                                           |       | — |   | 2 |   | — |   | — |   | 2 |   |
| Noncontrolling interest and Consolidated  Investment Products core earnings                     |       | —                                                      |       | (330 | ) | (330 | ) | (33,974 | ) | — |   | (34,304 | ) |
| Warrant expense                                                                                 |       | —                                                      |       | 529 |   | 529 |   | — |   | — |   | 529 |   |
| **Core Earnings**                                                                               |       | $                                                           | 3,335      |   | $ | 7,525 |   | $ | 10,860 |   | $ | — |   | $ | — |   | $ | 10,860 |   |

 

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**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

**SEGMENT CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                          | ** ** | **Six months ended June 30, 2009** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                          | ** ** | **Investment**                          | ** ** | **Principal** | ** ** | ** ** | ** ** |
| ** **                                                          | ** ** | **Management**                          | ** ** | **Investing** | ** ** | **DFR** | ** ** |
| ** **                                                          | ** ** | **Segment (1)**                         | ** ** | **Segment (1)** | ** ** | **Operations** | ** ** |
| ** **                                                          | ** ** | **(In thousands)**                      | ** ** |
| **Revenues**                                                        | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                     |       | $                                       | 62         |   | $ | 27,818 |   | $ | 27,880 |   |
| Interest expense                                                    |       | 2,658                                   |       | 10,007 |   | 12,665 |   |
| Net interest income                                                 |       | (2,596                                  | )          | 17,811 |   | 15,215 |   |
| Provision for loan losses                                           |       | —                                  |       | 11,226 |   | 11,226 |   |
| Net interest income (expense) after provision for  loan losses      |       | (2,596                                  | )          | 6,585 |   | 3,989 |   |
| Investment advisory fees                                            |       | 8,746                                   |       | — |   | 8,746 |   |
| Total net revenues                                                  |       | 6,150                                   |       | 6,585 |   | 12,735 |   |
|                                                                |       |                                    |       |   |   |   |   |
| **Expenses**                                                        |       |                                    |       |   |   |   |   |
| Compensation and benefits                                           |       | 6,383                                   |       | — |   | 6,383 |   |
| Professional services                                               |       | 236                                     |       | 1,282 |   | 1,518 |   |
| Insurance expense                                                   |       | 194                                     |       | 1,341 |   | 1,535 |   |
| Other general and administrative expenses                           |       | 1,053                                   |       | 4,707 |   | 5,760 |   |
| Depreciation and amortization                                       |       | 3,264                                   |       | — |   | 3,264 |   |
| Occupancy                                                           |       | 1,208                                   |       | — |   | 1,208 |   |
| Management and incentive fee expense to related  party              |       | —                                  |       | 295 |   | 295 |   |
| Cost savings initiatives                                            |       | 225                                     |       | — |   | 225 |   |
| Impairment of intangible assets                                     |       | 126                                     |       | — |   | 126 |   |
| Total expenses                                                      |       | 12,689                                  |       | 7,625 |   | 20,314 |   |
|                                                                |       |                                    |       |   |   |   |   |
| **Other Income (Expense) and Gain  (Loss)**                         |       |                                    |       |   |   |   |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities |       | (160                                    | )          | 39,708 |   | 39,548 |   |
| Net gain on the deconsolidation of Market Square  CLO               |       | —                                  |       | 29,551 |   | 29,551 |   |
| Other, net                                                          |       | (61                                     | )          | 164 |   | 103 |   |
| Net other income (expense) and gain (loss)                          |       | (221                                    | )          | 69,423 |   | 69,202 |   |
| Income (loss) before income tax expense                             |       | (6,760                                  | )          | 68,383 |   | 61,623 |   |
| Income tax expense                                                  |       | 28                                      |       | 150 |   | 178 |   |
|                                                                |       |                                    |       |   |   |   |   |
| **Net income (loss)**                                               |       | (6,788                                  | )          | 68,233 |   | 61,445 |   |
| Net loss attributable to noncontrolling interest                    |       | —                                  |       | 2,960 |   | 2,960 |   |
| **Net income (loss) attributable to  Deerfield Capital Corp.**      |       | $                                       | (6,788     | ) | $ | 71,193 |   | $ | 64,405 |   |
|                                                                |       |                                    |       |   |   |   |   |
| **Reconciliation of net income  (loss) and core earnings:**         |       |                                    |       |   |   |   |   |
| Net income (loss)                                                   |       | $                                       | (6,788     | ) | $ | 68,233 |   | $ | 61,445 |   |
| Adjusting items:                                                    |       |                                    |       |   |   |   |   |
| Provision for loan losses                                           |       | —                                  |       | 11,226 |   | 11,226 |   |
| Depreciation and amortization                                       |       | 3,264                                   |       | — |   | 3,264 |   |
| Impairment of intangible assets                                     |       | 126                                     |       | — |   | 126 |   |
| Net other income (expense) and gain (loss)                          |       | 221                                     |       | (69,423 | ) | (69,202 | ) |
| Income tax expense                                                  |       | 28                                      |       | 150 |   | 178 |   |
| Noncontrolling interest core earnings                               |       | —                                  |       | 3,297 |   | 3,297 |   |
| Cost saving initiatives                                             |       | 225                                     |       | — |   | 225 |   |
| **Core Earnings**                                                   |       | $                                       | (2,924     | ) | $ | 13,483 |   | $ | 10,559 |   |

 

----

(1)                                  For the threeand six months ended June 30, 2010, segment revenues and expenses excludes$0.6 million and $1.3 million, respectively, of intercompany investmentadvisory fees revenues for our Investment Management segment and correspondingintercompany management and incentive fee expense for our Principal Investingsegment related to the management agreement between the two segments. For thethree and six months ended June 30, 2009, segment revenues and expensesexcludes $1.4 million and $2.9 million, respectively, of intercompanyinvestment advisory fees revenues for our Investment 

 

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Management segment and corresponding intercompany management andincentive fee expense for our Principal Investing segment related to themanagement agreement between the two segments.

 

(2)                                  The coreearnings adjustment for net other income (expense) and gain (loss) includes$0.4 million in strategic transaction expenses related to the three monthsended March 31, 2010, which should have been included as an adjustment tocore earnings in that period. Additionally, core earnings for the six months endedJune 30, 2010 exclude $0.4 million of loss on investments at fair valuethat should have been an adjustment to core earnings in that period.

 

During the three and six months ended June 30, 2010, we recordednet income attributable to DFR of $17.9 million and $17.7 million,respectively, as compared to net income attributable to DFR of$52.9 million and $64.4 million for the same periods in 2009,respectively. During the three and six months ended June 30, 2010, coreearnings, calculated in the table above, was $6.4 million and $10.9 million,respectively, as compared to core earnings of $5.5 million and $10.6 millionfor the same periods in 2009, respectively.

 

During the three months ended June 30, 2010, DFR Operationsexperienced an increase in net revenues of $9.9 million as compared to the sameperiod in 2009.  This increase wasprimarily the result of a $3.0 million increase in investment advisory fees andan $8.8 million reduction in provision for loan losses, partially offset by a$2.0 million decrease in net interest income. During the six months ended June 30,2010, DFR Operations experienced an increase in net revenues of $7.0 million ascompared to the same period in 2009. This increase was primarily the result of a $4.8 million increase in investmentadvisory fees and a $6.7 million reduction in provision for loan losses,partially offset by a $4.5 million decrease in net interest income.

 

The increases in DFR Operations investment advisory fee income for thethree and six months ended June 30, 2010 are primarily the result of  increases in CLO investment advisory fees ascertain of our CLOs have resumed current payment of subordinated managementfees and have begun to pay deferred subordinated management fees during theperiods.  The decreases in net interestincome were primarily driven by decreases in net interest income on our RMBSportfolio and the deconsolidation of Market Square CLO as of June 30,2009.

 

During the three months ended June 30, 2010, DFR Operations totalexpenses decreased by $1.5 million as compared to the same period in 2009.  This decrease is primarily the result of a$3.4 million decrease in other general and administrative expenses, partiallyoffset by increases in depreciation and amortization of $1.4 million and professionalservices of $1.2 million.  The decreasein other general and administrative expenses is primarily the result of $3.3million in one-time DPLC structuring and organizational expenses incurredduring the three months ended June 30, 2009.  The increase in depreciation and amortizationis the result of accelerated depreciation and amortization in connection withabandoning the equipment and leasehold improvements associated with our oldlease. The increase in professional services is primarily a result of increasedlegal fees related to our ongoing SEC investigation.

 

During the six months ended June 30, 2010, DFR Operations totalexpenses increased by $2.2 million as compared to the same period in 2009.  This increase is primarily the result of a$5.5 million increase in depreciation and amortization, partially offset by adecline in other general and administrative expenses of $2.7 million.  The increase in depreciation and amortizationis the result of accelerated depreciation and amortization in connection withabandoning the equipment and leasehold improvements associated with our oldlease. The decrease in other general and administrative expenses is primarilythe result of $3.3 million in one-time DPLC structuring and organizationalexpenses incurred during the six months ended June 30, 2009, partiallyoffset by $0.5 million increase in expense related to the DPLC RestructuringWarrants.

 

During the three and sixmonths ended June 30, 2010, DFR Operations net other income (expense) andgain (loss) declined by $43.7 million and $48.2 million, respectively.  These declines were primarily driven byeffects of the deconsolidation of Market Square CLO on June 30, 2009.  During the three and six months ended June 30,2009, we recorded a net gain on the deconsolidation of Market Square CLO of$29.6 million and net gains on our loan portfolio (primarily attributable tonet gains on loans held in Market Square CLO ) of $24.9 million and $30.7million, respectively.  These declineswere partially offset by a $17.4 million gain on the Senior Notes Dischargeduring the three and six months ended June 30, 2010.

 

During the three and six months ended June 30, 2010, DFROperations incurred strategic transactions expenses of $2.6 million and $4.0million, respectively.  Strategictransactions expenses were primarily comprised of legal fees, investmentbanking fees and compensation.

 

SinceJanuary 1, 2008, we have not paid significant corporate income taxes as aresult of net operating losses and net capital losses incurred primarily in2008. As a result of the CNCIM Acquisition, our ability to use these netoperating losses and net capital losses to offset our taxable income will besignificantly reduced. Accordingly, if we have taxable income in futureperiods, we anticipate that we will incur corporate income tax liabilities.

 

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**Results ofOperations by Segment**

 

**InvestmentManagement Segment**

 

***Revenues***

 

Our Investment Management segment revenues primarily consist ofinvestment advisory fee income earned from the management of investmentaccounts for various types of clients.

 

*NetInterest Income*

 

Interest income for the three and six months ended June 30, 2010is primarily comprised of interest income on preferred shares of CDOs which iseliminated upon consolidation. Interest income for the three and six monthsended June 30, 2009 is primarily comprised of interest earned on our cashbalances. Interest expense is primarily comprised of $1.0 million and $1.3million of interest expense on our Senior Notes for the three months ended June 30,2010 and 2009, respectively, and $2.2 million and $2.7 million of interestexpense on our Senior for the six months ended June 30, 2010 and 2009,respectively. The reduction in interest expense during the three and six monthsended June 30, 2010, as compared to the same period in 2010, is primarilythe result of a decreased interest rate environment and the Senior NotesDischarge on June 9, 2010.

 

*InvestmentAdvisory Fees*

 

For the three months ended June 30, 2010 and 2009, investmentadvisory fees were $7.0 million and $4.0 million, respectively, on asegment basis, and $3.8 million and $4.0 million, respectively, on aconsolidated basis due to the $3.2 million of fees earned by our InvestmentManagement segment from our Consolidated Investment Products segment for thethree months ended June 30, 2010, which were eliminated uponconsolidation. For the six months ended June 30, 2010 and 2009, investmentadvisory fees were $13.5 million and $8.7 million, respectively, on asegment basis, and $6.7 million and $8.7 million, respectively, on aconsolidated basis due to the $6.8 million of fees earned by our InvestmentManagement segment from our Consolidated Investment Products segment for thesix months ended June 30, 2010, which were eliminated upon consolidation.Our investment advisory fee revenue during the periods presented was generatedby our CDOs and our separately managed accounts. The following discussionsfurther analyze and explain changes in our investment advisory fees by type andproduct.

 

*CDO Investment Advisory Fees*

 

The following table summarizes the investment advisory fee revenuesfrom our CDOs:

 
| ** **                           | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|--------------|------------|---------------------------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2010**                                            | ** ** | **2009**     | ** ** | **2010 vs. 2009**                       | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                           | ** ** | **(In thousands)**                             | ** ** |
| **Senior Management Fees:**          | ** ** | ** **                                          | ** ** | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                 |       | $                                                   | 1,842      |         | $          | 1,487                                             |       | $            | 355        |   | $ | 3,496 |   | $ | 3,053 |   | $ | 443 |   |
| ABS                                  |       | 642                                                 |       | 760          |       | (118                                              | )          | 1,413        |       | 1,812 |   | (399 | ) |
| Corporate Bonds                      |       | 348                                                 |       | 645          |       | (297                                              | )          | 738          |       | 965 |   | (227 | ) |
| **Total Senior Mangement Fees**      |       | 2,832                                               |       | 2,892        |       | (60                                               | )          | 5,647        |       | 5,830 |   | (183 | ) |
|                                 |       |                                                |       |         |       |                                              |       |         |       |   |   |   |   |
| **Subordinated Management Fees:**    | ** ** | ** **                                          | ** ** | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                 |       | 2,076                                               |       | 77           |       | 1,999                                             |       | 3,472        |       | 1,504 |   | 1,968 |   |
| ABS                                  |       | —                                              |       | 152          |       | (152                                              | )          | 27           |       | 152 |   | (125 | ) |
| Corporate Bonds                      |       | 255                                                 |       | 296          |       | (41                                               | )          | 255          |       | 272 |   | (17 | ) |
| **Total Subordinate Mangement Fees** |       | 2,331                                               |       | 525          |       | 1,806                                             |       | 3,754        |       | 1,928 |   | 1,826 |   |
|                                 |       |                                                |       |         |       |                                              |       |         |       |   |   |   |   |
| **Performance Fees (1):**            | ** ** | ** **                                          | ** ** | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                 |       | 1,687                                               | (2)        | 172          | (2)        | 1,515                                             |       | 3,755        | (2)        | 172 | (2) | 3,583 |   |
| ABS                                  |       | —                                              |       | —       |       | —                                            |       | —       |       | — |   | — |   |
| Corporate Bonds                      |       | —                                              |       | 73           | (3)        | (73                                               | )          | —       |       | 225 | (3) | (225 | ) |
| **Total Performance Fees**           |       | 1,687                                               |       | 245          |       | 1,442                                             |       | 3,755        |       | 397 |   | 3,358 |   |
|                                 |       |                                                |       |         |       |                                              |       |         |       |   |   |   |   |
| **Total CDO Advisory Fees:**         | ** ** | ** **                                          | ** ** | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                 |       | 5,605                                               |       | 1,736        |       | 3,869                                             |       | 10,723       |       | 4,729 |   | 5,994 |   |
| ABS                                  |       | 642                                                 |       | 912          |       | (270                                              | )          | 1,440        |       | 1,964 |   | (524 | ) |
| Corporate Bonds                      |       | 603                                                 |       | 1,014        |       | (411                                              | )          | 994          |       | 1,462 |   | (468 | ) |
| **Total CDO Advisory Fees**          |       | $                                                   | 6,850      |         | $          | 3,662                                             |       | $            | 3,188      |   | $ | 13,157 |   | $ | 8,155 |   | $ | 5,002 |   |

 

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(1)                                  Performancefees are generally earned after certain investors’ returns exceed a specifiedinternal rate of return. 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)                                  Performancefees on CLOs for the three and six months ended June 30, 2010 and 2009represent previously deferred subordinated management fees.

 

(3)                                  Performancefees on corporate bond CDOs for the three months ended June 30, 2009primarily represent previously deferred subordinated management fees.  Inaddition, performance fees for the six months ended June 30, 2009 include$0.2 million in fees related to a previously liquidated corporate bond CDO as aresult of a settlement received in connection with certain litigation relatingto one of the assets previously held in the CDO.

 

Our fees differ from account to account, but in general, our fees fromCDOs consist of a senior management fee (payable before the interest payable onthe debt securities issued by the CDO) that ranges from 5 basis points to 20basis points annually of the principal balance of the underlying collateral ofthe CDO, a subordinate management fee (payable after the interest payable onthe debt securities issued by the CDO and certain other expenses) that rangesfrom 5 basis points to 45 basis points annually of the principal balance of theunderlying collateral of the CDO, and, in certain CDOs, performance fees thatare paid after certain investors’ returns exceed an internal rate of return(the “IRR hurdle”). The performance fees are based on residual cash flows abovethe IRR Hurdle and vary by transaction.

 

Under the investment management agreements between DCM or CNCIM and theCDOs we manage, the payment of management fees is generally subject to a “waterfall”structure. Pursuant to these “waterfalls,” all or a portion of our subordinatedmanagement fees may be deferred if the CDOs do not generate sufficient cashflows to pay the required interest on the notes that the CDOs have issued toinvestors and certain expenses they have incurred. This could occur if, forexample, the issuers of the collateral underlying the CDOs default on or deferpayments of principal or interest relating to such collateral or the ratingsassigned to such collateral are downgraded below a specified threshold. Inaddition, all or a portion of our subordinated management fees may be deferredif, among other things, overcollateralization tests and other structuralprovisions built into the CDOs divert cash flows to the prepayment of the debtsecurities issued by the CDOs.

 

The following table summarizes the average AUM and effective andcontractual fee rates of our CDOs for the periods presented:

 
| ** **          | ** ** | **Three months ended June 30, 2010** | ** ** |
|---------------------|------------|---------------------------------------------------------------|------------|
| ** **          | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **          | ** ** | ** **                                                    | ** ** | **Effective Rate (1)** | ** ** | **Contractual Rate (2)** | ** ** |
| ** **          | ** ** | ** **                                                    | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **          | ** ** | **Average AUM (3)**                                 | ** ** | **Management Fee** | ** ** | **Management Fee (4)** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **          | ** ** | **(In thousands)**                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (5)            |       | $                                                             | 4,032,402  |   | 0.18 | % | 0.37 | % | 0.18 | % | 0.32 | % |
|                |       |                                                          |       |   |   |   |   |   |   |   |   |
| ABS:                |       |                                                          |       |   |   |   |   |   |   |   |   |
| High-grade ABS      |       | 2,816,048                                                     |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other ABS           |       | 928,530                                                       |       | 0.12 | % | 0.00 | % | 0.15 | % | 0.23 | % |
| Total ABS           |       | 3,744,578                                                     |       | 0.07 | % | 0.00 | % | 0.07 | % | 0.10 | % |
|                |       |                                                          |       |   |   |   |   |   |   |   |   |
| Corporate bonds (6) |       | 668,220                                                       |       | 0.21 | % | 0.15 | % | 0.22 | % | 0.23 | % |
| Total CDOs          |       | $                                                             | 8,445,200  |   | 0.13 | % | 0.19 | % | 0.14 | % | 0.22 | % |

 

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| ** **          | ** ** | **Three months ended June 30, 2009** | ** ** |
|---------------------|------------|---------------------------------------------------------------|------------|
| ** **          | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **          | ** ** | ** **                                                    | ** ** | **Effective Rate (1)** | ** ** | **Contractual Rate (2)** | ** ** |
| ** **          | ** ** | ** **                                                    | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **          | ** ** | **Average AUM (3)**                                 | ** ** | **Management Fee** | ** ** | **Management Fee (4)** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **          | ** ** | **(In thousands)**                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (5)            |       | $                                                             | 3,546,845  |   | 0.17 | % | 0.01 | % | 0.18 | % | 0.33 | % |
|                |       |                                                          |       |   |   |   |   |   |   |   |   |
| ABS:                |       |                                                          |       |   |   |   |   |   |   |   |   |
| High-grade ABS      |       | 3,262,753                                                     |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other ABS           |       | 1,449,331                                                     |       | 0.10 | % | 0.04 | % | 0.15 | % | 0.22 | % |
| Total ABS           |       | 4,712,084                                                     |       | 0.06 | % | 0.01 | % | 0.08 | % | 0.11 | % |
|                |       |                                                          |       |   |   |   |   |   |   |   |   |
| Corporate bonds (6) |       | 890,437                                                       |       | 0.29 | % | 0.13 | % | 0.18 | % | 0.23 | % |
| Total CDOs          |       | $                                                             | 9,149,366  |   | 0.13 | % | 0.02 | % | 0.13 | % | 0.20 | % |

 
| ** **          | ** ** | **Six months ended June 30, 2010** | ** ** |
|---------------------|------------|-------------------------------------------------------------|------------|
| ** **          | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **          | ** ** | ** **                                                  | ** ** | **Effective Rate (1)** | ** ** | **Contractual Rate (2)** | ** ** |
| ** **          | ** ** | ** **                                                  | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **          | ** ** | **Average AUM (3)**                               | ** ** | **Management Fee** | ** ** | **Management Fee (4)** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **          | ** ** | **(In thousands)**                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (5)            |       | $                                                           | 3,895,354  |   | 0.18 | % | 0.37 | % | 0.18 | % | 0.33 | % |
|                |       |                                                        |       |   |   |   |   |   |   |   |   |
| ABS:                |       |                                                        |       |   |   |   |   |   |   |   |   |
| High-grade ABS      |       | 2,873,403                                                   |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other ABS           |       | 990,915                                                     |       | 0.14 | % | 0.01 | % | 0.15 | % | 0.23 | % |
| Total ABS           |       | 3,864,318                                                   |       | 0.07 | % | 0.00 | % | 0.08 | % | 0.10 | % |
|                |       |                                                        |       |   |   |   |   |   |   |   |   |
| Corporate bonds (6) |       | 697,041                                                     |       | 0.21 | % | 0.07 | % | 0.21 | % | 0.23 | % |
| Total CDOs          |       | $                                                           | 8,456,713  |   | 0.13 | % | 0.18 | % | 0.14 | % | 0.22 | % |

 
| ** **          | ** ** | **Six months ended June 30, 2009** | ** ** |
|---------------------|------------|-------------------------------------------------------------|------------|
| ** **          | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **          | ** ** | ** **                                                  | ** ** | **Effective Rate (1)** | ** ** | **Contractual Rate (2)** | ** ** |
| ** **          | ** ** | ** **                                                  | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **          | ** ** | **Average AUM (3)**                               | ** ** | **Management Fee** | ** ** | **Management Fee (4)** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **          | ** ** | **(In thousands)**                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (5)            |       | $                                                           | 3,586,176  |   | 0.17 | % | 0.08 | % | 0.18 | % | 0.33 | % |
|                |       |                                                        |       |   |   |   |   |   |   |   |   |
| ABS:                |       |                                                        |       |   |   |   |   |   |   |   |   |
| High-grade ABS      |       | 3,315,114                                                   |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other ABS           |       | 1,558,582                                                   |       | 0.13 | % | 0.02 | % | 0.15 | % | 0.22 | % |
| Total ABS           |       | 4,873,696                                                   |       | 0.07 | % | 0.01 | % | 0.08 | % | 0.11 | % |
|                |       |                                                        |       |   |   |   |   |   |   |   |   |
| Corporate bonds (6) |       | 858,146                                                     |       | 0.22 | % | 0.06 | % | 0.18 | % | 0.23 | % |
| Total CDOs          |       | $                                                           | 9,318,018  |   | 0.13 | % | 0.04 | % | 0.13 | % | 0.20 | % |

 

----

(1)                                  The effectiverate for the three months ended June 30, 2010 and 2009 is calculated bytaking the management fees earned during the period multiplied by four (toannualize) and divided by the average AUM. The effective rate for the sixmonths ended June 30, 2010 and 2009 is calculated by taking managementfees earned during the period multiplied by two (to annualize) and divided bythe average AUM. The senior and subordinated management fee effective rates maydiffer from the contractual fee rates for various reasons, including thefollowing: (a) we may have entered into agreements with specific investorspursuant to which a portion of our management fees are paid to those investorsand (b) our senior or subordinated management fees may be deferred as aresult of certain structural provisions built into the documents governing theCDO. In certain circumstances, we may at a later date, subject to certainperformance triggers, be entitled to repayment of the fees paid to investorsdescribed in (a) above. In addition, we may at a later date, subject tothe satisfaction of certain structural provisions, be entitled to payment ofthe deferred fees described in (b) above.

 

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(2)                                  The weightedaverage contractual senior and subordinated management fee rates are obtainedby multiplying the contractual fee rates for each CDO by that CDO’s average AUMand dividing that number by the total average AUM for the relevant asset class.

 

(3)                                  Average AUM iscalculated as the average of the AUM on the first day of April, May,June and July for the three months ended June 30, 2010 and 2009and the average of the first day of January, February, March, April, May,June and July for the six months ended June 30, 2010 and2009.  CDO AUM numbers generally reflectthe aggregate principal or notional balance of the collateral and, in somecases, the cash balance held by the CDO and are as of the date of the lasttrustee report received for each CDO prior to the AUM date, as appropriate. TheAUM for our Euro-denominated CDOs has been converted to U.S. dollars using thespot rate of exchange as of the respective AUM date.

 

(4)                                  Thesubordinated management fee effective rates include previously deferredsubordinated management fees received during the year and categorized asperformance fees.

 

(5)                                  DFR MM CLO hasbeen excluded from all categories in this table as DCM manages this CLO, but isnot contractually entitled to receive any management fees for DFR MM CLO solong as all of the equity is held by DC LLC or an affiliate thereof. Inaddition, Market Square CLO has been excluded from all categories for the threeand six months ended June 30, 2009, as DCM managed this CLO but was notcontractually entitled to receive any management fees therefrom prior to thesale of all of our preference shares of Market Square CLO on June 30,2009.

 

(6)                                  The effectiveand contractual rates for Robeco CDO II Limited are calculated based on thefees that we are entitled to receive pursuant to the asset purchase agreement betweenDCM and Robeco Investment Management, Inc. and are not the total fees paidby the CDO or the contractual fee rates set forth in the management agreement.

 

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The following table summarizes select details of the structure of eachof our CDOs:

 
| ** **                         | ** ** | **Closing Date** | ** ** | **July 1, 2010 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                 |       | $                                            | 116,309    |                                                   | 10/05      |                                       | n/a        |                                                               | 01/07      |                     | 2013       |   |
| Forest Creek CLO Ltd.              |       | 05/03                 |       | 216,790                                      |       | 07/07                                                  |       | n/a                                        |       | 07/08                                                              |       | 2015                     |       |
| Long Grove CLO Ltd.                |       | 06/04                 |       | 320,246                                      |       | 08/08                                                  |       | n/a                                        |       | 05/10                                                              |       | 2016                     |       |
| Market Square CLO Ltd.             |       | 05/05                 |       | 252,873                                      |       | 07/07                                                  |       | n/a                                        |       | 04/11                                                              |       | 2017                     |       |
| Cumberland II CLO Ltd.             |       | 09/05                 |       | 374,847                                      |       | 02/10                                                  |       | n/a                                        |       | 11/11                                                              |       | 2019                     |       |
| Marquette Park CLO Ltd.            |       | 12/05                 |       | 284,923                                      |       | 04/10                                                  |       | n/a                                        |       | 01/12                                                              |       | 2020                     |       |
| Bridgeport CLO Ltd.                |       | 06/06                 |       | 487,191                                      |       | 10/09                                                  |       | n/a                                        |       | 07/13                                                              |       | 2020                     |       |
| Columbus Nova 2006-I               |       | 08/06                 |       | 377,234                                      |       | 10/09                                                  |       | n/a                                        |       | 10/12                                                              |       | 2018                     |       |
| Burr Ridge CLO Plus Ltd.           |       | 12/06                 |       | 282,579                                      |       | 06/12                                                  |       | n/a                                        |       | 03/13                                                              |       | 2023                     |       |
| Columbus Nova 2006-II              |       | 12/06                 |       | 481,387                                      |       | 10/10                                                  |       | n/a                                        |       | 02/10                                                              |       | 2018                     |       |
| Columbus Nova 2007-I               |       | 03/07                 |       | 464,769                                      |       | 05/10                                                  |       | n/a                                        |       | 05/13                                                              |       | 2019                     |       |
| Schiller Park CLO Ltd.             |       | 05/07                 |       | 403,517                                      |       | 07/11                                                  |       | n/a                                        |       | 04/13                                                              |       | 2021                     |       |
| Bridgeport CLO II Ltd.             |       | 06/07                 |       | 493,164                                      |       | 12/10                                                  |       | n/a                                        |       | 09/14                                                              |       | 2021                     |       |
| DFRMiddleMarketCLOLtd.(5)          |       | 07/07                 |       | 275,624                                      |       | 07/10                                                  |       | n/a                                        |       | 07/10                                                              |       | 2019                     |       |
| Gillespie CLO PLC (6)              |       | 08/07                 |       | 324,098                                      |       | 02/13                                                  |       | n/a                                        |       | 08/13                                                              |       | 2023                     |       |
| Columbus Nova 2007-II              |       | 11/07                 |       | 426,534                                      |       | 10/10                                                  |       | n/a                                        |       | 10/14                                                              |       | 2021                     |       |
| **Total CLOs**                     |       |                  |       | 5,582,085                                    |       |                                                   |       |                                       |       |                                                               |       |                     |       |
|                               |       |                  |       |                                         |       |                                                   |       |                                       |       |                                                               |       |                     |       |
| **ABS CDOs:**                      |       |                  |       |                                         |       |                                                   |       |                                       |       |                                                               |       |                     |       |
| Mid Ocean CBO 2000-1 Ltd.          |       | 01/01                 |       | 104,717                                      |       | 04/06                                                  |       | n/a                                        |       | 01/06                                                              |       | 2036                     |       |
| Mid Ocean CBO 2001-1 Ltd.          |       | 10/01                 |       | 121,930                                      |       | 02/06                                                  |       | n/a                                        |       | 01/06                                                              |       | 2036                     |       |
| Northlake CDO I, Limited           |       | 02/03                 |       | 98,595                                       |       | 03/06                                                  |       | 03/13                                      |       | 03/07                                                              |       | 2033, 2038(7)       |       |
| Knollwood CDO Ltd.                 |       | 03/04                 |       | 108,428                                      |       | 04/07                                                  |       | 04/12                                      |       | 04/08                                                              |       | 2039                     |       |
| River North CDO Ltd.               |       | 01/05                 |       | 190,032                                      |       | 02/09                                                  |       | 02/13                                      |       | 02/09                                                              |       | 2040                     |       |
| Buckingham CDO Ltd.                |       | 07/05                 |       | 759,596                                      |       | 08/10                                                  |       | 08/13                                      |       | 08/10                                                              |       | 2040                     |       |
| Pinetree CDO Ltd.                  |       | 11/05                 |       | 167,426                                      |       | 01/10                                                  |       | 01/14                                      |       | 01/10                                                              |       | 2045                     |       |
| Buckingham CDO II Ltd.             |       | 12/05                 |       | 1,068,422                                    |       | 03/11                                                  |       | 03/14                                      |       | 03/11                                                              |       | 2041                     |       |
| Knollwood CDO II Ltd.              |       | 07/06                 |       | 31,465                                       |       | 07/09                                                  |       | 07/13                                      |       | n/a                                                                |       | 2046                     |       |
| Buckingham CDO III Ltd.            |       | 08/06                 |       | 950,785                                      |       | 09/11                                                  |       | 09/14                                      |       | 09/11                                                              |       | 2051                     |       |
| Aramis CDO                         |       | 03/07                 |       | 4,030                                        |       | 03/12                                                  |       | n/a                                        |       | n/a                                                                |       | 2047                     |       |
| **Total ABS CDOs**                 |       |                  |       | 3,605,426                                    |       |                                                   |       |                                       |       |                                                               |       |                     |       |
|                               |       |                  |       |                                         |       |                                                   |       |                                       |       |                                                               |       |                     |       |
| **Corporate Bond CDOs:**           |       |                  |       |                                         |       |                                                   |       |                                       |       |                                                               |       |                     |       |
| Valeo Investment Grade CDO Ltd.    |       | 01/01                 |       | 252,723                                      |       | 01/05                                                  |       | n/a                                        |       | 01/06                                                              |       | 2013                     |       |
| Valeo Investment Grade CDO II Ltd. |       | 05/01                 |       | 191,344                                      |       | 06/05                                                  |       | n/a                                        |       | 06/06                                                              |       | 2013                     |       |
| Robeco CDO II Limited              |       | 08/01                 |       | 89,326                                       |       | 08/05                                                  |       | n/a                                        |       | 02/06                                                              |       | 2013                     |       |
| Mayfair Euro CDO I B.V. (6)        |       | 06/01                 |       | 69,437                                       |       | 05/06                                                  |       | n/a                                        |       | 05/06                                                              |       | 2013                     |       |
| **Total Corporate Bond CDOs**      |       |                  |       | 602,830                                      |       |                                                   |       |                                       |       |                                                               |       |                     |       |
|                               |       |                  |       |                                         |       |                                                   |       |                                       |       |                                                               |       |                     |       |
| **Total CDO AUM**                  |       |                  |       | $                                            | 9,790,341  |                                                   |       |                                       |       |                                                               |       |                     |       |   |

 

----

(1)                                  CDO AUM numbersgenerally reflect the aggregate principal or notional balance of the collateraland, in some cases, the cash balance held by the CDOs and are as of the date ofthe last trustee report received for each CDO prior to July 1, 2010.

 

(2)                                  CDOs aregenerally callable by equity holders once per quarter beginning on the “firstoption call date” and subject to satisfaction of certain conditions.

 

(3)                                  ABS CDOsgenerally contain a provision requiring the manager thereof to attempt toliquidate the collateral held therein on the “auction call date,” subject tocertain conditions, generally including that the proceeds from any suchliquidation be sufficient to redeem the notes and pay certain additionalexpenses.

 

(4)                                  Termination ofreinvestment period refers to the date after which we can no longer use certainprincipal collections to purchase additional collateral, and such collectionsare instead used to repay the outstanding amounts of certain debt securitiesissued by the CDO.

 

(5)                                  We are notcontractually entitled to receive any management fees from this CLO so long asall of the equity is held by DC LLC or an affiliate thereof.

 

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(6)                                  The AUM for ourEuro-denominated CDOs has been converted into U.S. dollars using the spot rateof exchange on June 30, 2010.

 

(7)                                  Maturity datevaries by tranche of notes.

 

The CDOs that we manage generally contain certain structuralprovisions, including but not limited to overcollateralization requirements,that are meant to protect investors from deterioration in the credit qualityand value of the underlying collateral pool. During 2009, we experiencedincreased defaults and downgrades of the collateral underlying our CDOs, whichput downward pressure on overcollateralization ratios and increased the likelihoodthat the CDOs we manage will experience events of default or trigger otherstructural provisions. Noncompliance with overcollateralization tests and otherstructural provisions may cause cash flows from the CDOs to be diverted toprepay the debt securities issued by the CDOs, which may decrease the assetbase on which our future management fees are calculated and typically resultsin the deferral of the payment of our subordinated management fees. Inaddition, in certain cases, noncompliance with these overcollateralizationtests or other structural provisions can lead to events of default under theindentures governing the CDOs and, ultimately, acceleration of the notes issuedby the CDO and the liquidation of the underlying collateral. Certain of ourCDOs contain provisions prohibiting the liquidation of the CDO following anevent of default unless either the proceeds from the liquidation will besufficient to pay off all of the notes issued by the CDO along with certainspecified expenses or a majority or supermajority of certain specified classesof notes vote to liquidate the CDO. We believe that CDOs that contain theseprovisions are less likely to liquidate upon the occurrence of an event ofdefault. In addition, certain CDOs we manage contain provisions wherenoncompliance with overcollateralization tests causes us to become subject toremoval as investment manager at the discretion of certain classes ofinvestors.

 

CLO investment advisory fee revenue increased by $3.9 million and$6.0 million, respectively, for the three and six months ended June 30,2010, as compared to the three and six months ended June 30, 2009.  The increase in CLO investment advisory feerevenue for the three and six months ended June 30, 2010, compared to thesame periods in 2009, is primarily based on increases in subordinatedmanagement fees of $2.0 million and $2.0 million, respectively, as certain ofour CLOs have resumed current payment of subordinated management fees, andreceipt of $1.5 million and $3.6 million, respectively, of deferredsubordinated management fees. In addition, the CNCIM CDOs contributed $0.2million to senior management fees during the three and six months ended June 30,2010.

 

We expect a portion of our CLO subordinated management fees to continueto be deferred in the near term. As a result of improvement in marketconditions and effective portfolio management, most of our CLOs have returnedto compliance with their overcollateralization tests, and we have begun torecoup some of our deferred subordinated management fees from those CLOs andexpect those CLOs to pay future subordinated management fees on a currentbasis. With continued improvement in market conditions and ongoingeffective portfolio management, we expect most of our other CLOs to return tocompliance with their overcollateralization tests, and, subject to thesatisfaction of certain other conditions, we would expect to recoupsubstantially all of our deferred subordinated management fees from those CLOsand to receive future subordinated management fees on a current basis. As of June 30,2010, our CLOs have unrecognized deferred subordinated management fees totalingapproximately $5.8 million.

 

ABS CDO revenue decreased by $0.3 million and $0.5 million,respectively, for the three and six months ended June 30, 2010 as comparedto the same periods in 2009. This decrease is primarily based on declines insenior management fees of $0.1 million and $0.4 million, for the three andsix months ended June 30, 2010, respectively, resulting from declines inAUM on our ABS CDOs. We expect our ABS CDO AUM and management fees to continueto decline as a result of both the diversion of cash flows to repay the debtsecurities issued by those CDOs based on continued noncompliance withovercollateralization tests and other structural provisions and additionaldefaults and ratings downgrades with respect to the underlying collateral inthose CDOs.

 

Corporate Bonds CDO revenue declined by $0.4 million and $0.5million, respectively, for the three and six months ended June 30, 2010,as compared to the same periods in 2009, primarily based on declines in seniormanagement fees of $0.3 million and $0.2 million, respectively. Thedecline in senior fees is primarily due to a decline in AUM on our CorporateBond CDOs as a result of paydowns or maturities of the underlying collateral inthese CDOs.

 

We are continuing to focus on our previously announced strategy ofacquiring existing CDO management contracts. On June 9, 2010, we acquiredCNCIM, an investment manager with four CLOs under management. In addition, wepreviously acquired the management contracts for Robeco CDO II Limited andMayfair Euro CDO I B.V.

 

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*Other Investment Advisory Fees*

 

The following table summarizes the investment advisory fee revenues forour investment management contracts related to our separately managed accountsand other investment vehicles:

 
| ** **                                  | ** ** | **Average   AUM (1)** | ** ** | **Management   Fees** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **(In thousands)**    | ** ** |
| **Three months ended June 30,  2010:** |       |                  |       |                  |       |
| Separately managed accounts                 |       | $                     | 320,262    |                  | $          | 195 |   |
| Other investment vehicle (2)                |       | $                     | 9,347      |                  | $          | — |   |
|                                        |       |                  |       |                  |       |
| **Three months ended June 30,  2009:** |       |                  |       |                  |       |
| Separately managed accounts                 |       | $                     | 322,367    |                  | $          | 223 |   |
| Other investment vehicle                    |       | $                     | 13,217     |                  | $          | 124 |   |
|                                        |       |                  |       |                  |       |
| **Six months ended June 30,  2010:**   |       |                  |       |                  |       |
| Separately managed accounts                 |       | $                     | 320,178    |                  | $          | 390 |   |
| Other investment vehicle (2)                |       | $                     | 15,993     |                  | $          | — |   |
|                                        |       |                  |       |                  |       |
| **Six months ended June 30,  2009:**   |       |                  |       |                  |       |
| Separately managed accounts                 |       | $                     | 308,521    |                  | $          | 467 |   |
| Other investment vehicle                    |       | $                     | 7,552      |                  | $          | 124 |   |

 

----

(1)                                  Average AUM forthe three months ended June 30, 2010 and 2009 is calculated as the averageof the AUM on the first day of April, May and June 2010 and 2009,respectively.  Average AUM for the sixmonths ended June 30, 2010 and 2009 is calculated as the average of theAUM on the first day of January, February, March, April, May and June 2010and 2009, respectively.

 

(2)                                  Represents AUMfor DPLC.  As of January 1, 2010,Deerfield and Pegasus Deerfield agreed to temporarily suspend payment ofmanagement fees related to DPLC.

 

The reduction in other investment advisory fees during the three andsix months ended June 30, 2010, as compared to the three and six monthsended June 30, 2009, was primarily the result of agreements with DPLC andone of our separately managed accounts pursuant to which DCM is not currentlycharging investment advisory fees for management of those vehicles.

 

*Intercompany investment advisory fees*

 

As a result of the consolidation of the CIP CDOs in our ConsolidatedInvestment Products segment effective January 1, 2010, we earnedintercompany investment advisory fees of $3.3 million and $6.9 million for thethree and six months ended June 30, 2010, respectively, which wereeliminated upon consolidation.

 

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***Expenses***

 

The following table summarizes our Investment Management segmentexpenses for the periods presented:

 
| ** **                                                | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                                | ** ** | **2010**                             | ** ** | **2009**     | ** ** | **2010 vs. 2009**                  | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                                                | ** ** | **(In thousands)**                   | ** ** |
| Salaries                                                  |       | $                                    | 1,992      |         | $          | 1,868                              |       | $            | 124        |   | $ | 4,038 |   | $ | 4,054 |   | $ | (16 | ) |
| Incentive compensation                                    |       | 866                                  |       | 996          |       | (130                               | )          | 1,572        |       | 1,985 |   | (413 | ) |
| Employee benefits                                         |       | 219                                  |       | 165          |       | 54                                 |       | 308          |       | 344 |   | (36 | ) |
| Total compensation and benefits                           |       | 3,077                                |       | 3,029        |       | 48                                 |       | 5,918        |       | 6,383 |   | (465 | ) |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Audit and audit-related fees                              |       | 164                                  |       | 86           |       | 78                                 |       | 244          |       | 153 |   | 91 |   |
| Other professional fees                                   |       | 26                                   |       | 54           |       | (28                                | )          | 64           |       | 83 |   | (19 | ) |
| Total professional services                               |       | 190                                  |       | 140          |       | 50                                 |       | 308          |       | 236 |   | 72 |   |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Insurance expense                                         |       | 93                                   |       | 97           |       | (4                                 | )          | 184          |       | 194 |   | (10 | ) |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Software and data feeds                                   |       | 220                                  |       | 308          |       | (88                                | )          | 453          |       | 614 |   | (161 | ) |
| Other general and administrative fees                     |       | 268                                  |       | 222          |       | 46                                 |       | 449          |       | 439 |   | 10 |   |
| Total general and administrative expense                  |       | 488                                  |       | 530          |       | (42                                | )          | 902          |       | 1,053 |   | (151 | ) |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Equipment and improvements depreciation and  amortization |       | 1,576                                |       | 317          |       | 1,259                              |       | 6,032        |       | 639 |   | 5,393 |   |
| Intangible asset amortization                             |       | 1,449                                |       | 1,312        |       | 137                                |       | 2,731        |       | 2,625 |   | 106 |   |
| Total depreciation and amortization                       |       | 3,025                                |       | 1,629        |       | 1,396                              |       | 8,763        |       | 3,264 |   | 5,499 |   |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Occupancy                                                 |       | 386                                  |       | 569          |       | (183                               | )          | 876          |       | 1,208 |   | (332 | ) |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Cost savings initiative                                   |       | —                               |       | 28           |       | (28                                | )          | —       |       | 225 |   | (225 | ) |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Impairment of intangible assets                           |       | —                               |       | 126          |       | (126                               | )          | 168          |       | 126 |   | 42 |   |
|                                                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Total Investment Management segment expenses              |       | $                                    | 7,259      |         | $          | 6,148                              |       | $            | 1,111      |   | $ | 17,119 |   | $ | 12,689 |   | $ | 4,430 |   |

 

The increase in expenses of $1.1 million for the three months ended June 30,2010, as compared to the same period in 2009, was primarily attributable to a$1.4 million increase in depreciation and amortization, partially offset by a$0.2 million decrease in occupancy costs.

 

The increase in expenses of $4.4 million for the six months ended June 30,2010, as compared to the same period in 2009, was primarily attributable to a$5.5 million increase in depreciation and amortization, partially offset by a$0.5 million decrease in compensation and benefits and a $0.3 million decreasein occupancy costs.

 

On November 27, 2009, we entered into an amendment to our originallease agreement dated July 11, 2005 (as amended, the “Lease”). Pursuant tothe amendment, we vacated our original premises on April 30, 2010 andrelocated to a new space in the same building. The new term of the Lease willexpire on February 28, 2021. As a result of our relocation, our annualrent expense under the Lease will be reduced by approximately $1.3 million.During the three and six months ended June 30, 2010, occupancy costs werereduced by $0.2 million and $0.3 million, respectively, as compared to the sameperiods in 2009, primarily as a result of the amendment.

 

In connection with the amendment, we recognized a non-cash accelerationof depreciation and amortization expense related to certain leaseholdimprovements and equipment on the original premises as a result of a shorterestimated life for the use of those assets. The total impact of the accelerationof the depreciation and amortization expense is approximately$6.9 million, which we expensed ratably from the date the amendment wassigned (November 27, 2009) to the date on which we vacated the originalpremises (April 30, 2010). The impact of the accelerated depreciation forthe three and six months ended June 30, 2010 was $1.4 million and$5.5 million, respectively.

 

The $0.5 million decrease in compensation and benefits for the sixmonths ended June 30, 2010, as compared to the same period in 2009, wasprimarily the result of reduced incentive compensation.

 

During the six months ended June 30, 2010, we recorded$0.2 million of impairment charges on the intangible assets associatedwith the management contract for Oceanview CBO I, Ltd., as DCM is nolonger the manager of this CDO.

 

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

 

During the three and six months ended June 30, 2010, other income(expense) and gain (loss) for our Investment Management segment included a$17.4 million gain related to the Senior Notes Discharge.

 

Other income (expense) and gain (loss) also includes the realized andunrealized gains related to our investments in equity interests in CDOs thatare managed by DCM, which may take the form of either preference shares orsubordinated notes but are generally referred to herein as “preference shares,”and beneficial interests in CDOs. During the three and six months ended June 30,2010, we recognized net unrealized losses of $1.0 million and net unrealizedgains of $0.2 million, respectively, related to these investments. The majorityof these investments are eliminated upon consolidation, and as a result, duringthe three and six months ended June 30, 2010, we recognized net unrealizedlosses of $0.2 million in net gain (loss) on investments, loans,derivatives and liabilities in the condensed consolidated statements ofoperations related to these investments.

 

***Income Tax Expense***

 

For the three months and sixmonths ended June 30, 2010, our Investment Management segment recorded deminimis income tax expense related to Deerfield Capital Management (Europe)Limited.

 

**PrincipalInvesting Segment**

 

***Revenues***

 

Our Principal Investing segment revenues represent the differencebetween the interest income we earn on our investment portfolio and the cost ofour borrowings, net of hedges, if any. We also recognize the impact of ourprovision for loan losses on our Principal Investing segment revenues.

 

The following table summarizes our Principal Investing segment interestincome:

 
| ** **                                  | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **% of total interest income** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|--------------|------------|--------------------------------|------------|
| ** **                                  | ** ** | **2010**                             | ** ** | **2009**     | ** ** | **2010 vs. 2009**              | ** ** | **Year ended December 31,** | ** ** |
| ** **                                  | ** ** | **(In thousands)**                   | ** ** | **2010**     | ** ** | **2009**                       | ** ** |
| ** **                                  | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| RMBS                                        |       | $                                    | 2,670      |         | $          | 4,220                          |       | $ | (1,550 | ) | 30.3 | % | 30.0 | % |
| Corporate Loans:                            |       |                                 |       |         |       |                           |       |   |   |   |   |
| Loans held in DFR MM CLO                    |       | 5,749                                |       | 6,226        |       | (477                           | )          | 65.2 | % | 44.2 | % |
| Loans held in the Wachovia Facility         |       | —                               |       | 561          |       | (561                           | )          | 0.0 | % | 4.0 | % |
| Other corporate leveraged loans             |       | 71                                   |       | 19           |       | 52                             |       | 0.8 | % | 0.1 | % |
| Corporate bonds held in DFR MM CLO          |       | 80                                   |       | —       |       | 80                             |       | 0.9 | % | 0.0 | % |
| Assets held in Market Square CLO            |       | —                               |       | 3,003        |       | (3,003                         | )          | 0.0 | % | 21.3 | % |
| Assets held in DPLC                         |       | 112                                  |       | 35           |       | 77                             |       | 1.3 | % | 0.3 | % |
| Commercial real estate loans and securities |       | 35                                   |       | —       |       | 35                             |       | 0.4 | % | 0.0 | % |
| Other investments                           |       | 100                                  |       | 18           |       | 82                             |       | 1.1 | % | 0.1 | % |
| **Total interest income**                   |       | $                                    | 8,817      |         | $          | 14,082                         |       | $ | (5,265 | ) | 100.0 | % | 100.0 | % |

 

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| ** **                                  | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** | **% of total interest income** | ** ** |
|---------------------------------------------|------------|------------------------------------|------------|--------------|------------|--------------------------------|------------|
| ** **                                  | ** ** | **2010**                           | ** ** | **2009**     | ** ** | **2010 vs. 2009**              | ** ** | **Year ended December 31,** | ** ** |
| ** **                                  | ** ** | **(In thousands)**                 | ** ** | **2010**     | ** ** | **2009**                       | ** ** |
|                                        |       |                               |       |         |       |                           |       |   |   |   |   |
| RMBS                                        |       | $                                  | 4,027      |         | $          | 8,720                          |       | $ | (4,693 | ) | 25.1 | % | 31.4 | % |
| Corporate Loans:                            |       |                               |       |         |       |                           |       |   |   |   |   |
| Loans held in DFR MM CLO                    |       | 11,281                             |       | 12,046       |       | (765                           | )          | 70.1 | % | 43.3 | % |
| Loans held in the Wachovia Facility         |       | —                             |       | 1,196        |       | (1,196                         | )          | 0.0 | % | 4.3 | % |
| Other corporate leveraged loans             |       | 78                                 |       | (17          | )          | 95                             |       | 0.5 | % | -0.1 | % |
| Corporate bonds held in DFR MM CLO          |       | 80                                 |       | —       |       | 80                             |       | 0.5 | % | 0.0 | % |
| Assets held in Market Square CLO            |       | —                             |       | 6,073        |       | (6,073                         | )          | 0.0 | % | 21.8 | % |
| Assets held in DPLC                         |       | 353                                |       | 35           |       | 318                            |       | 2.2 | % | 0.1 | % |
| Commercial real estate loans and securities |       | 69                                 |       | (88          | )          | 157                            |       | 0.4 | % | -0.3 | % |
| Other investments                           |       | 198                                |       | (147         | )          | 345                            |       | 1.2 | % | -0.5 | % |
| **Total  interest income**                  |       | $                                  | 16,086     |         | $          | 27,818                         |       | $ | (11,732 | ) | 100.0 | % | 100.0 | % |

 

Interest income decreased by $5.3 million for the three months ended June 30,2010, as compared to the three months ended June 30, 2009. This decreasewas primarily comprised of a $3.0 million reduction in interest on assets heldin Market Square CLO, a $1.6 million reduction in interest income earned on ourRMBS portfolio and a $1.0 million reduction of interest earned on CorporateLoans. Interest income decreased by $11.7 million for the six months ended June 30,2010, as compared to the six months ended June 30, 2009. This decrease wasprimarily comprised of a $6.1 million reduction in interest on assets held inMarket Square CLO, a $4.7 million reduction in interest income earned on ourRMBS portfolio and a $1.9 million decrease in interest earned on CorporateLoans.

 

The $3.0 million and $6.1 million decrease interest income earned onassets held in Market Square CLO for the three and six months ended June 30,2010, as compared to the three and six months ended June 30, 2009,respectively, was directly attributable to the deconsolidation of Market SquareCLO as of June 30, 2009.

 

The $1.6 million and $4.7 million decrease in interest earned on ourRMBS portfolio during the three and six months ended June 30, 2010, ascompared to the three and six months ended June 30, 2009, respectively, isprimarily the result of increased premium amortization and the acceleration ofpremium amortization of $0.9 million and $3.3 million during the three and sixmonths ended June 30, 2010, respectively. In addition, the reduction inthe average size of our RMBS portfolio contributed to a $0.7 million and $1.4million decline in interest income during the three and six months ended June 30,2010, as compared to the three and six months ended June 30, 2009,respectively.

 

The$1.0 million and $1.9 million decrease in interest income on Corporate Loansfor the three and six months ended June 30, 2010, as compared to the threeand six months ended June 30, 2009, respectively, was primarily the resultof a lower interest rate environment for loans held in DFR MM CLO, whichcontributed to declines in interest income of $0.5 million and $0.8 millionduring the periods, respectively, and the sale of loans previously held in oursince dissolved revolving warehouse funding facility with Wachovia CapitalMarkets, LLC (the “Wachovia Facility”), which contributed declines in interestincome of $0.6 million and $1.2 million during the periods, respectively.

 

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The following table summarizes our Principal Investing segment interestexpense:

 
| ** **                           | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2010**                             | ** ** | **2009**     | ** ** | **2010 vs. 2009**                  | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                           | ** ** | **(In thousands)**                   | ** ** |
| Short term debt:                     | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Repurchase agreements                |       | $                                    | 225        |         | $          | 556                                |       | $            | (331       | ) | $ | 454 |   | $ | 1,194 |   | $ | (740 | ) |
| Hedging activity                     |       | 7                                    |       | 46           |       | (39                                | )          | 31           |       | 95 |   | (64 | ) |
| Total short term debt                |       | 232                                  |       | 602          |       | (370                               | )          | 485          |       | 1,289 |   | (804 | ) |
| Long term debt:                      |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Recourse:                            |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Subordinated debt and securities (1) |       | 488                                  |       | 1,205        |       | (717                               | )          | 1,279        |       | 2,654 |   | (1,375 | ) |
| Convertible notes                    |       | 183                                  |       | —       |       | 183                                |       | 183          |       | — |   | 183 |   |
| Non-Recourse:                        |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| DFR MM CLO                           |       | 555                                  |       | 1,053        |       | (498                               | )          | 1,083        |       | 2,521 |   | (1,438 | ) |
| Market Square CLO                    |       | —                               |       | 1,117        |       | (1,117                             | )          | —       |       | 2,735 |   | (2,735 | ) |
| Wachovia Facility                    |       | —                               |       | 5            |       | (5                                 | )          | —       |       | 19 |   | (19 | ) |
| Total long term debt                 |       | 1,226                                |       | 3,380        |       | (2,154                             | )          | 2,545        |       | 7,929 |   | (5,384 | ) |
| Amortization of debt issuance cost   |       | 137                                  |       | 370          |       | (233                               | )          | 350          |       | 789 |   | (439 | ) |
| Total interest expense               |       | $                                    | 1,595      |         | $          | 4,352                              |       | $            | (2,757     | ) | $ | 3,380 |   | $ | 10,007 |   | $ | (6,627 | ) |

 

----

(1)                                  Subordinateddebt and securities includes interest expense for both the trust preferredsecurities and Junior Subordinated Debt.

 

The decrease in interest expense of $2.8 million and $6.6 millionfor the three and six months ended June 30, 2010, as compared to the threeand six months ended June 30, 2009, respectively, was primarily the resultof reduced repurchase agreement and long term debt balances and, to a lesserextent, a lower interest rate environment. The decrease in both the averageoutstanding repurchase agreement balance and the weighted average borrowingrate for the three and six months ended June 30, 2010, as compared to thethree and six months ended June 30, 2009, contributed to reductions of$0.3 and $0.7 million, respectively, in interest expense on repurchaseagreements.

 

Theinterest expense related to long term debt decreased by $2.2 million and $5.4million for the three and six months ended June 30, 2010, as compared tothe three and six months ended June 30, 2009, respectively.  The deconsolidation of Market Square CLO on June 30,2009 provided a decrease in interest expense of $1.1 million and $2.7 millionfor the three and six months ended June 30, 2010, as compared to the threeand six months ended June 30, 2009, respectively.  Lower outstanding long term debt balances andlower interest rates on DFR MM CLO provided a decrease in interest expense of$0.5 and $1.4 million for the three and six months ended June 30, 2010, ascompared to the three and six months ended June 30, 2009, respectively. Inaddition, subordinated debt and securities provided a $0.7 million and $1.4million reduction in interest expense for the three and six months ended June 30,2010, respectively, as compared to the three and six months ended June 30,2009.  The reduction in interest expenserelated to the subordinated debt and securities was primarily due to a decreasein the average borrowing rate for the periods.

 

Intereston subordinated debt and securities will continue to decline as compared toprior periods primarily as a result of the Trust Preferred Exchange and theissuance of our Junior Subordinated Debt, which accrues interest at a fixed rateof 1.0% per annum through April 30, 2015. See *Liquidity*—*Sources ofFunds* for further information on the Trust Preferred Exchange andthe Junior Subordinated Debt. Additionally, we expect a further net reductionin long term debt interest expense as a result of the Senior Notes Discharge,which eliminated $73.9 million in aggregate principal amount of outstandingdebt, although this reduction will be partially offset by an increase ininterest expense associated with the issuance of the $25.0 million in aggregateprincipal amount of Convertible Notes.

 

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***Provision for Loan Losses***

 

The following table summarizes our Principal Investing segmentprovision for loan losses:

 
| ** **                      | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **2010**                             | ** ** | **2009**                           | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(In thousands)**                   | ** ** |
| Loans held in DFR MM CLO        |       | $                                    | 291        |                               | $          | 8,847 |   | $ | 4,477 |   | $ | 9,640 |   |
| Commercial real estate loans    |       | —                               |       | 272                                |       | — |   | 1,586 |   |
| Total provision for loan losses |       | $                                    | 291        |                               | $          | 9,119 |   | $ | 4,477 |   | $ | 11,226 |   |

 

Duringthe three months ended June 30, 2010, we recorded additional provisionsfor loan losses of $0.3 million related to three loans held in DFR MM CLO (withtotal outstanding principal of $6.0 million), with respect to which we hadpreviously recorded provisions for loan losses. In addition, during thethree months ended March 31, 2010, we recorded provisions for loan lossesof $4.2 million related to three loans held in DFR MM CLO for a total of $4.5million in provisions recorded on loans held in DFR MM CLO during the sixmonths ended June 30, 2010.

 

Duringthe three months ended June 30, 2009, we recorded additional provisionsfor loan losses of $9.1 million, including $8.8 million related to two loansheld in DFR MM CLO (with total outstanding principal of $10.1 million) and$0.3 million in provisions related to two commercial real estate loans(with total outstanding principal of $6.0 million). In addition, duringthe three months ended March 31, 2009, we recorded provisions for loanlosses of $0.8 million related to two loans held in the DFR MM CLO and$1.3 million related to three commercial real estate loans. Thus, duringthe six months ended June 30, 2009 we recorded provisions for loan lossesof $11.2 million, including $9.6 million recorded on loans held in DFR MM CLOand $1.6 million recorded related to commercial real estate loans.

 

***Expenses***

 

The following table summarizes Principal Investing segment expenses forthe periods presented:

 
| ** **                                   | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2010**                             | ** ** | **2009**     | ** ** | **2010 vs. 2009**                  | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                   | ** ** |
| ** **                                   | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Management fee expense to related party (1)  |       | $                                    | —     |         | $          | 295                                |       | $            | (295       | ) | $ | — |   | $ | 295 |   | $ | (295 | ) |
| ** **                                   | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Audit and audit-related fees                 |       | 356                                  |       | 245          |       | 111                                |       | 527          |       | 391 |   | 136 |   |
| Legal and other professional fees            |       | 1,334                                |       | 343          |       | 991                                |       | 1,506        |       | 891 |   | 615 |   |
| Total professional services                  |       | 1,690                                |       | 588          |       | 1,102                              |       | 2,033        |       | 1,282 |   | 751 |   |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Insurance expense                            |       | 608                                  |       | 674          |       | (66                                | )          | 1,209        |       | 1,341 |   | (132 | ) |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Board of directors fees                      |       | 795                                  |       | 774          |       | 21                                 |       | 1,308        |       | 1,025 |   | 283 |   |
| Banking and other administrative fees        |       | 104                                  |       | 187          |       | (83                                | )          | 234          |       | 308 |   | (74 | ) |
| Other general and administrative fees        |       | —                               |       | 58           |       | (58                                | )          | 67           |       | 109 |   | (42 | ) |
| Warrant expense                              |       | —                               |       | —       |       | —                             |       | 529          |       | — |   | 529 |   |
| DPLC structuring and organizational expenses |       | —                               |       | 3,265        |       | (3,265                             | )          | —       |       | 3,265 |   | (3,265 | ) |
| Total general and administrative expenses    |       | 899                                  |       | 4,284        |       | (3,385                             | )          | 2,138        |       | 4,707 |   | (2,569 | ) |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Total Principal Investing segment expenses   |       | $                                    | 3,197      |         | $          | 5,841                              |       | $            | (2,644     | ) | $ | 5,380 |   | $ | 7,625 |   | $ | (2,245 | ) |

 

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(1)                                  Management feeexpense represents fees charged to the noncontrolling interest investors inDPLC.

 

The $2.6 million decrease in expenses for the three months ended June 30,2010, as compared to the three months ended June 30, 2009, is primarilycomprised of a $3.4 million in decrease in total general and administrativeexpenses and a $0.3 million decrease in management fee expense to relatedparty, partially offset by a $1.1 million increase in professional servicesexpenses. The $3.4 million decrease in general and administrative expenses isprimarily attributable to $3.3 million in one-time DPLC structuring andorganizational expenses incurred during the three months ended June 30,2009. The $0.3 million decrease in management fee expense to related party isrelated to fees charged to the noncontrolling interest investors in DPLC duringthe three months ended June 30, 2009. Management fees charged to noncontrollinginterest investors in DPLC were discontinued effective January 1, 2010. 

 

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Theincrease of $1.1 million in professional services is primarily a result ofincreased legal fees for the period related to our ongoing SEC investigation.

 

The$2.2 million decrease in expenses for the six months ended June 30, 2010,as compared to the six months ended June 30, 2009, is primarily comprisedof a $2.6 million in decrease in total general and administrative expenses, anda $0.3 million decrease in management fee expense to related party, partiallyoffset by a $0.8 million increase in professional services expenses. The $2.6million decrease in general and administrative expenses is primarilyattributable to $3.3 million in one-time DPLC structuring and organizationalexpenses incurred during the six months ended June 30, 2009, partiallyoffset by a $0.5 increase in expense related to the DPLC Restructuring Warrantsand a $0.3 million increase in directors’ fees. The $0.3 million decrease inmanagement fee expense to related party is related to fees charged to thenoncontrolling interest investors in DPLC during the six months ended June 30,2009. Management fees charged to noncontrolling interest investors in DPLC werediscontinued effective January 1, 2010. The increase of $0.8 million inprofessional services is primarily a result of increased legal fees for theperiod related to our ongoing SEC investigation.

 

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

 

 

The following table summarizes our Principal Investing segment otherincome (expense) and gain (loss) for the periods presented:

 
| ** **                                                        | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                                        | ** ** | **2010**                             | ** ** | **2009**     | ** ** | **2010 vs. 2009**                  | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                                                        | ** ** | **(In thousands)**                   | ** ** |
| ** **                                                        | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other-than-temporary impairment on  available-for-sale securities | ** ** | $                                    | —     | ** **   | $          | —                             | ** ** | $            | —     | ** ** | $ | — | ** ** | $ | (31 | ) | $ | 31 | ** ** |
| Net loss on available-for-sale securities                         |       | —                               |       | —       |       | —                             |       | —       |       | (31 | ) | 31 |   |
| ** **                                                        | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net realized gain (loss) on investments at fair  value            |       | (1,815                               | )          | (353         | )          | (1,462                             | )          | 460          |       | (348 | ) | 808 |   |
| Net unrealized gain (loss) on investments at fair  value          |       | 3,137                                |       | 1,526        |       | 1,611                              |       | 4,210        |       | 6,819 |   | (2,609 | ) |
| Net gain on investments at fair value                             |       | 1,322                                |       | 1,173        |       | 149                                |       | 4,670        |       | 6,471 |   | (1,801 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net realized gain (loss) on loans                                 |       | (105                                 | )          | (1,881       | )          | 1,776                              |       | 147          |       | (7,053 | ) | 7,200 |   |
| Net unrealized gain on loans                                      |       | 4,341                                |       | 26,757       |       | (22,416                            | )          | 6,843        |       | 37,744 |   | (30,901 | ) |
| Net gain on loans                                                 |       | 4,236                                |       | 24,876       |       | (20,640                            | )          | 6,990        |       | 30,691 |   | (23,701 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net realized gain (loss) on interest rate swaps                   |       | 7                                    |       | (9,906       | )          | 9,913                              |       | (194         | )          | (9,370 | ) | 9,176 |   |
| Net realized loss on credit default swaps                         |       | —                               |       | —       |       | —                             |       | —       |       | (522 | ) | 522 |   |
| Net realized loss on interest rate floors and caps                |       | (18                                  | )          | (18          | )          | —                             |       | (37          | )          | (37 | ) | — |   |
| Net unrealized gain (loss) on interest rate swaps                 |       | (7                                   | )          | 12,846       |       | (12,853                            | )          | 188          |       | 12,136 |   | (11,948 | ) |
| Net unrealized gain on credit default swaps                       |       | —                               |       | —       |       | —                             |       | —       |       | 403 |   | (403 | ) |
| Net unrealized gain (loss) on warrants                            |       | 3                                    |       | 40           |       | (37                                | )          | (45          | )          | (71 | ) | 26 |   |
| Net unrealized loss on Embedded Derivative                        |       | (3,267                               | )          | —       |       | (3,267                             | )          | (3,267       | )          | — |   | (3,267 | ) |
| Net unrealized gain on interest rate floors and  caps             |       | 18                                   |       | 19           |       | (1                                 | )          | 37           |       | 38 |   | (1 | ) |
| Net gain (loss) on derivatives                                    |       | (3,264                               | )          | 2,981        |       | (6,245                             | )          | (3,318       | )          | 2,577 |   | (5,895 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net gain on investments, loans, derivatives and  liabilties       |       | 2,294                                |       | 29,030       |       | (26,736                            | )          | 8,342        |       | 39,708 |   | (31,366 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Strategic transactions expenses                                   |       | (1,738                               | )          | —       |       | (1,738                             | )          | (3,167       | )          | — |   | (3,167 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net gain on the deconsolidation of Market Square  CLO             |       | —                               |       | 29,551       |       | (29,551                            | )          | —       |       | 29,551 |   | (29,551 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Other, net                                                        |       | (1,215                               | )          | 106          |       | (1,321                             | )          | (957         | )          | 164 |   | (1,121 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net other income (expense) and gain (loss)                        |       | $                                    | (659       | )            | $          | 58,687                             |       | $            | (59,346    | ) | $ | 4,218 |   | $ | 69,423 |   | $ | (65,205 | ) |

 

Net other income (expense) and gain (loss) declined by$59.3 million for the three months ended June 30, 2010, as comparedto the three months ended June 30, 2009. This decline was primarilyattributable to a $29.6 million net gain on the deconsolidation of MarketSquare CLO as of June 30, 2009. Additionally, the decrease is comprised ofa $20.7 million decrease in the net gains on loans, a $6.2 million variance innet losses on derivatives, a $1.7 million increase in strategic transactionsexpenses and a $1.3 million variance in other, net.

 

Net other income (expense) and gain (loss) declined by$65.2 million for the six months ended June 30, 2010, as compared tothe six months ended June 30, 2009. This decline was primarilyattributable to a $29.6 million net gain on the deconsolidation of MarketSquare CLO as of June 30, 2009. Additionally, the decrease is comprised ofa $23.7 million decrease in net gains on loans, a 

 

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$5.9million variance in net losses on derivatives, a $3.2 million increase instrategic transactions expenses, a $1.8 decrease in gains on investments atfair value and a $1.1 million variance in other, net.

 

The decrease in net gains on loans during both the three and six monthsended June 30, 2010, as compared to the three and six months ended June 30,2009, is primarily attributable to the deconsolidation of loans held in MarketSquare CLO as of June 30, 2009. Loans held in Market Square CLO accountedfor $30.8 million and $45.2 million in gains on loans for the three and sixmonths ended June 30, 2009, respectively. During the three months ended June 30,2010, net gains on loans is primarily comprised of $2.4 million in gains onloans held in DFR MM CLO and $1.8 million in gains on other corporate leveragedloans, while net gains on loans during the six months ended June 30, 2010is primarily comprised of $5.1 million in gains on loans held in DFR MM CLO and$1.9 million in gains on other corporate leveraged loans.

 

During the three and six months ended June 30, 2010, the net losson derivatives is primarily comprised of a $3.3 million loss on the EmbeddedDerivative related to the Convertible Notes. For the three and six months ended June 30, 2009, the net gain onderivatives is primarily comprised of net gains on interest rate swaps of $2.9million and $2.7 million, respectively.

 

During the three months ended June 30, 2010, the net gains oninvestments at fair value was primarily the result of $1.5 million in net gainson RMBS. During the six months ended June 30. 2010, the net gains oninvestments at fair value was primarily the result of $2.1 million in net gainson RMBS and $2.4 million in net gains on investments and other interests in ourCLOs. The net gains on RMBS were primarily driven by valuation increases on ourRMBS portfolio. During the three and six months ended June 30, 2009, thenet gains on investments at fair value of $1.2 million and $6.5 million,respectively, were primarily driven by valuation increases on our RMBSportfolio.

 

During the three and six months ended June 30, 2010, other, net isprimarily comprised of the $1.3 million reserve recorded during the three andsix months ended June 30, 2010, representing our current best estimate ofthe probable loss associated with the resolution of the SEC investigation.

 

***Income Tax Expense***

 

For the three and six months ended June 30, 2010, our PrincipalInvesting segment recorded no income tax expense.

 

**ConsolidatedInvestment Products Segment**

 

Our Consolidated Investment Products Segmentwas established on January 1, 2010 consistent with the consolidation guidancein the amendments to ASC Topic 810. As such, there is no prior periodcomparable data.  The results ofoperations include the results for the seven CIP CDOs that we were required toconsolidate effective January 1, 2010 for the three and six months ended June 30,2010.  In addition, the results ofoperations include the four CNCIM CDOs that we were required to consolidateeffective June 9, 2010 for the period from June 9, 2010 to June 30,2010.

 

***Revenues***

 

Our Consolidated Investment Products segment revenues represent thedifference between the interest income earned on the assets held by the CIPCDOs and the cost of the borrowings of the CIP CDOs. The assets of the CIP CDOsare held solely as collateral to satisfy the obligations of the CIP CDOs. We haveno right to the benefits from, nor do we bear the risks associated with, theassets held by the CIP CDOs, beyond our minimal direct investments in, andmanagement fees generated from, the CIP CDOs. If we were to liquidate, theassets would not be available to our general creditors, and as a result, we donot consider them to be our assets. Additionally, the investors in the CIP CDOshave no recourse to us for the debt obligations of the CIP CDOs. We thereforedo not consider this debt to be an obligation of ours. The following tablesummarizes our Consolidated Investment Products segment revenues:

 
| ** **                                             | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                             | ** ** | **2010**                             | ** ** | **2010**                           | ** ** |
| ** **                                             | ** ** | **(In thousands)**                   | ** ** |
| **Consolidated Investment Products  Segment Revenues** |       |                                 |       |                               |       |
| Interest income                                        |       | $                                    | 28,423     |                               | $          | 52,709 |   |
| Interest expense                                       |       | 5,917                                |       | 10,672                             |       |
| Net interest income                                    |       | $                                    | 22,506     |                               | $          | 42,037 |   |

 

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Net interest income for the three months ended June 30, 2010 isprimarily composed of $24.5 million of interest income on loans and $3.9million of interest income on corporate bonds, partially offset by $5.9 millionof interest expense on non-recourse long term debt.  Net interest income for the six months ended June 30,2010 is primarily composed of $44.7 million of interest income on loans and$8.0 million of interest income on corporate bonds, partially offset by $10.7million of interest expense on non-recourse long term debt.

 

***Expenses***

 

The following table summarizes our Consolidated Investment Productssegment expenses for the three and six months ended June 30, 2010:

 
| ** **                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                               | ** ** | **2010**                             | ** ** | **2010**                           | ** ** |
| ** **                                               | ** ** | **(In thousands)**                   | ** ** |
| ** **                                               | ** ** | ** **                           | ** ** | ** **                         | ** ** |
| Investment advisory fee to related party                 |       | $                                    | 3,263      |                               | $          | 6,869 |   |
|                                                     |       |                                 |       |                               |       |
| Audit and audit-related fees                             |       | 93                                   |       | 251                                |       |
| Other professional fees                                  |       | 123                                  |       | 328                                |       |
| Total professional services                              |       | 216                                  |       | 579                                |       |
|                                                     |       |                                 |       |                               |       |
| Insurance expense                                        |       | 51                                   |       | 51                                 |       |
|                                                     |       |                                 |       |                               |       |
| Other general and administrative fees                    |       | 306                                  |       | 564                                |       |
|                                                     |       |                                 |       |                               |       |
| Total Consolidated Investment Products segment  expenses |       | $                                    | 3,836      |                               | $          | 8,063 |   |

 

The most significant expense for our Consolidated Investment Productssegment is the investment advisory fee expense to related party of $3.3 millionand $6.9 million for the three and six months ended June 30, 2010,respectively, which is eliminated upon consolidation. This amount is charged byour Investment Management segment in connection with the CIP CDO managementcontracts with DCM and CNCIM.

 

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

 

The following table summarizes our Consolidated Investment Productssegment other income (expense) and gain (loss) for the three and six monthsended June 30, 2010:

 
| ** **                                                  | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                  | ** ** | **2010**                             | ** ** | **2010**                           | ** ** |
| ** **                                                  | ** ** | **(In thousands)**                   | ** ** |
| Net realized gain on investments at fair value              |       | $                                    | 6,870      |                               | $          | 14,319 |   |
| Net unrealized gain (loss) on investments at fair  value    |       | (51,892                              | )          | 10,650                             |       |
| Net gain (loss) on investments investments at fair  value   |       | (45,022                              | )          | 24,969                             |       |
|                                                        |       |                                 |       |                               |       |
| Net realized loss on liabilities                            |       | (2,953                               | )          | (4,702                             | )          |
| Net unrealized gain (loss) on liabilities                   |       | 18,659                               |       | (68,927                            | )          |
| Net gain (loss) on liabilities                              |       | 15,706                               |       | (73,629                            | )          |
|                                                        |       |                                 |       |                               |       |
| Net realized loss on derivatives                            |       | (4,710                               | )          | (4,710                             | )          |
| Net unrealized gain on derivatives                          |       | 4,761                                |       | 4,149                              |       |
| Net gain (loss) on derivatives                              |       | 51                                   |       | (561                               | )          |
|                                                        |       |                                 |       |                               |       |
| Net loss on investments, loans, derivatives and  liabilties |       | (29,265                              | )          | (49,221                            | )          |
|                                                        |       |                                 |       |                               |       |
| Other net gain                                              |       | 282                                  |       | 1,090                              |       |
|                                                        |       |                                 |       |                               |       |
| Net other income (expense) and gain (loss)                  |       | $                                    | (28,983    | )                                  | $          | (48,131 | ) |

 

We have elected the fair value option for all assets and liabilities ofthe CIP CDOs.  As a result, other income(expense) and gain (loss) for our Consolidated Investment Products segmentconsisted primarily of realized and unrealized gains on investments,derivatives and liabilities. Net gain (loss) on investments consists of net gainsand losses on loans, corporate bonds and other investments.

 

**Off-BalanceSheet Arrangements**

 

Through our wholly-owned subsidiary, DC LLC, we own all of thecommon shares of Deerfield Capital Trust I (“Trust I”). Trust I, a VIE, wasformed in September 2005 and issued, in the aggregate, $25.0 millionof preferred shares to unaffiliated investors. DC LLC issued juniorsubordinated debt securities, which we refer to as the trust preferredsecurities, to Trust I in the aggregate of $25.8 million which remainoutstanding, and are guaranteed by us. The rights of the holders of commonshares of Trust I are subordinate to the rights of the holders of preferredshares only in the event of a default. Otherwise, the common stockholders’economic and voting rights rank pari passu with the preferred stockholders. Werecord the investment in the Trust I common shares as other investments at costand record dividend income upon declaration by the Trust. The juniorsubordinated debt securities are recorded as long term debt, and debt issuancecosts are deferred in prepaid and other assets in the consolidated balancesheet. Interest on the debt securities and amortization of debt issuance costsare recorded in the consolidated statements of operations as interest expense.

 

As of June 30, 2010, we did not maintain any other relationshipswith unconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance, special purpose or VIEs, established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes. Further, as of June 30, 2010, we did notguarantee any obligations of unconsolidated entities or entered into anycommitment or intent to provide additional funding to any such entities, otherthan Trust I.

 

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**Liquidity**

 

We held cash and cash equivalents of $43.0 million as of June 30,2010.

 

Our operating activities provided cash of $1.7 million for the sixmonths ended June 30, 2010, primarily through the following:

 

Net inflows and non-cash adjustments of $101.9 million, consistingof the following:

 

·                                     Netincome—$4.1 million

 

·                                     Net loss onliabilities at fair value—$73.1 million

 

·                                     Depreciationand amortization—$8.8 million

 

·                                     Net change inoperating assets and liabilities—$7.4 million

 

·                                     Provision forloan losses—$4.5 million

 

·                                     Net premium anddiscount amortization on investments, loans and debt issuance—$1.7 million

 

·                                     Net otherlosses—$1.2 million

 

·                                     Issuance ofstock warrants—$0.5 million

 

·                                     Share-basedcompensation $0.4 million

 

·                                     Impairment ofintangible assets—$0.2 million

 

Net outflows and non-cash adjustments totaled $100.2 million,consisting of the following:

 

·                                     Net purchasesof investments at fair value—$45.2 million

 

·                                     Net gain oninvestments at fair value—$29.3 million

 

·                                     Net gain on thedischarge of the Senior Notes—$17.4 million

 

·                                     Net gain onloans—$7.0 million

 

·                                     Net changes inundesignated derivatives—$1.1 million

 

·                                     Non-cash rentalexpense—$0.2 million

 

Our investing activities provided cash of $166.7 million for the sixmonths ended June 30, 2010, primarily from principal receipts and proceedsfrom the sale of investments at fair value previously classified asavailable-for-sale of $122.5 million, principal receipts and proceeds fromloans held for investment of $83.0 million, changes in restricted cash and cashequivalents of $39.2 million, principal receipts and proceeds from the sale ofloans held for sale previously classified as held for investment of $6.9million and net cash acquired from the CNCIM Acquisition of $2.5 million,partially offset by the origination and purchase of loans held for investmentof $86.2 million and purchases of equipment and improvements of $1.2million.

 

Our financing activities used cash of $174.1 million for the sixmonths ended June 30, 2010, primarily for payments on long term debt of$160.9 million, distributions to noncontrolling interest and investors inConsolidated Investment Products of $28.0 million, net payments on repurchaseagreements of $9.2 million and stock and debt issuance costs of$1.0 million, partially offset by proceeds from the issuance of long termdebt of $25.0 million.

 

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***Leverage***

 

Our RMBS holdings were $305.8 million and $311.2 million as of June 30,2010 and 2009, respectively. Our repurchase agreements liabilities were$282.2 million and $294.5 million as of June 30, 2010 and 2009,respectively. As discussed in more detail in the following section, *“Sources of Funds,”* our remaining long term debt (other thanthe long term debt in our Consolidated Investment Products segment) of$354.6 million consists of $217.3 million of non-recourse debt,$16.5 million (net of a $8.5 million discount) of Convertible Notes, $95.0million of Junior Subordinated Debt and $25.8 million of trust preferredsecurities.

 

***Sourcesof Funds***

 

We believe that our current cash and cash equivalents, unencumberedliquid assets and net equity in our financed RMBS portfolio, along with cashflows from operations, among other things, are adequate to meet our anticipatedlong term liquidity requirements. Unencumbered RMBS and unrestricted cash andcash equivalents aggregated $45.0 million at June 30, 2010. Inaddition, net equity in our financed RMBS portfolio (including associatedinterest rate swaps), excluding the unencumbered RMBS included above, totaled$15.9 million at June 30, 2010. In total, we had unrestricted cashand cash equivalents, unencumbered RMBS and net equity in the financed RMBSportfolio of $60.9 million as of June 30, 2010. As of June 30,2010, the fair value of our Agency RMBS and non-Agency RMBS portfolios were$304.2 million and $1.6 million, respectively.

 

We attempt to maintain our leverage related to our RMBS portfolio at alevel that we believe ensures that our cash and cash equivalents will besufficient to satisfy our liquidity requirements. If we are required to sellRMBS at prices lower than their carrying value, it would result in losses andreduced future income. For further discussion concerning the availability ofrepurchase agreement financing, which we use to finance our RMBS portfolio, see*“Trends—Liquidity”* above. We mayincrease our capital resources by consummating offerings of securities orissuing new debt, possibly including preferred stock, common stock, commercialpaper, medium-term notes, CDOs, collateralized mortgage obligations and otherborrowings. The ability to execute these strategies will depend on, among otherthings, market conditions for capital raises and for the investment of anyproceeds.

 

Pursuant to the amendment to our Lease, the amount of the letter ofcredit constituting our security deposit under the Lease was reduced fromapproximately $2.3 million to approximately $1.3 million. Theamendment also provides for a further reduction of the amount of the letter ofcredit to $0.5 million on September 30, 2010 upon the satisfaction ofcertain conditions.

 

As we focus on growing our Investment Management segment, we expect toutilize our cash and other sources of liquidity to invest in new investmentproducts and in connection with the acquisition of CDO management contracts.

 

The economic impact of our investment in DFR MM CLO is determined bythe cash flows distributed to us on our investment in $50.0 million of preferenceshares and $19.0 million of debt, subject to diversion of cash flows awayfrom us as provided in accordance with its indenture. For the three and sixmonths ended June 30, 2010, the net income of $7.4 million and $10.6million, respectively, recorded in our condensed consolidated statements ofoperations for DFR MM CLO was not indicative of the cash flow distributions of$4.1 million and $7.9 million for the three and six months ended June 30,2010, respectively. These cash distributions included $3.9 million and $7.5million related to our preference shares investment for the three and sixmonths ended June 30, 2010, respectively, and $0.2 million and $0.4million in interest on our debt investment for the three and six months ended June 30,2010, respectively.  We have not receivedand will not receive a cash distribution related to our preference sharesinvestment in the third quarter of 2010. While we expect to receive future cashflows from this investment, it is very difficult to predict the timing andamount of such future cash flows.

 

*Investment Management Segment*

 

We used the proceeds of the issuance of theConvertible Notes, together with other available funds, to complete the SeniorNotes Discharge on June 9, 2010. We recorded a $17.4 million gainon the condensed consolidated statement of operations related to the SeniorNotes Discharge. As a result, we no longer have any long term debt within ourInvestment Management segment.

 

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* *

*Principal Investing Segment*

 

The following is a summary of our Principal Investing segmentborrowings as of June 30, 2010:

 
| ** **                                     | ** ** | **Recourse**   | ** ** | **Non-Recourse**   | ** ** |
|------------------------------------------------|------------|----------------|------------|--------------------|------------|
| ** **                                     | ** ** | ** **     | ** ** | **Trust**          | ** ** | **Junior** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Repurchase** | ** ** | **Preferred**      | ** ** | **Subordinated** | ** ** | **Convertible** | ** ** | **DFR** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Agreements** | ** ** | **Securities (1)** | ** ** | **Debt (2)** | ** ** | **Notes (3)** | ** ** | **MM CLO (4)** | ** ** | **Total** | ** ** |
|                                           |       |           |       |               |       |   |   |   |   |   |   |   |   |
| Outstanding carrying value (in thousands)      |       | $              | 282,246    |               | $          | 25,775 |   | $ | 95,000 |   | $ | 16,522 |   | $ | 217,296 |   | $ | 636,839 |   |
| Current weighted average borrowing rate        |       | 0.33           | %          | 3.84               | %          | 1.00 | % | 8.00 | % | 1.02 | % | 2.95 | % |
| Weighted-average remaining maturity (in years) |       | 0.06           |       | 25.35              |       | 25.35 |   | 7.45 |   | 9.06 |   | 23.80 |   |
|                                                |            |                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  The remainingtrust preferred securities are callable by us after October 30, 2010.

 

(2)                                  OnMarch 4, 2010, $95.0 million of trust preferred securities were exchangedin the Trust Preferred Exchange (as defined below) for $95.0 million of newJunior Subordinated Debt (as defined below). The Junior Subordinated Debt iscallable by us after October 30, 2010.

 

(3)                                  The ConvertibleNotes principal outstanding of $25.0 million is presented net of an $8.5million discount. The Convertible Notes currently pay interest at the 8.00%stated rate; however, including the discount, the effective rate of interest is18.14%.

 

(4)                                  Excludes$19.0 million of DFR MM CLO debt that is owned by us and eliminated uponconsolidation. Had this debt been included, the weighted-average borrowing ratewould have been 1.29%.  DFR MM CLOfinancing is callable after July 20, 2010 and quarterly thereafter,subject to certain conditions.

 

*RecourseDebt*

 

Recourse debt refers to debt that is a general obligation of ours.

 

*Repurchase Agreements*

 

As of June 30, 2010, wehad repurchase agreements outstanding with two counterparties in the amount of$282.2 million with a weighted-average borrowing rate of 0.33% andremaining weighted average maturity of 22 days. As of June 30, 2010, thefair value of securities pledged minus repurchase agreement liabilities andrelated accrued interest payable was $11.0 million. At June 30, 2010,88.3% of our repurchase agreement liabilities were concentrated with onecounterparty.

 

Increases in interest rates or spreads on Agency RMBS could reduce thevalue of our RMBS, which could limit our borrowing ability or cause our lendersto initiate additional margin calls. As most of our borrowings via repurchaseagreements are short-term in nature, there is a risk that the terms presentlyavailable to us from counterparties to these borrowings could adversely changeor that counterparties could become unwilling to continue to provide suchfinancing to us.

 

*Junior Subordinated Debt and Trust Preferred Securities*

 

OnMarch 4, 2010, we entered into an exchangeagreement with the holders of our trust preferred securities to exchange$95.0 million of the $120.0 million aggregate outstanding principalamount of trust preferred securities previously issued by our threewholly-owned indirect subsidiaries, Deerfield Capital Trust I, DeerfieldCapital Trust II and Deerfield Capital Trust III, for$95.0 million aggregate outstanding principal amount of juniorsubordinated notes (the “JuniorSubordinated Debt”) issued by us (the “Trust Preferred Exchange”). The Trust Preferred Exchange wascompleted on March 4, 2010. An aggregate of $25.0 million inprincipal amount of trust preferred securities issued by Deerfield CapitalTrust I was not exchanged and remains outstanding and is subject to theterms and covenants, including the net worth covenant, set forth in the amendedtrust preferred indenture and described in our 2009 10-K.

 

TheJunior Subordinated Debt is governed by a junior subordinated indenture (the “Junior Subordinated Debt Indenture”),dated March 4, 2010, between us and The Bank of New York Mellon TrustCompany, National Association, as trustee. Pursuant to the Junior SubordinatedDebt Indenture, the Junior Subordinated Debt bears interest at a fixed rate of1.00% per annum from the date of issuance through April 30, 2015 as aresult of the CNCIM Acquisition and the related strategic transactions, whichcollectively qualified as a Credit Enhancing Transaction (as defined in theJunior Subordinated Debt Indenture). Thereafter, the Junior 

 

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SubordinatedDebt will be subject to a variable interest rate equal to LIBOR plus 2.58% perannum, until maturity on October 30, 2035.

 

The Junior Subordinated Debt Indenture contains certain restrictivecovenants including, among other things, (i) a covenant that requires allasset management activities to be conducted by DFR and its subsidiaries, andwhich permits us to sell equity and material assets of DCM only if all assetmanagement fees and proceeds from equity and asset sales are subject to thelimits on restricted payments set forth in the Junior Subordinated DebtIndenture, (ii) a debt covenant that permits DFR and DCM to incurindebtedness only if the proceeds of such indebtedness are subject to thelimits on restricted payments set forth in the Junior Subordinated DebtIndenture and (iii) a restricted payments covenant that restricts ourability to pay dividends or make distributions in respect of our equity securities,subject to a number of exceptions and conditions. Unlike the indentures for thetrust preferred securities, the Junior Subordinated Debt Indenture does notcontain a covenant requiring us to maintain a minimum net worth.

 

*Convertible Notes*

 

The$25.0 million in principal amount of our Convertible Notes were issued toBounty simultaneously with the closing of the CNCIM Acquisition.  The Convertible Notes are convertible into4,132,231 shares of common stock (as such amount may be adjusted incertain events or increased in connection with the payment of PIK Interest) atan initial conversion price of $6.05 per share, subject to adjustment. TheConvertible Notes issued on the Closing Date will mature on December 9,2017. Interest on the Convertible Notes will be payable to the holders of theConvertible Notes quarterly in arrears on each January 1, April 1,July 1 and October 1, beginning on July 1, 2010. We will payinterest in cash at a per annum rate starting at 8% on the Closing Date andincreasing incrementally to 11% on June 9, 2014; provided, that we may, inour sole discretion and upon notice to the holders of the Convertible Notes,elect to pay up to 50% of the interest payment due to any holder of theConvertible Notes in PIK Interest subject to certain conditions.

 

Theterms and conditions of the conversion feature contained in the ConvertibleNotes, and certain of the antidilution provisions of the conversion featurecause it to be deemed an Embedded Derivative under the provision of ASCTopic 815. These antidilution provisions prevent the conversion featurefrom qualifying as being indexed to our common stock. The Convertible Notes arerecorded as two components: (i) the Embedded Derivative initially recordedon the Closing Date as a $6.9 million derivative liability and, (ii) longterm debt initially recorded on the Closing Date at $16.5 million. At eachsubsequent balance sheet date, the Embedded Derivative will be marked to fairvalue and the change in fair value will be recorded in the condensed consolidatedstatement of operations as net gain (loss) on investments, loans, derivativesand liabilities. The total Closing Date fair value of the two components was$23.4 million. We did not elect the fair value option for the long term debtcomponent of the Convertible Notes. The difference between the $16.5 millionClosing Date fair value of the component of the Convertible Notes recorded aslong term debt and the $25.0 million principal amount of the ConvertibleNotes will be accreted to earnings using the effective yield method ofrecognizing interest expense. Debt issuance costs of $0.5 million were recordedwithin prepaid and other assets and will be amortized into expense over theterm of the Convertible Notes in accordance with ASC Topic 470 - *Debt*.

 

TheConvertible Notes Agreement contains events of default customary for agreementsof its type (with customary grace periods, as applicable) and provides that,upon the occurrence of an event of default arising from certain events ofbankruptcy or insolvency with respect to us and our material subsidiaries, alloutstanding Convertible Notes will become due and payable immediately withoutfurther action or notice. If any other type of event of default occurs and iscontinuing, then the holders of at least 33-1/3% in principal amount of thethen outstanding Convertible Notes may declare all of the outstandingConvertible Notes to be due and payable immediately.

 

TheConvertible Notes Agreement contains customary covenants, including thefollowing: (i) that we will not, and will not permit any of oursubsidiaries to, incur any indebtedness that is contractually subordinated inright of payment to other indebtedness of ours unless such indebtedness is alsocontractually subordinated in right of payment to the Convertible Notes onsubstantially similar terms; (ii) that we will not consolidate or mergewith or into another person or sell, transfer or otherwise dispose of all orsubstantially all of our assets to another person unless certain conditions aresatisfied; (iii) that, upon a change of control, we will offer torepurchase all or any part of the Convertible Notes of each holder ofConvertible Notes at a purchase price in cash equal to 100% of the aggregateprincipal amount of the Convertible Notes repurchased, plus accrued and unpaidinterest; and (iv) that we will use commercially reasonable efforts tokeep the Conversion Shares listed on the NASDAQ Stock Market or anothersecurities exchange on which our common stock is listed or quoted.

 

*Non-RecourseDebt*

 

Non-recourse debt refers to debt with recourse only to specific assetspledged as collateral to the lenders, such as debt issued by the CIP CDOs andDFR MM CLO. The creditors of the non-recourse debt have no recourse to ourother assets. None of the long term debt is subject to potential margin callsfor additional pledges of our cash or assets.

 

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*DFR MM CLO*

 

TheDFR MM CLO notes are due in 2019, but are callable by us, at par, onJuly 20, 2010 and quarterly thereafter, subject to certain conditions. DFRMM CLO is a consolidated bankruptcy remote subsidiary, and the holders of itsdebt securities have recourse only to its assets which had a carrying value of$285.5 million as of June 30, 2010.

 

*Consolidated Investment ProductsSegment*

 

All of the debt in our Consolidated Investment Products segment isnon-recourse debt as the investors in the CIP CDOs have no recourse to ourgeneral credit for the debt issued by the CIP CDOs. We therefore do notconsider this debt to be an obligation of ours. The following is a summary of our Consolidated Investment Productssegment borrowings as of June 30, 2010:

 
| ** **                                     | ** ** | **Non-recourse**       | ** ** |
|------------------------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **long term debt (1)** | ** ** |
| Outstanding carrying value (in thousands)      |       | $                      | 3,498,074  |   |
| Weighted average borrowing rate                |       | 0.95                   | %          |
| Weighted-average remaining maturity (in years) |       | 8.96                   |       |
|                                                |            |                        |            |  |

 

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(1)                                  Long term debtof our Consolidated Investment Products is recorded at fair value in accordancewith ASC Topic 820.  Long term debtincludes the fair value of the preference shares issued by the CIP CDOs in thecarrying value, however, the preference shares do not have a stated interestrate and are therefore excluded from the calculation of the weighted averageborrowing rate. The outstanding carrying value includes $3.7 million that iseliminated upon consolidation.

 

***Distribution Policy***

 

The covenants contained in our indebtedness currently restrict ourability to declare dividends or distributions on our common stock, andtherefore, we do not expect to make dividend distributions in the foreseeablefuture.

 

**ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

As of June 30, 2010, the primary component of our market risk wasinterest rate and spread risk, as described below. While we do not seek toavoid risk completely, we manage interest rate risk and regularly assesswhether earnings in our portfolio include appropriate compensation for theinherent market risks to which it is exposed. In light of these risks, weregularly consider our capital levels and currently are focused on redeployingcapital from Principal Investing activities to growing our InvestmentManagement segment.

 

**InterestRate Risk**

 

We are subject to interest rate risk primarily in connection with ourinvestments in hybrid adjustable-rate and fixed-rate RMBS and our debtobligations related to those investments, which are generally repurchaseagreements of short duration that periodically reset at current market rates.We seek to manage this risk through utilization of derivative contracts,primarily interest rate swap agreements and futures contracts on U.S. Treasurysecurities.

 

**Effect onNet Interest Income**

 

We fund our investments in RMBS primarily with short term borrowingsunder repurchase agreements. During periods of rising interest rates, shortterm borrowing costs tend to increase while the income earned on hybridadjustable-rate (during the fixed-rate period of such securities) and fixed-rateRMBS may remain substantially unchanged. When this happens, the result is anarrowing of the net interest spread between the related assets and borrowingsand may even result in losses.

 

In order to assist in mitigating our interest rate exposure, we haveone interest rate swap transaction outstanding as of June 30, 2010 with anotional value of $10.0 million which expires during 2010.

 

Our hedging strategies are partly based on assumed levels ofprepayments of our RMBS. If prepayments are slower or faster than assumed, thelife of the RMBS will be longer or shorter, which changes the net impact of ourhedging activity and may cause unexpected gains or losses on such transactions.Hedging strategies involving the use of derivative instruments are highlycomplex and may produce volatile returns.

 

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**ExtensionRisk**

 

The majority of our RMBS portfolio consists of hybrid adjustable-rateRMBS, which have interest rates that are fixed for the first several years ofthe loan (typically three, five, seven or 10 years) and, thereafter, resetperiodically on the same basis as adjustable-rate RMBS. We compute the projectedweighted-average life of our RMBS based on assumptions regarding the rate atwhich the borrowers will prepay the underlying mortgages. In general, when afixed-rate or hybrid adjustable-rate RMBS is funded by a short term borrowing,we may, but are not required to, enter into an interest rate swap agreement orother hedging instrument that effectively fixes a portion of our borrowingcosts for a period close to the anticipated weighted-average life of thefixed-rate portion of the related RMBS. This strategy is designed to protect aportion of our portfolio from increased funding costs due to rising interestrates because the borrowing costs are not fixed for the duration of thefixed-rate period of the related RMBS.

 

However, if prepayment rates decrease in a rising interest rateenvironment, the weighted average life of the fixed-rate portion of the relatedRMBS could extend beyond the term of the swap agreement or other hedginginstrument. This could have a negative impact on our results of operations, asborrowing costs would no longer be effectively fixed after the maturity of thehedging instrument, while the income earned on the remaining hybridadjustable-rate RMBS would remain fixed for a period of time. This situationmay also cause the market value of our hybrid adjustable-rate RMBS to decline,with little or no offsetting gain from the related hedging transactions. We maybe forced to sell assets to maintain adequate liquidity, which could cause usto incur losses, and we may be unable to sell assets on favorable terms or atall.

 

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

 

We also invest in hybrid adjustable-rate RMBS which are based onmortgages that are typically subject to periodic and lifetime interest ratecaps and floors, which limit the amount by which the security’s interest ratemay change during any given period. However, our borrowing costs pursuant toour repurchase agreements will not be subject to similar restrictions.Therefore, in a period of increasing interest rates, interest rate costs on ourborrowings could increase without limitation by caps, while the interest-rateyields on our hybrid adjustable-rate RMBS could be limited by caps. Thesefactors could lower our net interest income or cause a net loss during periodsof rising interest rates, which would negatively impact our financialcondition, cash flows and results of operations.

 

**InterestRate Mismatch Risk**

 

We intend to fund a substantial portion of our purchases of RMBS withborrowings that, after the effect of hedging, have interest rates based onindices and repricing terms similar to, but of somewhat shorter maturitiesthan, the interest rate indices and repricing terms of the RMBS. Thus, weanticipate that in most cases the interest rate indices and repricing terms ofour RMBS and our funding sources will not be identical, thereby creating aninterest rate mismatch between assets and liabilities. Therefore, our cost offunds would likely rise or fall more quickly than would our earnings rate onassets. During periods of changing interest rates, such interest ratemismatches could negatively impact our financial condition, cash flows andresults of operations. To mitigate interest rate mismatches, we may utilizehedging strategies discussed above.

 

Our analysis of portfolio risks is based on management’s experience,estimates, quantitative analysis and assumptions. These analyses rely onmodels, which utilize estimates of fair value and interest rate sensitivity.Actual economic conditions or implementation of investment decisions by ourmanagement may produce results that differ significantly from the estimates andassumptions used in our models and the projected results reflected herein.

 

**PrepaymentRisk**

 

Prepayments are the full or partial repayments of principal prior tocontractual due dates of mortgage loans and often occur due to refinancingactivity. Prepayment rates for existing RMBS generally increase when prevailinginterest rates fall below the market rate existing when the underlyingmortgages were originated. In addition, prepayment rates on adjustable-rate andhybrid adjustable-rate RMBS generally increase when the spread betweenlong-term and short-term interest rates declines or becomes negative.Prepayments of RMBS could impact our results of operations in several ways.Some adjustable-rate mortgages underlying our adjustable-rate RMBS may bearinitial teaser interest rates that are lower than their fully-indexed rates,which refers to the applicable index rates plus a spread. In the event thatsuch an adjustable-rate mortgage is prepaid prior to or soon after the time ofadjustment to a fully-indexed rate, the holder of the related RMBS would haveheld such security while it was less profitable and lost the opportunity toreceive interest at the fully-indexed rate over the expected life of theadjustable-rate RMBS. Additionally, we currently own RMBS that were purchasedat a premium. The prepayment of such RMBS at a rate faster than anticipatedwould result in a write-off of any remaining unamortized premium and acorresponding reduction of our net interest income by such amount.

 

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**Effect onFair Value**

 

Another component of interest rate risk is the effect changes ininterest rates will have on the fair value of our assets. We face the risk thatthe fair value of our assets will increase or decrease at different rates thanthat of our liabilities, including our hedging instruments.

 

We primarily assess our interest rate risk by estimating the durationof our assets and the duration of our liabilities. Duration essentiallymeasures the market price volatility of financial instruments as a function ofinterest rates changes. We calculate duration using various third partyfinancial models and empirical data. Different models and methodologies canproduce different duration numbers for the same securities.

 

The following sensitivity analysis table shows the impact on theestimated fair value of our RMBS interest rate-sensitive investments andinterest rate swaps as of June 30, 2010, assuming rates instantaneouslyfall 100 basis points and rise 100 basis points. The below table excludes thesecurities held in DFR MM CLO and the CIP CDOs because these investments areimpacted by cash flows and the terms of their respective indentures, ratherthan fair values.

 
| ** **                        | ** ** | **Interest Rates**         | ** ** | ** **    | ** ** | **Interest Rates** | ** ** |
|-----------------------------------|------------|----------------------------|------------|---------------|------------|--------------------|------------|
| ** **                        | ** ** | **Fall 100**               | ** ** | ** **    | ** ** | **Rise 100**       | ** ** |
| ** **                        | ** ** | **Basis Points**           | ** ** | **Unchanged** | ** ** | **Basis Points**   | ** ** |
| ** **                        | ** ** | **(Dollars in thousands)** | ** ** |
| **RMBS**                          |       |                       |       |          |       |               |       |
| Fair value                        |       | 305,346                    |       | 305,780       |       | 302,188            |       |
| Change in fair value              |       | (434                       | )          |          |       | (3,592             | )          |
| Change as a percent of fair value |       | -0.14                      | %          |          |       | -1.17              | %          |
| **Interest Rate Swaps**           |       |                       |       |          |       |               |       |
| Fair value                        |       | (207                       | )          | (207          | )          | (207               | )          |
| Change in fair value              |       | —                     |       |          |       | —             |       |
| Change as a percent of fair value |       | 0.00                       | %          |          |       | 0.00               | %          |
| **Net Portfolio Impact**          |       | (434                       | )          |          |       | (3,592             | )          |

 

The impact of changing interest rates on fair value can changesignificantly when interest rates change beyond 100 basis points from currentlevels. Therefore, the volatility in the fair value of our assets couldincrease significantly when interest rate changes exceed 100 basis points. Inaddition, other factors impact the fair value of our interest rate-sensitiveinvestments and hedging instruments, such as the shape of the yield curve,market expectations as to future interest rate changes and other marketconditions. Accordingly, in the event of changes in actual interest rates, thechange in the fair value of our assets would likely differ from that shown aboveand such difference might be material and adverse to our stockholders.

 

As of June 30, 2010, substantially all investments in ouralternative investments portfolio (non-RMBS) are instruments with variableinterest rates that are indexed to LIBOR. Because the variable rates on theseinstruments are short term in nature, we are not exposed to material changes infair value as a result of changes in interest rates.

 

**RiskManagement**

 

We look at investment risk across all of our products specifically asit relates to the product’s target returns or asset/liability managementframework. We believe that in order to achieve long-term investment performanceconsistent with our clients’ expectations, we need an understanding of theinvestment risks taken, or proposed to be taken, in each portfolio relative tothe corresponding liability and return profile, as well as those risks inherentin the increasingly complex global capital markets. Our risk management processemphasizes trading system and data integrity, counterparty creditworthiness,adherence to investment guidelines and client communication.

 

We employ active risk monitoring for both our portfolio management andoperational activities within the business. Our risk management program seeksto address not only the risks of unexpected portfolio losses, but also theoperational risks that can have major adverse impacts on our business results.Portfolio risks include, for example, potential losses due to price volatility,position sizing and leverage. Operational risks include, for example,settlement and clearing of transactions, properly recording and valuingpositions, supervision of traders, counterparty credit monitoring and approval,custodian reconciliations, trader authorization, accounting and regulatory.

 

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Our risk management committee meets at regular intervals to ensure wehave properly identified the risks inherent in the operation of our business,formulated and approved policies and procedures to mitigate the identifiedrisks, monitor overall adherence to the policies and report to management anysignificant concerns regarding the adequacy of procedures, systems or personnelin the conduct of our business.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

Pursuant to Rule 13a-15(b) under the Securities Exchange Actof 1934, as amended, or the Exchange Act, we carried out an evaluation, withthe participation of our management, including our Chief Executive Officer andour Interim Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures (as defined under Rule 13a-15(e) under theExchange Act), as of the end of the period covered by this Quarterly Report.Based upon that evaluation, our Chief Executive Officer and our Interim ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective.

 

**Change inInternal Control Over Financial Reporting**

 

There have been no changes in our internal control over financialreporting during the three months ended June 30, 2010 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**InherentLimitations on Effectiveness of Controls**

 

There are inherent limitations in the effectiveness of any controlsystem, including the potential for human error and the circumvention oroverriding of the controls and procedures. Additionally, judgments indecision-making can be faulty and breakdowns can occur because of simple erroror mistake. An effective control system can provide only reasonable, notabsolute, assurance that the control objectives of the system are adequatelymet. Accordingly, our management, including our Chief Executive Officer and ourInterim Chief Financial Officer do not expect that our control system canprevent or detect all errors or fraud. Finally, projections of any evaluationor assessment of effectiveness of a control system to future periods aresubject to the risks that, over time, controls may become inadequate because ofchanges in 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 risk factors disclosed in“Part I — Item 1A. Risk Factors” of our 2009 10-K, set forth areadditional risk factors we believe are applicable to our business.

 

***Our results of operations may be negatively affected by our future taxliabilities.***

 

Asa result of the stock issuance to Bounty in connection with the CNCIMAcquisition, we experienced an ownership change under Section 382 and 383of the Internal Revenue Code, as amended, which will severely limit our abilityto use our existing net operating losses and net capital losses to offset ourtaxable income and capital gains recognized after the CNCIM Acquisition.Accordingly, to the extent we have future taxable income, we anticipatethat we will incur federal corporate income tax liabilities, which mayhave a significant impact on our results of operations.

 

***We have goodwill and other intangibles assets that may become impairedand have a material adverse effect on our financial condition and results of operations.***

 

AtJune 30, 2010, we had $10.4 million of goodwill and $29.4 million ofintangible assets. Goodwill and other intangible assets are tested forimpairment on an annual basis, or when facts and circumstances indicate thatimpairment may have occurred.  If thesetests indicate that an asset has been impaired, we will recognize a charge toresults of operations, which may have a material adverse effect on ourfinancial condition and results of operations.

 

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**ITEM6.  EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

 
| **Exhibit.   No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                  |
|--------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                                                                                                                        |
| 3.1                |       | Articles  of Amendment and Restatement of Deerfield Capital Corp., as amended and  supplemented.(1)                                                                                                         |
|               |       |                                                                                                                                                                                                        |
| 3.2                |       | Deerfield  Capital Corp. Amended and Restated Bylaws.(2)                                                                                                                                                    |
|               |       |                                                                                                                                                                                                        |
| 4.1                |       | Form of  Senior Subordinated Convertible Note due 2017.(2)                                                                                                                                             |
|               |       |                                                                                                                                                                                                        |
| 10.1               |       | Stockholders  Agreement between Deerfield Capital Corp. and Bounty Investments, LLC, dated  June 9, 2010.(2)                                                                                           |
|               |       |                                                                                                                                                                                                        |
| 10.2               |       | Registration  Rights between Deerfield Capital Corp. and Bounty Investments, LLC, dated  June 9, 2010.(2)                                                                                              |
|               |       |                                                                                                                                                                                                        |
| 10.3               |       | Form of  Indemnification Agreement.(2)                                                                                                                                                                 |
|               |       |                                                                                                                                                                                                        |
| **10.4             |       | Employment  Agreement by and between Deerfield Capital Management LLC and Robert A.  Contreras, dated June 30, 2010.(3)                                                                                |
|               |       |                                                                                                                                                                                                        |
| **10.5             |       | Interim  Services Agreement by and between SFN Professional Services LLC d/b/a Tatum  and Deerfield Capital Corp., dated June 21, 2010*                                                                |
|               |       |                                                                                                                                                                                                        |
| 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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*                                         Filed herewith.

 

**                                  Compensatoryplan or arrangement.

 

(1)                                  Incorporated byreference to our Quarterly Report on Form 10-Q for the quarterly periodended June 30, 2009, filed with the SEC on August 10, 2009.

 

(2)                                  Incorporated byreference to our Current Report on Form 8-K filed with the SEC on June 15,2010.

 

(3)                                  Incorporated byreference to our Current Report on Form 8-K filed with the SEC on July 2,2010.

 

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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:  August 16, 2010 | By:                                                        | /s/  Jonathan W. Trutter |
|                        | Jonathan  W. Trutter, Chief Executive Officer and Director |
|                        | (Principal  Executive Officer)                             |
|                        |                                                       |
| Date:  August 16, 2010 | By:                                                        | /s/  Kenneth R. Posner |
|                        | Kenneth  R. Posner, Interim Chief Financial Officer   |
|                        | (Principal  Financial and Accounting Officer)              |

 

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