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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****     ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended September 30, 2009**

 

**OR**

 

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

 

**Forthe transition periodfrom             to            **

 

**Commissionfile number: 1-32551**

 

**DEERFIELDCAPITAL CORP.**

(Exact name ofregistrant as specified in its charter)

 

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

 

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

**(773) 380-1600**

(Address, includingzip code, and telephone number,

including areacode, of registrant’s principal executive offices)

 

**n/a**

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.     Yes x  No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post suchfiles).     Yes o  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).     Yes o No x

 

There were 6,454,924shares of the registrant’s Common Stock outstanding as of November 6,2009.

 

 

 

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**DEERFIELDCAPITAL CORP.**

**QUARTERLYREPORT ON FORM 10-Q**

**FORTHE QUARTER ENDED SEPTEMBER 30, 2009**

 

**INDEX**

 
| ** **                                                                                                                 | ** ** | **Page** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|
|                                                                                                                       |       |     |
| Part I. Financial  Information                                                                                        |       |     |
|                                                                                                                       |       |     |
| Item 1. Condensed  Consolidated Financial Statements and Notes (Unaudited)                                            |       | 6        |
|                                                                                                                       |       |     |
| Condensed  Consolidated Balance Sheets — September 30, 2009 and December 31,  2008                          |       | 6        |
|                                                                                                                       |       |     |
| Condensed  Consolidated Statements of Operations — Three and Nine Months Ended  September 30, 2009 and 2008      |       | 7        |
|                                                                                                                       |       |     |
| Condensed  Consolidated Statement of Stockholders’ Equity (Deficit) — Nine Months Ended  September 30, 2009 |       | 8        |
|                                                                                                                       |       |     |
| Condensed  Consolidated Statements of Cash Flows — Nine Months Ended September 30,  2009 and 2008                |       | 9        |
|                                                                                                                       |       |     |
| Notes to  Condensed Consolidated Financial Statements                                                                      |       | 10       |
|                                                                                                                       |       |     |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                  |       | 30       |
|                                                                                                                       |       |     |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                                   |       | 63       |
|                                                                                                                       |       |     |
| Item 4.  Controls and Procedures                                                                                      |       | 65       |
|                                                                                                                       |       |     |
| Item 1A. Risk Factors                                                                                                 |       | 66       |
|                                                                                                                       |       |     |
| Item 6.  Exhibits                                                                                                     |       | 67       |
|                                                                                                                       |       |     |
| Signatures                                                                                                                 |       | 68       |

 

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**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

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

 

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

 

**Relatingto our business generally:**

 

·             effects of the recent dislocation and weakness in themortgage market and credit markets generally;

 

·             effects of the recent global economic crisis andrecession;

 

·            failure to comply with covenantscontained in the agreements governing our indebtedness and failure to obtain waiversfor future non-compliance;

 

·             limitations and restrictions contained in instrumentsand agreements governing our indebtedness;

 

·            our ability to maintain adequateliquidity, including ability to raise additional capital and secure additional financing;

 

·            our ability to maintain compliance withthe continued listing standards of the NYSE Amex LLC (the “NYSE Amex”) and tomaintain the listing of our securities on a national securities exchange;

 

·             our ability to generate earnings or raise capital tomaintain positive stockholders’ equity;

 

·            our ability to satisfy the conditions tothe capital commitments in our investment venture with Pegasus Capital AdvisorsL.P. (“Pegasus”), whether Pegasus ultimately invests all or a portion of its$74.0 million capital commitment and whether such investment venture issuccessful;

 

·            rapid changes in the fair values of ourassets, making it difficult for us to comply with our exemption fromregistration under the Investment Company Act of 1940, as amended (the “1940Act”);

 

·            our ability to forecast our taxattributes, which are based upon various facts and assumptions, and our abilityto protect and use our net operating losses and net capital losses to offsetfuture taxable income and gains, including whether our recently adopted charteramendment will be effective in preventing an ownership change that wouldsignificantly limit our ability to utilize such losses;

 

·             increases in borrowing costs relative to interestreceived on our assets;

 

·            the costs and effects of the currentSecurities and Exchange Commission (“SEC”) investigation into certain mortgagesecurities trading procedures in connection with which the SEC has requestedinformation from Deerfield Capital Corp. (“DFR”) and Deerfield CapitalManagement LLC (“DCM”) regarding certain mortgage securities trades of ours;

 

·             changes in strategy, including investment strategy;

 

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·            effect of the current market conditionson management fees and equity cash flows from collateralized debt obligations (“CDOs”);

 

·             loss of key personnel, most of whom are not bound by employmentagreements;

 

·             our ability to enter into, and the effects of, anypotential strategic transaction;

 

·             adverse changes in accounting principles, tax law orlegal or regulatory requirements;

 

·             failure to comply with applicable laws and regulations;

 

·             liability resulting from actual or potential futurelitigation;

 

·             the costs, uncertainties and other effects of legaland administrative proceedings;

 

·            the costs of obtaining, and the potentialinability to obtain, necessary or prudent insurance to cover our businessoperations;

 

·             the impact of competition; and

 

·             actions of domestic and foreign governments and theeffect of war or terrorist activity.

 

**Relatingto our investment management segment:**

 

·            continued reductions in assets undermanagement (“AUM”) and related reductions in our investment advisory feerevenue, due to such factors as weak investment performance, substantialilliquidity or price volatility in the fixed income instruments in which weinvest, loss of key portfolio management or other personnel (or lack ofavailability of additional key personnel if needed for expansion), reducedinvestor demand for the types of investment products that we offer or loss ofinvestor confidence due to weak investment performance, volatility of returns,general declines in economic conditions and adverse publicity;

 

·            non-renewal or early termination ofinvestment management agreements or removal of DCM as investment managerpursuant to the terms of such investment management agreements;

 

·             pricing pressure on the advisory fees that we cancharge for our investment advisory services;

 

·             our ability to assume or otherwise acquire additionalCDO management contracts on favorable terms, or at all;

 

·            difficulty in increasing AUM, orefficiently managing existing AUM, due to market-related constraints on tradingcapacity, inability to hire the necessary additional or replacement personnelor lack of potentially profitable trading opportunities;

 

·            the reduction in CDO management fees orAUM resulting from payment defaults by issuers of the underlying collateral,downgrades of the underlying collateral by the rating agencies or depressedmarket values of the underlying collateral, all of which may contribute to thetriggering of certain structural provisions and/or events of default built intoCDOs;

 

·            our inability, due to market conditions,to launch CDO or other investment vehicles, which provide us with investmentmanagement fee revenue;

 

·            liability relating to our failure tocomply with investment guidelines set by our clients or the provisions of themanagement and other agreements; and

 

·            changes in laws, regulations orgovernment policies affecting our business, including investment managementregulations and accounting standards.

 

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**Relatingto our principal investing segment:**

 

·             impact of changes in our strategy surrounding thecomposition and decreased size of our investment portfolio;

 

·            a decrease in the value of our mortgageportfolio resulting in higher counterparty margin calls and decreasedliquidity;

 

·             effects of leverage and indebtedness on portfolioperformance;

 

·             effects of defaults or terminations under repurchasetransactions, interest rate swaps and long term debt obligations;

 

·            the impact on our investments andbusiness strategy resulting from conservatorship of the Federal NationalMortgage Association (“Fannie Mae”) and the Federal Home Loan MortgageCorporation (“Freddie Mac”), and related efforts, along with any changes inlaws and regulations affecting the relationship between Fannie Mae and FreddieMac and the U.S. government;

 

·             effects of having the majority of our repurchasetransactions concentrated with one counterparty;

 

·            higher or lower than expected prepaymentrates on the mortgages underlying our residential mortgage backed securities (“RMBS”)portfolio;

 

·             illiquid nature of certain of the assets in ourinvestment portfolio;

 

·            increased rates of default on ourinvestment portfolio (which risk rises as the portfolio seasons) and decreasedrecovery rates on defaulted loans;

 

·            our inability to obtain the financingneeded to leverage our RMBS and other portfolios and our inability to obtainfavorable interest rates, margin or other terms on any such financing;

 

·            flattening or inversion of the yieldcurve (a decreased differential between long and short term interest rates)reducing our net interest income on our financed mortgage securities positions;

 

·            our inability to adequately hedge or ourdecision to not fully hedge our holdings that are sensitive to changes ininterest rates;

 

·            narrowing of credit spreads, thusdecreasing our net interest income on future credit investments (such as bank loans);

 

·             concentration of investment portfolio inadjustable-rate RMBS;

 

·             effects of investing in equity and mezzaninesecurities of CDOs; and

 

·             effects of investing in the debt of middle marketcompanies.

 

These and other factorsthat could cause our actual results to differ materially from those describedin the forward-looking statements are set forth in our annual report on Form 10-Kfor the year ended December 31, 2008, including those factors set forth inour annual report under the heading*“RiskFactors”* as well as other factors set forth in this Quarterly Reportand our other public filings with the SEC and public statements. Readers ofthis Quarterly Report are cautioned to consider these risks and uncertaintiesand not to place undue reliance on any forward-looking statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS(UNAUDITED)**

** **
| ** **                                                                                                                                                  | ** ** | **September 30,**          | ** **    | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|---------------|-----------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2009**                        | ** **    | **2008**              | ** ** |
| ** **                                                                                                                                                  | ** ** | **(In thousands, except share** | ** **    |
| ** **                                                                                                                                                  | ** ** | **and per share amounts)**      | ** **    |
| **ASSETS**                                                                                                                                                  |       |                            |          |                  |       |
| Cash  and cash equivalents                                                                                                                                  |       | $                               |  47,542  |                  | $          |  32,791 |   |
| Due  from broker                                                                                                                                            |       | 1,004                           |          | 15,065                |       |
| Restricted  cash and cash equivalents                                                                                                                       |       | 21,786                          |          | 76,892                |       |
| Available-for-sale  securities—at fair value                                                                                                           |       | —                          |          | 2,338                 |       |
| Investments  at fair value, including $315,241 and $340,866 pledged                                                                                         |       | 336,170                         |          | 347,977               |       |
| Other  investments                                                                                                                                          |       | 4,287                           |          | 4,764                 |       |
| Derivative  assets                                                                                                                                          |       | 74                              |          | 132                   |       |
| Loans  held for sale                                                                                                                                        |       | 9,053                           |          | 218,137               |       |
| Loans  held for investment                                                                                                                                  |       | 295,916                         |          | 255,351               |       |
| Allowance  for loan losses                                                                                                                                  |       | (24,131                         | )             | (19,979               | )          |
| Loans  held for investment, net of allowance for loan losses                                                                                                |       | 271,785                         |          | 235,372               |       |
| Investment  advisory fee receivables                                                                                                                        |       | 2,189                           |          | 4,012                 |       |
| Interest  receivable                                                                                                                                        |       | 3,447                           |          | 5,843                 |       |
| Other  receivable                                                                                                                                           |       | 1,995                           |          | 4,249                 |       |
| Prepaid  and other assets                                                                                                                                   |       | 8,373                           |          | 11,831                |       |
| Fixed  assets, net                                                                                                                                          |       | 8,181                           |          | 9,143                 |       |
| Intangible  assets, net                                                                                                                                     |       | 24,246                          |          | 28,310                |       |
| TOTAL  ASSETS                                                                                                                                               |       | $                               |  740,132 |                  | $          |  996,856 |   |
|                                                                                                                                                        |       |                            |          |                  |       |
| **LIABILITIES**                                                                                                                                             |       |                            |          |                  |       |
| Repurchase  agreements, including $74 and $407 of accrued interest                                                                                          |       | $                               |  306,304 |                  | $          |  326,112 |   |
| Due  to broker                                                                                                                                              |       | 2,975                           |          | 1,514                 |       |
| Derivative  liabilities                                                                                                                                     |       | 832                             |          | 13,529                |       |
| Interest  payable                                                                                                                                           |       | 1,255                           |          | 6,606                 |       |
| Accrued  and other liabilities, including $414 and zero at fair value                                                                                       |       | 4,955                           |          | 15,112                |       |
| Long  term debt                                                                                                                                             |       | 417,921                         |          | 716,417               |       |
| TOTAL  LIABILITIES                                                                                                                                          |       | 734,242                         |          | 1,079,290             |       |
|                                                                                                                                                        |       |                            |          |                  |       |
| **STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                     |       |                            |          |                  |       |
| Preferred  stock, par value $0.001: 100,000,000 shares authorized; 14,999,992 shares  issued and zero outstanding                                           |       | —                          |          | —                |       |
| Common  stock, par value $0.001: 500,000,000 shares authorized; 6,455,357 and  6,455,466 shares issued and 6,454,924 and 6,449,102 shares outstanding  |       | 6                          |          | 6                |       |
| Additional  paid-in capital                                                                                                                                 |       | 866,546                         |          | 865,869               |       |
| Accumulated  other comprehensive loss                                                                                                                       |       | (111                            | )             | (4,256                | )          |
| Accumulated  deficit                                                                                                                                        |       | (877,832                        | )             | (944,053              | )          |
| DEERFIELD  CAPITAL CORP. STOCKHOLDERS’ DEFICIT                                                                                                         |       | (11,391                         | )             | (82,434               | )          |
| Noncontrolling  interest in consolidated entity                                                                                                             |       | 17,281                          |          | —                |       |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                  |       | 5,890                           |          | (82,434               | )          |
|                                                                                                                                                        |       |                            |          |                  |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                  |       | $                               |  740,132 |                  | $          |  996,856 |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS (UNAUDITED)**

 
| ** **                                                                            | ** ** | **Three months ended September 30,**              | ** **   | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------------|--------------|------------------------------------------|------------|
| ** **                                                                            | ** ** | **2009**                                               | ** **   | **2008**                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except share and per share amounts)** | ** **   |
| **Revenues**                                                                          |       |                                                   |         |                                     |       |   |   |   |   |
| Interest  income                                                                      |       | $                                                      |  10,839 |                                     | $          |  20,506 |   | $ |  38,719 |   | $ |  103,680 |   |
| Interest  expense                                                                     |       | 3,866                                                  |         | 11,671                                   |       | 16,531 |   | 71,692 |   |
| Net  interest income                                                                  |       | 6,973                                                  |         | 8,835                                    |       | 22,188 |   | 31,988 |   |
| Provision  for loan losses                                                            |       | 4,226                                                  |         | 15,459                                   |       | 15,452 |   | 19,961 |   |
| Net  interest income (expense) income after provision for loan losses                 |       | 2,747                                                  |         | (6,624                                   | )          | 6,736 |   | 12,027 |   |
| Investment  advisory fees                                                             |       | 3,949                                                  |         | 9,015                                    |       | 12,695 |   | 33,493 |   |
| Total  net revenues                                                                   |       | 6,696                                                  |         | 2,391                                    |       | 19,431 |   | 45,520 |   |
|                                                                                  |       |                                                   |         |                                     |       |   |   |   |   |
| **Expenses**                                                                          |       |                                                   |         |                                     |       |   |   |   |   |
| Compensation  and benefits                                                            |       | 2,637                                                  |         | 4,984                                    |       | 9,020 |   | 21,720 |   |
| Professional  services                                                                |       | 788                                                    |         | 2,211                                    |       | 2,306 |   | 5,941 |   |
| Insurance  expense                                                                    |       | 778                                                    |         | 740                                      |       | 2,313 |   | 2,207 |   |
| Other  general and administrative expenses                                            |       | 928                                                    |         | 1,417                                    |       | 6,688 |   | 4,697 |   |
| Depreciation  and amortization                                                        |       | 1,630                                                  |         | 2,498                                    |       | 4,894 |   | 7,765 |   |
| Occupancy                                                                             |       | 610                                                    |         | 645                                      |       | 1,818 |   | 1,875 |   |
| Management  and incentive fee expense to related party                                |       | 337                                                    |         | —                                   |       | 632 |   | — |   |
| Cost  savings initiatives                                                             |       | 11                                                     |         | (2                                       | )          | 236 |   | 325 |   |
| Impairment  of intangible assets and goodwill                                         |       | —                                                 |         | 110,268                                  |       | 126 |   | 139,302 |   |
| Total  expenses                                                                       |       | 7,719                                                  |         | 122,761                                  |       | 28,033 |   | 183,832 |   |
|                                                                                  |       |                                                   |         |                                     |       |   |   |   |   |
| **Other Income and Gain (Loss)**                                                      |       |                                                   |         |                                     |       |   |   |   |   |
| Net  loss on available-for-sale securities                                            |       | —                                                 |         | (856                                     | )          | (31 | ) | (4,712 | ) |
| Net  gain (loss) on investments at fair value                                         |       | 2,983                                                  |         | (13,655                                  | )          | 9,294 |   | (216,121 | ) |
| Net  gain (loss) on loans                                                             |       | 539                                                    |         | (14,367                                  | )          | 31,230 |   | (35,404 | ) |
| Net  (loss) gain on derivatives                                                       |       | (57                                                    | )            | (2,239                                   | )          | 2,520 |   | (219,384 | ) |
| Dividend  income and other net loss                                                   |       | (443                                                   | )            | (678                                     | )          | (340 | ) | (484 | ) |
| Net  gain on the deconsolidation of Market Square CLO                                 |       | —                                                 |         | —                                   |       | 29,551 |   | — |   |
| Net  other income and gain (loss)                                                     |       | 3,022                                                  |         | (31,795                                  | )          | 72,224 |   | (476,105 | ) |
| Income  (loss) before income tax expense                                              |       | 1,999                                                  |         | (152,165                                 | )          | 63,622 |   | (614,417 | ) |
| Income  tax expense                                                                   |       | 75                                                     |         | 4,718                                    |       | 253 |   | 384 |   |
|                                                                                  |       |                                                   |         |                                     |       |   |   |   |   |
| **Net income (loss)**                                                                 |       | 1,924                                                  |         | (156,883                                 | )          | 63,369 |   | (614,801 | ) |
| Less:  Cumulative convertible preferred stock dividends  and accretion           |       | —                                                 |         | —                                   |       | — |   | 2,393 |   |
| **Net income (loss) attributable to common stockholders**                             |       | 1,924                                                  |         | (156,883                                 | )          | 63,369 |   | (617,194 | ) |
| Net  (income) loss attributable to noncontrolling interest                            |       | (108                                                   | )            | —                                   |       | 2,852 |   | — |   |
| **Net income (loss) attributable to Deerfield Capital Corp.**                         |       | $                                                      |  1,816  |                                     | $          |  (156,883 | ) | $ |  66,221 |   | $ |  (617,194 | ) |
|                                                                                  |       |                                                   |         |                                     |       |   |   |   |   |
| **Net income (loss) attributable to Deerfield Capital Corp .****per  share - basic**  |       | $                                                      |  0.27   |                                     | $          |  (22.81 | ) | $ |  9.84 |   | $ |  (95.89 | ) |
| **Net income (loss) attributable to Deerfield Capital Corp.****per  share - diluted** |       | $                                                      |  0.27   |                                     | $          |  (22.81 | ) | $ |  9.84 |   | $ |  (95.89 | ) |
|                                                                                  |       |                                                   |         |                                     |       |   |   |   |   |
| WEIGHTED-AVERAGE  NUMBER OF SHARES OUTSTANDING - BASIC                                |       | 6,763,088                                              |         | 6,878,260                                |       | 6,732,272 |   | 6,436,583 |   |
| WEIGHTED-AVERAGE  NUMBER OF SHARES OUTSTANDING - DILUTED                              |       | 6,763,088                                              |         | 6,878,260                                |       | 6,732,272 |   | 6,436,583 |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

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

** **
| ** **                                                    | ** ** | **Deerfield  Capital Corp. Stockholders** | ** ** | ** **     | ** ** | ** **  | ** ** | ** **        | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------|------------|----------------|------------|-------------|------------|-------------------|------------|
| ** **                                                    | ** ** | ** **                                | ** ** | ** **     | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** ** | ** ** | **Noncontrolling** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **Common  Stock**                         | ** ** | **Additional** | ** ** | **Other**   | ** ** | ** **        | ** ** | **interest  in** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                | ** ** | **Par**        | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **consolidated** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                    | ** ** | **Shares**                                | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Loss**          | ** ** | **Deficit** | ** ** | **entity** | ** ** | **Total** | ** ** | **Income** | ** ** |
| ** **                                                    | ** ** | **(In  thousands)**                       | ** ** |
| **Balance - January 1, 2009**                            |       | 6,449                                     |       | $              |  6    |        | $          |  865,869     |       | $ |  (4,256 | ) | $ |  (944,053 | ) | $ |  — |   | $ |  (82,434 | ) |   |   |
| **Net income**                                                |       |                                      |       |           |       |        |       |              |       | 66,221 |   | (2,852 | ) | 63,369 |   | $ |  63,369 |   |
| Contributions  of noncontrolling interest                     |       |                                      |       |           |       |        |       |              |       |   |   | 20,133 |   | 20,133 |   |   |   |
| Available-for-sale  securities - fair value adjustment        |       |                                      |       |           |       |        |       | 1,452             |       |   |   |   |   | 1,452 |   | 1,452 |   |
| Previously  designated derivatives - amortization of net loss |       |                                      |       |           |       |        |       | 136               |       |   |   |   |   | 136 |   | 136 |   |
| Deconsolidation  of Market Square CLO                         |       |                                      |       |           |       |        |       | 2,603             |       |   |   |   |   | 2,603 |   | 2,603 |   |
| Foreign  currency translation loss                            |       |                                      |       |           |       |        |       | (46               | )          |   |   |   |   | (46 | ) | (46 | ) |
| Comprehensive  income                                         |       |                                      |       |           |       |        |       |              |       |   |   |   |   |   |   | $ |  67,514 |   |
| Equity  issuance cost - Market Square CLO deconsolidation     |       |                                      |       |           |       | 368         |       |              |       |   |   |   |   | 368 |   |   |   |
| Share-based  compensation                                     |       | 6                                         |       |           |       | 309         |       |              |       |   |   |   |   | 309 |   |   |   |
| **Balance - September 30, 2009**                         |       | 6,455                                     |       | $              |  6    |        | $          |  866,546     |       | $ |  (111 | ) | $ |  (877,832 | ) | $ |  17,281 |   | $ |  5,890 |   |   |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

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

** **
| ** **                                                                                                                                          | ** ** | **Nine months ended September 30,** | ** **   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|--------------|
| ** **                                                                                                                                          | ** ** | **2009**                                 | ** **   | **2008** | ** ** |
| ** **                                                                                                                                          | ** ** | **(In thousands)**                       | ** **   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                                                                           |       |                                     |         |   |   |
| Net  income (loss) attributable to Deerfield Capital Corp.                                                                                          |       | $                                        |  66,221 |   | $ |  (614,801 | ) |
| **Adjustments to reconcile net income (loss) attributable to  Deerfield Capital Corp.****to net cash (used in) provided by  operating activities:** |       |                                     |         |   |   |
| Net  loss attributable to noncontrolling interest                                                                                                   |       | (2,852                                   | )            | — |   |
| Net  premium and discount amortization on investments, loans and debt issuance                                                                      |       | (1,189                                   | )            | 2,286 |   |
| Share-based  compensation                                                                                                                           |       | 309                                      |         | 508 |   |
| Net  (purchases) sales of investments at fair value                                                                                                 |       | (99,606                                  | )            | 658,244 |   |
| Net  (gain) loss from investments at fair value                                                                                                     |       | (9,294                                   | )            | 216,121 |   |
| Net  gain on the deconsolidation of Market Square CLO                                                                                               |       | (29,551                                  | )            | — |   |
| Other-than-temporary  impairment on available-for-sale securities                                                                                   |       | 31                                       |         | 4,735 |   |
| Net  loss on other investments                                                                                                                      |       | 550                                      |         | 708 |   |
| Net  purchases of loans held for sale                                                                                                               |       | (866                                     | )            | (9,349 | ) |
| Net  (gain) loss on loans                                                                                                                           |       | (31,230                                  | )            | 35,416 |   |
| Provision  for loan losses                                                                                                                          |       | 15,452                                   |         | 19,961 |   |
| Net  realized gain on available-for-sale securities                                                                                                 |       | —                                   |         | (23 | ) |
| Net  changes in undesignated derivatives                                                                                                            |       | (12,901                                  | )            | (159,032 | ) |
| Amortization  of net loss on previously designated derivatives                                                                                      |       | 136                                      |         | 96,996 |   |
| Depreciation  and amortization                                                                                                                      |       | 4,894                                    |         | 7,765 |   |
| Impairment  of intangible assets and goodwill                                                                                                       |       | 126                                      |         | 139,302 |   |
| Non-cash  rental expense                                                                                                                            |       | 109                                      |         | 149 |   |
| Provision  for income taxes                                                                                                                         |       | 28                                       |         | — |   |
| Deferred  tax expense                                                                                                                               |       | 49                                       |         | 384 |   |
| **Changes in operating assets and liabilities:**                                                                                                    |       |                                     |         |   |   |
| Due  from broker                                                                                                                                    |       | 13,769                                   |         | 98,278 |   |
| Interest  receivable                                                                                                                                |       | (743                                     | )            | 25,400 |   |
| Other  receivable                                                                                                                                   |       | 4,000                                    |         | 1,842 |   |
| Prepaid  and other assets                                                                                                                           |       | (303                                     | )            | (103 | ) |
| Accrued  interest on repurchase agreements                                                                                                          |       | (333                                     | )            | (20,192 | ) |
| Due  to broker                                                                                                                                      |       | 1,723                                    |         | (1,516 | ) |
| Interest  payable                                                                                                                                   |       | (4,352                                   | )            | (8,794 | ) |
| Accrued  and other liabilities                                                                                                                      |       | (10,669                                  | )            | (19,892 | ) |
| **Net cash (used in) provided by operating activities**                                                                                             |       | (96,492                                  | )            | 474,393 |   |
|                                                                                                                                                |       |                                     |         |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                                                                           |       |                                     |         |   |   |
| Change  in restricted cash and cash equivalents                                                                                                     |       | 49,410                                   |         | (15,909 | ) |
| Purchase  of available-for-sale securities                                                                                                          |       | —                                   |         | (2,378 | ) |
| Principal  payments on available-for-sale securities                                                                                                |       | —                                   |         | 25,916 |   |
| Proceeds  from the sale of investments at fair value previously classified as  available-for-sale                                                   |       | 73,863                                   |         | 4,138,198 |   |
| Principal  payments on investments at fair value previously classified as  available-for-sale                                                       |       | 46,922                                   |         | 187,338 |   |
| Origination  and purchase of loans held for investment                                                                                              |       | (81,665                                  | )            | (15,646 | ) |
| Principal  payments on loans held for investment                                                                                                    |       | 22,412                                   |         | 54,755 |   |
| Proceeds  from sale of loans held for investment                                                                                                    |       | 12,882                                   |         | 33,701 |   |
| Proceeds  from sale of loans held for sale previously classified as held for investment                                                             |       | 11,960                                   |         | 11,387 |   |
| Sales  (purchases) of fixed assets                                                                                                                  |       | 6                                        |         | (16 | ) |
| **Net cash provided by investing activities**                                                                                                       |       | 135,790                                  |         | 4,417,346 |   |
|                                                                                                                                                |       |                                     |         |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                                                                           |       |                                     |         |   |   |
| Net  payments under repurchase agreements                                                                                                           |       | (19,475                                  | )            | (4,900,055 | ) |
| Proceeds  from Wachovia Facility                                                                                                                    |       | —                                   |         | 3,000 |   |
| Payments  made on Wachovia Facility                                                                                                                 |       | (13,932                                  | )            | (42,375 | ) |
| Payments  made on long term debt                                                                                                                    |       | (11,110                                  | )            | — |   |
| Payment  of debt issuance costs                                                                                                                     |       | (142                                     | )            | (875 | ) |
| Dividends  paid                                                                                                                                     |       | —                                   |         | (21,690 | ) |
| Payments  made on short term debt                                                                                                                   |       | —                                   |         | (1,523 | ) |
| Contributions  of noncontrolling interest                                                                                                           |       | 20,133                                   |         | — |   |
| **Net cash used in financing activities**                                                                                                           |       | (24,526                                  | )            | (4,963,518 | ) |
|                                                                                                                                                |       |                                     |         |   |   |
| Foreign  currency translation                                                                                                                       |       | (21                                      | )            | (46 | ) |
| Net  increase (decrease) in cash and cash equivalents                                                                                               |       | 14,751                                   |         | (71,825 | ) |
| Cash  and cash equivalents at beginning of period                                                                                                   |       | 32,791                                   |         | 113,733 |   |
| **Cash and cash equivalents at end of period**                                                                                                      |       | $                                        |  47,542 |   | $ |  41,908 |   |
|                                                                                                                                                |       |                                     |         |   |   |
| **SUPPLEMENTAL DISCLOSURE:**                                                                                                                        |       |                                     |         |   |   |
| Cash  paid for interest                                                                                                                             |       | $                                        |  19,243 |   | $ |  108,246 |   |
| Cash  paid for income taxes                                                                                                                         |       | 87                                       |         | 4,083 |   |
|                                                                                                                                                |       |                                     |         |   |   |
| **NONCASH INVESTING AND FINANCING ACTIVITIES:**                                                                                                     |       |                                     |         |   |   |
| Settlement  of interest income as an addition to principal balance of loans                                                                         |       | 2,353                                    |         | 4,894 |   |
| Establishment  of contingent liabiilty                                                                                                              |       | 473                                      |         | — |   |
| Equity  received upon loan restructuring                                                                                                            |       | 73                                       |         | — |   |
| Principal  payments receivable from available-for-sale securities                                                                                   |       | —                                   |         | 308 |   |
| Receipt  of warrants                                                                                                                                |       | —                                   |         | 1,092 |   |
| Share-based  compensation                                                                                                                           |       | —                                   |         | 2,789 |   |
| Dividends  declared, not yet paid                                                                                                                   |       | —                                   |         | 5,693 |   |
| Series A  cumulative convertible preferred stock dividend and accretion                                                                        |       | —                                   |         | 2,393 |   |
| Merger  purchase price adjustments                                                                                                                  |       | —                                   |         | 561 |   |

 

See notes tocondensed consolidated financial statements.

 

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**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

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

 

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

 

DFR was externallymanaged by DCM from the commencement of its operations in December 2004until December 21, 2007, when the Company acquired Deerfield &Company LLC (“Deerfield”), the parent company of DCM, in a merger transaction(the “Merger”). As a result of the Merger, Deerfield and its subsidiariesbecame indirect wholly-owned subsidiaries of DFR, and DFR became internallymanaged.

 

DFR and its subsidiarieshave operated, and intend to continue to operate, in such a way as to beexcluded from registration under the Investment Company Act of 1940, as amended(the “1940 Act”).  DFR and its wholly-owned subsidiary Deerfield Capital LLC(“DC LLC”) are excluded from registration under the 1940 Act because no morethan 40% of their respective assets, on an unconsolidated basis, excluding cashand government securities, are investment securities. The Company intends tocontinue to qualify for this exclusion by monitoring the value of all itssubsidiaries and any investment securities it owns to ensure that at all times,no more than 40% of its assets, on an unconsolidated basis, excluding certainitems, will be investment securities under the 1940 Act.

 

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

 

On April 14, 2009,the Company announced Deerfield Pegasus Loan Capital LP (“DPLC”), itsinvestment venture with Pegasus Capital Advisors L.P. (“Pegasus”).  Pegasusis a U.S.-based private equity firm.  Pegasus and the Company arecurrently committed to invest $74.0 million and $15.0 million, respectively, inDPLC.  The Company initially expectedsuch amounts to be invested primarily in corporate bank loans and other seniorsecured corporate loans.  However, as aresult of the rapid recovery of corporate loan prices, the return thresholdsinitially expected for DPLC are no longer attainable, and the Company iscurrently evaluating other investment strategies. DPLC is managed byDCM.  The commitments of each of Pegasus and the Company are subject tonumerous conditions, any or all of which may not be satisfied.  As of September 30,2009, Pegasus and DFR have funded $20.0 million and $4.0 million, respectively,of such commitments. See Note 11 for details related to the warrants theCompany issued to Pegasus in connection with the formation of DPLC.

 

***Business Segments***

 

The Company operateswithin two business segments:

 

*InvestmentManagement* —The Company manages assets within a variety of investment vehicles, includingcollateralized debt obligations (“CDOs”), separately managed accounts and otherinvestment vehicles, and earns investment advisory fees for providing itsservices. The Company specializes in managing fixed income investments,including corporate debt, RMBS, government securities and ABS.

 

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

 

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***Liquidity and Capital Resources***

 

The Company believes thatits current cash and cash equivalents, unencumbered liquid assets and netequity in its financed RMBS portfolio along with cash flows from operations,among other things, are adequate to meet anticipated long term (greater thanone year) liquidity requirements. Unencumbered RMBS and unrestricted cash andcash equivalents aggregated $50.6 million at September 30, 2009. Inaddition, net equity in the financed RMBS portfolio (including associatedinterest rate swaps), excluding the unencumbered RMBS included above, totaled$10.8 million at September 30, 2009. In total, the Company hadunrestricted cash and cash equivalents, unencumbered RMBS and net equity in thefinanced RMBS portfolio of $61.4 million as of September 30, 2009. Asof September 30, 2009, the fair value of the Company’s Agency RMBS (asdefined below) and non-Agency RMBS portfolios were $314.0 million and $2.9million, respectively. The Company’s largest repurchase agreement counterpartyhas required that it maintain a minimum of $20.0 million of cash and certaineligible securities in their custody in order to maintain its currentrepurchase agreement margin percentages on the Company’s Agency RMBS. If theCompany fails to satisfy this requirement, the counterparty will have the rightto immediately increase the margin percentage under the repurchase agreementsand may exercise other remedies.

 

On July 31, 2009,the Company entered into three supplemental indentures with the holders of thetrust preferred securities issued by each of Deerfield Capital Trust I,Deerfield Capital Trust II and Deerfield Capital Trust III(collectively, the “Trust Preferred Securities”).  See Note 10 for additionaldisclosure regarding the supplemental indentures.

 

Agency-issued RMBS arebacked by mortgage loans and are guaranteed as to principal and interest byfederally chartered entities such as the Federal National Mortgage Association(“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”),and, in the case of the Government National Mortgage Association (“Ginnie Mae”),the U.S. government. The Company refers to these entities as “Agencies”and to RMBS guaranteed or issued by the Agencies as “Agency RMBS.” The Company’sAgency RMBS portfolio at September 30, 2009 consists of Fannie Mae andFreddie Mac securities. The Company’s non-Agency RMBS portfolio at September 30,2009 consists of two securities with estimated fair values of $2.2 and$0.7 million that are both currently rated “CCC” by Standard &Poor’s.

 

**2.****             ****ACCOUNTING POLICIES ANDRECENT ACCOUNTING UPDATES**

 

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

 

*Principlesof Consolidation* —The condensed consolidated financial statements include the financialstatements of DFR and its subsidiaries which are (i) wholly-owned, (ii) subsidiariesin which DFR has a controlling interest and with respect to which the Companyfollows the consolidation guidance in the Financial Accounting Standards Board(“FASB”) Accounting Standards Codification (“ASC”) Topic 810 — *Consolidation* (“ASC Topic 810”) and (iii) entities thatare variable interest entities (“VIEs”) in which the Company is the primarybeneficiary under ASC Topic 810. Under ASC Topic 810, a company is the primarybeneficiary of a VIE if it absorbs a majority of the VIE’s expected losses orreceives a majority of the VIE’s expected residual returns, or both. Allintercompany balances and transactions have been eliminated in consolidation.

 

As of September 30,2009 and for the three and nine months ended September 30, 2009 and 2008,the Company consolidated DFR Middle Market CLO Ltd. (“DFR MM CLO”) as it isdeemed to be the primary beneficiary of this VIE.  The Company alsoconsolidated Market Square CLO Ltd. (“Market Square CLO”) as of December 31,2008 and for the three and nine months ended September 30, 2008.  On June 30, 2009, the Company sold allof its preference shares in Market Square CLO to an unrelated third party inexchange for an upfront payment and a delayed purchase price in the form of aright to receive a portion of the future distributions, if any, on thepreference shares.  As a result of the sale, the Company determined thatit was no longer the primary beneficiary of Market Square CLO and thereforedeconsolidated Market Square CLO.  The Company is, however, deemed toretain a beneficial interest in the preference shares of Market Square CLO as aresult of the delayed purchase price.  The carrying value of thebeneficial interest was de minimis as of June 30, 2009 and was $1.4million as of September 30, 2009.  As of September 30, 2009,none of the Market Square CLO assets, liabilities or equity are included in theCompany’s condensed consolidated balance sheet; however, all of the financialimpacts to the condensed consolidated statements of operations from theprevious consolidation of Market Square CLO were recognized through June 30,2009.  The Company recognized a gain on the deconsolidation of MarketSquare CLO of $29.6 million in the condensed consolidated statements ofoperations for the nine months ended September 30, 2009.

 

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Although the Companyconsolidates 100% of the assets and liabilities of DFR MM CLO, the Company’smaximum exposure to loss on its investment in this entity is limited to itsinitial investment of $69.0 million. The economic impact of the Company’sinvestment in DFR MM CLO is determined by the cash flows distributed to theCompany by DFR MM CLO on its investment in $50.0 million of preferred sharesand $19.0 million of debt of DFR MM CLO, subject to diversion of cash flowsaway from the Company as provided in accordance with the indenture for DFR MMCLO. For the three and nine months ended September 30, 2009, the netincome of $1.4 million and $2.2 million, respectively, recorded under GAAP forDFR MM CLO were not indicative of the economic impact to the Company of cashflow distributions from DFR MM CLO of $0.2 million and $5.2 million, respectively. Cash flows from the Company’s investment in the preferred shares of DFR MM CLObegan to be diverted during the second quarter of 2009 in accordance with theDFR MM CLO indenture; however, cash flows are still being received on theCompany’s investment in DFR MM CLO debt.  The debt holders of DFR MM CLOhave recourse only to the assets of this entity and not to the general assetsof the Company. The Company consolidated assets of $283.2 million andliabilities of $222.7 million related to DFR MM CLO as of September 30,2009.

 

During the three and ninemonths ended September 30, 2009, the Company also consolidated DPLC as aresult of the Company’s controlling interest therein pursuant to theconsolidation guidance of ASC Topic 810.  The Company also consolidatedDPLC General Partner LLC (“DPLC GP”), the general partner of DPLC through whichthe Company made its investment in DPLC. The Company has a controllingfinancial interest in DPLC and DPLC GP as a result of owning more than 50% ofthe outstanding voting interests in DPLC GP.  Although the Companyconsolidates 100% of the assets and liabilities and the results of operationsof DPLC and DPLC GP, the Company’s maximum exposure to loss on its investmentin this entity is limited to its investment in DPLC GP, which as of September 30,2009 totaled approximately $4.0 million. See Note 17 for additional informationconcerning the Company’s investment in DPLC. Net income (loss) attributable to DFR in the Company’s condensedconsolidated statements of operations excludes the net loss attributable to itsnoncontrolling interest in DPLC. The Company consolidated assets of$23.8 million and liabilities of $3.2 million related to DPLC as of September 30,2009.

 

*Reclassifications* — Certain amounts in the consolidatedfinancial statements and notes as of December 31, 2008 and for the threeand nine months ended September 30, 2008 have been reclassified to conformto the presentation as of and for the three and nine months ended September 30,2009. Occupancy and Cost savings initiatives, which were included in Othergeneral and administrative expenses and Compensation and benefits,respectively, in the condensed consolidated statements of operations for thethree and nine months ended September 30, 2008, are presented as separateline items in the current quarter condensed consolidated statements ofoperations.

 

*SignificantAccounting Policies*— The Company’s significant accounting policies are discussed in the Notes tothe Consolidated Financial Statements included in the 2008 10-K.

 

*RecentAccounting Updates*— In December 2007, the FASB issued amendments to ASC Topic 810, whichestablished accounting and reporting standards for the noncontrolling interestin a subsidiary and for the deconsolidation of a subsidiary.  During thethree and nine months ended September 30, 2009, the Company applied theamendments to ASC Topic 810 to the consolidation of DPLC.  In addition, the Company applied theamendments to ASC Topic 810 to the deconsolidation of Market Square CLO duringthe nine months ended September 30, 2009.

 

In February 2008,the FASB issued amendments to ASC Topic 860 —  *Transfers and Servicing* (“ASC Topic 860”)in order to address certain situations where assets purchased from a particularcounterparty and financed through a repurchase agreement with the samecounterparty can be considered and accounted for as separate transactions.Historically, the Company recorded such assets and the related financing on agross basis as separate transactions in the condensed consolidated balancesheet and the corresponding interest income and interest expense in the Company’scondensed consolidated statements of operations. ASC Topic 860 assumes that aninitial transfer of a financial asset and a repurchase financing are consideredpart of the same arrangement, or a linked transaction. However, if certaincriteria are met, the initial transfer and repurchase financing are not treatedas a linked transaction but rather are evaluated separately under ASC Topic860. The Company adopted the amendments to ASC Topic 860 on January 1,2009, and the adoption has had no impact on the Company’s condensedconsolidated financial statements as no linked transactions have occurred sinceadoption.

 

In March 2008, theFASB issued amendments to ASC Topic 815 —*Derivatives and Hedging*(“ASCTopic 815”). The amendments to ASC Topic 815 require qualitative disclosuresregarding objectives and strategies for using derivatives, quantitativedisclosures regarding fair value amounts of gains and losses on derivativeinstruments and disclosures regarding credit-risk-related contingent featuresin derivative contracts. The Company adopted the amendments to ASC Topic 815and included the required additional disclosures in Note 7.

 

In June 2008, theFASB issued amendments to ASC Topic 260 — *Earnings Per Share*(“ASCTopic 260”). The amendments to ASC Topic 260 address whether instrumentsgranted in share-based payment transactions are participating securities priorto vesting and, therefore, need to be included in the earnings allocation incomputing earnings per share under the two-class method. The Company adoptedthe amendments to ASC Topic 260 on January 1, 2009, and the adoption hadno impact on the Company’s condensed consolidated financial statements.

 

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In April 2009, theFASB issued amendments to ASC Topic 820 — *Fair Value Measurementsand Disclosures* (“ASC Topic 825”). The amendments to ASC Topic 825 were issued to provide additionalguidance for estimating fair value when the volume and level of activity havesignificantly decreased and to provide guidance on identifying circumstancesthat indicate a transaction is not orderly.  In addition, the amendmentsto ASC Topic 825 require an entity to disclose, in interim and annual periods,the inputs and valuation techniques used to measure fair value and provide adiscussion of changes in valuation techniques and related inputs, if any,during the period.  The amendments to ASC Topic 825 also requiredisclosures regarding fair value of financial instruments for interim andannual reporting periods. The Company adopted the amendments to ASC Topic 825and considered this guidance in determining and disclosing the fair valuesincluded in the Company’s condensed consolidated financial statements.

 

In April 2009, theFASB issued amendments to ASC Topic 320 —*Investments —**Debt and Equity Securities*(“ASC Topic 320”).  The amendmentsto ASC Topic 320 were issued to amend the other-than-temporary impairmentguidance in GAAP for debt securities to make the guidance more operational andto improve the presentation and disclosure of other-than-temporary impairmentson debt and equity securities in the financial statements.  The amendmentsto ASC Topic 320 do not amend existing recognition and measurement guidancerelated to other-than-temporary impairments of equity securities.  TheCompany adopted the amendments to ASC Topic 320 in the preparation of theCompany’s condensed consolidated financial statements.

 

In May 2009, theFASB issued amendments to ASC Topic 855 —*Subsequent Events*(“ASC Topic 855”).  The amendments to ASC Topic 855 establish generalstandards of accounting for, and disclosure of, events that occur after thebalance sheet date but before financial statements are issued or are availableto be issued.  In particular, the amendments set forth: (i) theperiod after the balance sheet date during which management of a reportingentity should evaluate events or transactions that may occur for potentialrecognition or disclosure in the financial statements, (ii) thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements and (iii) thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date.  The Company adopted the amendmentsto ASC Topic 855 and has included the required disclosures in Note 18.

 

In June 2009, theFASB issued Statement of Financial Accounting Standards (“SFAS”) No. 166,*Accounting for Transfers of Financial Assets*—*an amendment of FASB Statement No. 140*(“SFAS No. 166”).  This statement was issued to address concerns aboutthe previously existing guidance governing transfers of financial assets. SFAS No. 166 provides clarification concerning measuring whether atransferor and all of the entities included in the transferor’s financialstatements have surrendered control over transferred financial assets andstates that a determination must consider the transferor’s continuinginvolvements in the transferred financial assets.  In addition, thisstatement removes the concept of a qualifying special-purpose entity from SFAS No. 140and removes the exception from applying FIN 46(R) to qualifyingspecial-purpose entities.  SFAS No. 166 is effective for transfers offinancial assets that occur during the Company’s interim and annual reportingperiods that begin after November 15, 2009.  Management is currentlyevaluating the effects that SFAS No. 166 will have on the Company’scondensed consolidated financial statements and disclosures included in thosecondensed consolidated financial statements.

 

In June 2009, theFASB issued SFAS No. 167,*Amendments toFASB Interpretation No. 46(R) *(“SFAS No. 167”). This statement was issued to address concerns about financial statementpreparers’ ability to structure transactions to avoid consolidation, balancedwith the need for more relevant, timely and reliable information about anentity’s involvement in a VIE.  This statement requires an enterprise toperform an analysis to determine whether the enterprise’s variable interest orinterests give it a controlling financial interest in a VIE.  Thisanalysis identifies the primary beneficiary of a VIE as the enterprise that hasboth the power to direct the activities of a VIE that most significantly impactthe entity’s economic performance and the obligation to absorb losses of theentity that could potentially be significant to the VIE or the right to receivebenefits from the entity that could potentially be significant to the VIE.Additionally, an enterprise is required to assess whether it has an implicitfinancial responsibility to ensure that a VIE operates as designed whendetermining whether it has the power to direct the activities of the VIE thatmost significantly impacts the entity’s economic performance. * *SFAS No. 167 also amends FIN 46(R) toeliminate the quantitative approach to determining the primary beneficiary of aVIE and requires ongoing reassessments of VIE status.  SFAS No. 167is effective for the Company’s interim and annual reporting periods that beginafter November 15, 2009.  Management is currently evaluating the effectsthat SFAS No. 167 will have on the Company’s condensed consolidatedfinancial statements and disclosures included in those condensed consolidatedfinancial statements.  Management’s initial conclusion, based on currentguidance, is that a significant number of the CDOs that the Company manageswould need to be consolidated as a result of the adoption of SFAS No. 167.The Company is not yet able to finalize its assessment because the FASB iscurrently discussing potential exemptions, deferrals and/or modifications tothe application of this rule for certain investment managers.

 

In June 2009, theFASB issued amendments to ASC Topic 105 — *Generally AcceptedAccounting Principles* (“ASC Topic 105”) to establish the FASBAccounting Standards Codification (the “Codification”).  The Codification is now the single source ofauthoritative nongovernmental U.S. GAAP. Rules and interpretive releasesof the SEC under authority of federal securities laws are also sources ofauthoritative GAAP for SEC registrants. All existing accounting standards aresuperseded as described in the amendments to ASC Topic 105. All otheraccounting literature not included in the Codification is nonauthoritative. TheCompany adopted the amendments to ASC Topic 105 and has included the appropriatereferences to the Codification within the disclosures included in thesecondensed consolidated financial statements.

 

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In August 2009, theFASB issued Accounting Standards Update (“ASU”) No. 2009-05 — *Fair Value Measurements and Disclosures (“ASC Topic 820”) — MeasuringLiabilities at Fair Value*(“ASU 2009-05”).  ASU 2009-05 provides clarification and guidancewith respect to the estimation of the fair value of liabilities incircumstances where a quoted price in an active market for an identicalliability is not available.  A reportingentity is required to measure fair value using one of the following techniques:(i) a valuation technique that uses the quoted price of the identicalliability when traded as an asset, (ii) a valuation technique that usesquoted prices for similar liabilities or similar liabilities when traded asassets or (iii) another valuation technique that is consistent with theASC Topic 820.  ASU 2009-05 alsoclarifies that, when estimating the fair value of a liability, a reportingentity is not required to include a separate input or adjustment to otherinputs relating to the existence of a restriction that prevents the transfer ofthe liability.  The Company adopted ASU2009-05 and has taken this guidance into account in determining the estimatedfair values for its liabilities presented in the required disclosures in Note3.

 

**3.****             ****FAIR VALUE OF FINANCIALINSTRUMENTS**

 

Effective January 1,2008, the Company adopted ASC Topic 820. ASC Topic 820 defines fair value,establishes a framework used to measure fair value and enhances disclosurerequirements for fair value measurements. In accordance with ASC Topic 820, theCompany has categorized its financial instruments carried at fair value, basedon the priority of the valuation technique, into a three-level fair valuehierarchy. The valuation hierarchy is based upon the transparency of the inputsto the valuation of the asset or liability as of the measurement date. Afinancial instrument’s categorization within the valuation hierarchy is basedon the lowest level of input that is significant to the fair value measurement.The three levels are defined as follows:

 

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

 

The types of assetscarried at Level 1 generally are equity securities listed on an activeexchange. The Company held no Level 1 securities as of September 30,2009.

 

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

 

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

 

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

 

The Company’s assets andliabilities that are generally included in this category are non-Agency RMBS,commercial mortgage-backed securities (“CMBS”), corporate bonds, preferredshares of CDOs, beneficial interests in CDOs, contingent liabilities related toCDOs, loans classified as investments at fair value, certain loans held forinvestment, certain loans held for sale and warrants.

 

The Company’s fullvaluation methodology and ASC Topic 820 accounting policy are discussed in theNotes to the Consolidated Financial Statements included in the2008 10-K.  There were no significant changes in the Company’svaluation methodologies during the three and nine months ended September 30,2009.

 

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

 

The following tablepresents the financial instruments carried at fair value on a recurring basisas of September 30, 2009, by caption in the condensed consolidated balancesheet and by level within the ASC Topic 820 valuation hierarchy:

 

| ** **                              | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|-----------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| ** **                              | ** ** | **(In thousands)** | ** ** |
| Investments  at fair value:             |       |               |       |        |       |        |       |               |       |
| RMBS                                    |       | $                  | —     |        | $          | 313,977     |       | $                  | 2,943      |   | $ | 316,920 |   |
| Loans                                   |       | —             |       | —      |       | 14,807      |       | 14,807             |       |
| Other                                   |       | —             |       | —      |       | 4,443       |       | 4,443              |       |
| Derivative  assets                      |       | —             |       | —      |       | 74          |       | 74                 |       |
| Total  financial instrument assets      |       | $                  | —     |        | $          | 313,977     |       | $                  | 22,267     |   | $ | 336,244 |   |
|                                    |       |               |       |        |       |        |       |               |       |
| Derivative  liabilities                 |       | $                  | —     |        | $          | 832         |       | $                  | —     |   | $ | 832 |   |
| Accrued  and other liabilities          |       | —             |       | —      |       | 414         |       | 414                |       |
| Total  financial instrument liabilities |       | $                  | —     |        | $          | 832         |       | $                  | 414        |   | $ | 1,246 |   |

 

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

 

The table below includesa rollforward of the balance sheet amounts for the three months ended September 30,2009 (including the change in fair value) for financial instruments classifiedby the Company within Level 3 of the valuation hierarchy.

 
| ** **                         | ** ** | ** **                                                         | ** ** | ** **          | ** ** | ** **               | ** ** | ** **         | ** ** | ** **                   | ** ** | **Changes  in Unrealized**      | ** ** |
|------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------|------------|--------------------------|------------|--------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **Fair  Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains  (Losses)** | ** ** |
| ** **                         | ** ** | **Estimated**                                                      | ** ** | **Net  Realized/**  | ** ** | **Purchases,  (Sales),** | ** ** | **Net  Transfers** | ** ** | **Estimated**                | ** ** | **Related  to Financial**       | ** ** |
| ** **                         | ** ** | **Fair  Value**                                                    | ** ** | **Unrealized**      | ** ** | **Issuances  and**       | ** ** | **In  (Out)**      | ** ** | **Fair  Value**              | ** ** | **Instruments  Held**           | ** ** |
| ** **                         | ** ** | **July 1,  2009**                                             | ** ** | **Gains**           | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** ** | **September 30,  2009** | ** ** | **at  September 30, 2009** | ** ** |
| ** **                         | ** ** | **(In  thousands)**                                                | ** ** |
| Investments  at fair value:        |       |                                                               |       |                |       |                     |       |               |       |                         |       |                            |       |
| RMBS                               |       | $                                                                  | 3,110      |                | $          | 310                      | (1)        | $                  | (477       | )                            | $          | —                          |       | $ | 2,943 |   | $ | 285 | (1) |
| Loans                              |       | 6,841                                                              |       | 581                 | (1)        | 7,385                    |       | —             |       | 14,807                       |       | 493                             | (1)        |
| Other                              |       | 315                                                                |       | 3,112               | (1)        | 1,016                    |       |               |       | 4,443                        |       | 2,576                           | (1)        |
| Derivative  assets                 |       | 61                                                                 |       | 13                  | (2)        | —                   |       | —             |       | 74                           |       | 13                              | (2)        |
| Total  financial instrument assets |       | $                                                                  | 10,327     |                | $          | 4,016                    |       | $                  | 7,924      |                         | $          | —                          |       | $ | 22,267 |   | $ | 3,367 |   |
|                               |       |                                                               |       |                |       |                     |       |               |       |                         |       |                            |       |
| Accrued  and other liabilities     |       | $                                                                  | —     |                | $          | —                   | (3)        | $                  | 414        |                         | $          | —                          |       | $ | 414 |   | $ | — | (3) |

 

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(1)        Net realized and unrealized gains(losses) on investments at fair value are reported within net gain (loss) oninvestments at fair value in the condensed consolidated statements ofoperations.

(2)        Net realized and unrealized gains(losses) on derivative assets and derivative liabilities are recorded in net(loss) gain on derivatives in the condensed consolidated statements ofoperations.

(3)        Net realized and unrealized gains(losses) on accrued and other liabilities at fair value are recorded individend income and other net loss in the condensed consolidated statements ofoperations.

 

The table below includesa rollforward of the balance sheet amounts for the nine months ended September 30,2009 (including the change in fair value) for financial instruments classified bythe Company within Level 3 of the valuation hierarchy.

 
| ** **                              | ** ** | ** **                                                         | ** ** | ** **          | ** ** | ** **               | ** ** | ** **         | ** ** | ** **             | ** ** | ** **                   | ** ** | **Changes  in Unrealized**      | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------|------------|--------------------------|------------|--------------------|------------|------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **Fair  Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains  (Losses)** | ** ** |
| ** **                              | ** ** | **Estimated**                                                      | ** ** | **Net  Realized/**  | ** ** | **Purchases,  (Sales),** | ** ** | **Net  Transfers** | ** ** | **Deconsolidation**    | ** ** | **Estimated**                | ** ** | **Related  to Financial**       | ** ** |
| ** **                              | ** ** | **Fair  Value**                                                    | ** ** | **Unrealized**      | ** ** | **Issuances  and**       | ** ** | **In  (Out)**      | ** ** | **of**                 | ** ** | **Fair  Value**              | ** ** | **Instruments  Held**           | ** ** |
| ** **                              | ** ** | **January 1,  2009**                                          | ** ** | **Gains  (Losses)** | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** ** | **Market  Square CLO** | ** ** | **September 30,  2009** | ** ** | **at  September 30, 2009** | ** ** |
| ** **                              | ** ** | **(In  thousands)**                                                | ** ** |
| Available-for-sale  securities          |       | $                                                                  | 2,338      |                | $          | 1,428                    | (1)        | $                  | —     |                   | $          | —                       |       | $                               | (3,766     | ) | $ | — |   | $ | (31 | )(1) |
| Investments  at fair value              |       |                                                               |       |                |       |                     |       |               |       |                   |       |                         |       |                            |       |
| RMBS                                    |       | 5,394                                                              |       | (1,109              | )(2)       | (1,342                   | )          | —             |       | —                 |       | 2,943                        |       | (1,180                          | )(2)       |
| Loans                                   |       | —                                                             |       | 938                 | (2)        | 13,869                   |       | —             |       | —                 |       | 14,807                       |       | 831                             | (2)        |
| Other                                   |       | 160                                                                |       | 2,965               | (2)        | 2,184                    |       | —             |       | (866                   | )          | 4,443                        |       | 2,340                           | (2)        |
| Derivative  assets                      |       | 132                                                                |       | (58                 | )(3)       | —                   |       | —             |       | —                 |       | 74                           |       | (58                             | )(3)       |
| Total  financial instrument assets      |       | $                                                                  | 8,024      |                | $          | 4,164                    |       | $                  | 14,711     |                   | $          | —                       |       | $                               | (4,632     | ) | $ | 22,267 |   | $ | 1,902 |   |
|                                    |       |                                                               |       |                |       |                     |       |               |       |                   |       |                         |       |                            |       |
| Derivative  liabilities                 |       | $                                                                  | 402        |                | $          | 120                      | (3)        | $                  | (522       | )                      | $          | —                       |       | $                               | —     |   | $ | — |   | $ | — | (3) |
| Accrued  and other liabilities          |       | —                                                             |       | —              | (4)        | 414                      |       | —             |       | —                 |       | 414                          |       | —                          | (4)        |
| Total  financial instrument liabilities |       | $                                                                  | 402        |                | $          | 120                      |       | $                  | (108       | )                      | $          | —                       |       | $                               | —     |   | $ | 414 |   | $ | — |   |

 

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(1)        Net unrealized changes in fair value foravailable-for-sale securities are reported as an adjustment to accumulatedother comprehensive loss on the condensed consolidated statement ofstockholders’ equity (deficit). Impairment charges on available-for-salesecurities are reported within net loss on available-for-sale securitiesin the condensed consolidated statements of operations.

(2)        Net realized and unrealized gains(losses) on investments in fair value are reported within net gain (loss)on investments at fair value in the condensed consolidated statements ofoperations.

(3)        Net realized and unrealized gains(losses) on derivative assets and derivative liabilities are recorded innet (loss) gain on derivatives in the condensed consolidated statements ofoperations.

(4)        Net realized and unrealized gains (losses)on accrued and other liabilities at fair value are recorded in dividend incomeand other net loss in the condensed consolidated statements of operations.

 

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

 

Certain assets aremeasured at fair value on a nonrecurring basis, meaning that the instrumentsare measured at fair value only in certain circumstances (for example, whenheld at the lower of cost or fair value). The following table presents theassets carried on the condensed consolidated balance sheet by caption and bylevel within the ASC Topic 820 valuation hierarchy, as of September 30,2009, for which a nonrecurring change in fair value has been recorded duringthe three months ended September 30, 2009:

 
| ** **                                                   | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying  Value** | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **(In thousands)** | ** ** |
| Loans  held for sale                                         |       | $                  | —     |        | $          | —      |       | $                   | 6,893      |   | $ | 6,893 |   |
| Loans  held for investment, net of allowance for loan losses |       | —             |       | —      |       | 7,906       |       | 7,906               |       |
| Total  assets at fair value on a nonrecurring basis          |       | $                  | —     |        | $          | —      |       | $                   | 14,799     |   | $ | 14,799 |   |

 

In the table above, “Loansheld for sale” includes changes in fair value of loans which are carried on thebalance sheet at the lower of cost or fair value. “Loans held for investment”represents loans which are measured at fair value as a result of theestablishment of or subsequent change in the allowance for loan losses as of September 30,2009.

 

The following table presentsthe total change in value of financial assets for which a fair value adjustmenthas been included in the condensed consolidated financial statements for thethree and nine months ended September 30, 2009, related to financialinstruments still held at September 30, 2009:

 
| ** **                            | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** |
|---------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **September 30, 2009** | ** ** | **September 30, 2009** | ** ** |
| ** **                            | ** ** | **(In thousands)**          | ** ** |
| Other  investments                    |       | $                           | (550       | )(1)                        | $          | (550 | )(1) |
| Loans  held for sale                  |       | 3                           | (2)        | (4,996                      | )(2)       |
| Loans  held for investment            |       | (4,226                      | )(3)       | (12,619                     | )(3)       |
| Total  nonrecurring fair value losses |       | $                           | (4,773     | )                           | $          | (18,165 | ) |

 

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(1)        Changes in the fair value of otherinvestments are reported within dividend income and other net loss in thecondensed consolidated statements of operations.

(2)        Changes in the fair value of loans heldfor sale are reported within net gain (loss) on loans in the condensedconsolidated statements of operations.

(3)        Impairment charges to mark loans held forinvestment to fair value are reported within provision for loan losses in thecondensed consolidated statements of operations.

 

ASC Topic 825 requiresquarterly disclosure of the fair value of financial instruments for which it ispractical to estimate that value. Estimated fair values presented below arecalculated in accordance with ASC Topic 820. For securities which the fairvalue option was not elected, quoted market prices, if available, are utilizedas estimates of fair values. In the absence of available quoted market prices,fair values have been derived based on management’s assumptions, the estimatedamount and timing of future cash flows and estimated discount rates. Differentassumptions could significantly affect these estimates.

 

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The carrying amounts andestimated fair values of the Company’s financial instruments, for which thedisclosure of fair values is required, were as follows as of September 30,2009:

 
| ** **                                            | ** ** | ** **         | ** ** | **Estimated** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                            | ** ** | **Carrying**       | ** ** | **Fair**      | ** ** |
| ** **                                            | ** ** | **Value**          | ** ** | **Value**     | ** ** |
| ** **                                            | ** ** | **(In thousands)** | ** ** |
| Financial  assets:                                    |       |               |       |          |       |
| Cash  and cash equivalents (1)                        |       | $                  | 47,542     |          | $          | 47,542 |   |
| Restricted  cash and cash equivalents (1)             |       | 21,786             |       | 21,786        |       |
| Investments  at fair value (2)                        |       | 336,170            |       | 336,170       |       |
| Other  investments (3)                                |       | 4,287              |       | 4,287         |       |
| Derivative  assets (2)                                |       | 74                 |       | 74            |       |
| Loans  held for sale (2)                              |       | 9,053              |       | 9,731         |       |
| Loans,  net of allowance for loan losses (2) (3) |       | 271,785            |       | 262,524       |       |
| Investment  advisory fee receivables (1)              |       | 2,189              |       | 2,189         |       |
|                                                  |       |               |       |          |       |
| Financial  liabilities:                               |       |               |       |          |       |
| Repurchase  agreements (1)                            |       | 306,304            |       | 306,304       |       |
| Derivative  liabilities (2)                           |       | 832                |       | 832           |       |
| Accrued  and other liabilities (2)                    |       | 414                |       | 414           |       |
| Long  term debt:                                      |       |               |       |          |       |
| DFR  MM CLO (4)                                       |       | 222,026            |       | 142,120       |       |
| Trust  preferred securities (4)                       |       | 123,717            |       | 26,067        |       |
| Series A &  Series B Notes (4)     |       | 72,178             |       | 44,522        |       |
|                                                       |            |                    |            |               |            |  |  |

 

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(1)        Carrying amounts approximate the fairvalue due to the short term nature of these instruments.

(2)        The estimated fair values were determinedin accordance with ASC Topic 820.

(3)        It was not practicable to estimate thefair value of certain loans and other investments because they are not tradedin an active market; therefore, the carrying value displayed is anapproximation of fair value for loans with a carrying value of $140.6 millionand other investments with a carrying value of $4.3 million. If an independentpricing service cannot provide fair value estimates for a given loan, theCompany may determine estimated fair value based on some or all of thefollowing: (a) current financial information of the borrowing company andperformance against its operating plan; (b) changes in the fair value ofcollateral supporting the loan; (c) changes to the market for theborrowing company’s service or product and (d) present value of projectedfuture cash flows.

(4)        The estimated fair values were calculatedutilizing the guidance from ASC Topic 820. The Company utilized comparablemarket data and internal models to calculate the estimated fair value of thelong term debt.

 

**4.****             ****AVAILABLE-FOR-SALESECURITIES**

 

During the nine monthsended September 30, 2009, the majority of the Company’s available-for-salesecurities were held in Market Square CLO, with the exception of certain CMBSsecurities which had a carrying value of zero as of September 30,2009.  On June 30, 2009, the Company sold all of its preferenceshares in and deconsolidated Market Square CLO.

 

For the three and ninemonths ended September 30, 2009, the Company recognized zero and $31,000,respectively, of other-than-temporary impairments related to certain CMBS. Forthe three and nine months ended September 30, 2008, the Company recognized$0.9 million and $4.7 million, respectively, of other-than-temporaryimpairments on available-for-sale securities.

 

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**5.****  ****INVESTMENTS AT FAIRVALUE**

 

The following tablesummarizes the Company’s securities classified as investments at fair value asof September 30, 2009:

 
| ** **                | ** ** | **Estimated**      | ** ** |
|---------------------------|------------|--------------------|------------|
| ** **                | ** ** | **Fair Value**     | ** ** |
| **Security Description**  | ** ** | **(In thousands)** | ** ** |
| RMBS:                     |       |               |       |
| Agency                    |       | $                  | 313,977    |   |
| Non-Agency                |       | 2,943              |       |
| Investments  held in DPLC |       |               |       |
| Loans                     |       | 14,807             |       |
| Other  investments        |       | 862                |       |
| Other  investments        |       | 3,581              |       |
| Total                     |       | $                  | 336,170    |   |

 

The Company elected torecord all investments held in DPLC at fair value in accordance with ASC Topic825.  This election was made to align the accounting basis for theseinvestments for their consolidation into DFR with the accounting basis of suchinvestments for DPLC’s financial and investor reporting where they are valuedat fair value. As of September 30, 2009, the difference between theaggregate estimated fair value of loans held in DPLC of $14.8 million and theoutstanding principal balance of loans held in DPLC of $15.7 million was $0.9million. As of September 30, 2009, there were no loans held in DPLCthat were 90 days or more past due on interest payments or on nonaccrualstatus.  Interest income on loans held in DPLC are recorded in interestincome on the condensed consolidated income statements and represent thecurrent period interest accrual.  ASC Topic 825 requires an estimate ofthe gains and losses included in earnings during the period which areattributable to changes in instrument specific credit risk.  For floatingrate loans, all changes in estimated fair value are attributed to instrumentspecific credit risk.  For fixed rate instruments, an allocation of thechanges in value for the period is made between those changes in estimated fairvalue that are interest rate related and changes that are credit rated. As of and for the three and nine months ended September 30, 2009, allloans held in DPLC and recorded at fair value were floating rate loans, and thenet gains (losses) included in net gain (loss) on investments at fair valueattributed to instrument specific credit risk on loans were $0.6 million and$0.9 million, respectively.

 

The Company recordschanges in fair value of investments at fair value in its condensedconsolidated statements of operations. The following table summarizes theCompany’s securities classified as investments at fair value as of September 30,2009, according to their weighted average life:

 
| ** **                                       | ** ** | ** **          | ** ** | ** **     | ** ** | **Weighted** | ** ** |
|--------------------------------------------------|------------|---------------------|------------|----------------|------------|--------------|------------|
| ** **                                       | ** ** | **Amortized**       | ** ** | **Estimated**  | ** ** | **Average**  | ** ** |
| **Weighted Average Life**                        | ** ** | **Cost**            | ** ** | **Fair Value** | ** ** | **Coupon**   | ** ** |
| ** **                                       | ** ** | **(In  thousands)** | ** ** | ** **     | ** ** |
| Less  than one year                              |       | $                   | 2,000      |           | $          | 2,025        |       | 13.25 | % |
| Greater  than one year and less than five years  |       | 40,895              |       | 25,327         |       | 5.31         | %          |
| Greater  than five years and less than ten years |       | 293,057             |       | 300,079        |       | 5.00         | %          |
| Greater  than ten years                          |       | 7,590               |       | 8,739          |       | 4.32         | %          |
| Total                                            |       | $                   | 343,542    |           | $          | 336,170      |       | 5.06 | % |

 

The weighted averagelives in the table above are based upon contractual maturity for loans held inDPLC and other investments and are primarily based on a prepayment model forRMBS that considers current yields, forward yields, the slope of the yieldcurve, current mortgage rates and the contractual rate of the outstandingloans, the loan’s age, margin and volatility. Weighted average life is anestimate of how many years it will take to receive half of the outstandingprincipal. Actual lives of RMBS are generally shorter than stated contractualmaturities, are affected by the contractual maturities of the underlyingmortgages, periodic payments of principal and prepayments of principal and maydiffer materially from those set forth above.

 

For the three and ninemonths ended September 30, 2009, the Company had net purchases of RMBS of$24.3 million and $11.5 million, respectively, and received RMBS principalpaydowns of $18.2 million and $48.2 million, respectively. During the threemonths ended March 31, 2008, the RMBS portfolio experienced a significantdecrease in value, fueled by the recent credit crisis. This negativeenvironment had several impacts on the Company’s ability to successfullyfinance and hedge its RMBS portfolio. As a result, during the three monthsended March 31, 2008, the Company sold a significant portion of its RMBSportfolio to improve liquidity.

 

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The following tablepresents the realized and unrealized gains (losses) on investments at fairvalue as reported in the Company’s condensed consolidated statements ofoperations:

 
| ** **                 | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **2009**                                  | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                 | ** ** | **(In thousands)**                        | ** ** |
| Realized  gains (losses)   |       | $                                         | 2,378      |                                     | $          | 85 |   | $ | 2,030 |   | $ | (169,057 | ) |
| Unrealized  gains (losses) |       | 605                                       |       | (13,740                                  | )          | 7,264 |   | (47,064 | ) |
| Total  gains (losses)      |       | $                                         | 2,983      |                                     | $          | (13,655 | ) | $ | 9,294 |   | $ | (216,121 | ) |

 

As of September 30,2009, there were $3.0 million of unsettled purchases of loans held in DPLCclassified as investments at fair value.

 

**6.****  ****LOANS HELD FOR SALE ANDLOANS HELD FOR INVESTMENT**

 

The following summarizesthe Company’s loans held for sale and loans held for investment as of September 30,2009:

 
| ** **                        | ** ** | **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)     |       | $                | —      |               | $             | 286,540    |       | $ | 286,540 |   |
| Other  corporate leveraged loans  |       | 9,053            |        | —             |          | 9,053      |       |
| Commercial  real estate loans (3) |       | —           |        | 9,376              |          | 9,376      |       |
|                              |       | $                |  9,053 |               | 295,916       |       | 304,969    |   |
| Allowance  for loan losses        |       |             |        | (24,131            | )             | (24,131    | )          |
|                              |       |             |        | $                  |  271,785 |       | $          | 280,838 |   |

 

----

| (1) | Carrying value of loans  held for sale is lower of cost or estimated fair value.                                                 |
|-----|----------------------------------------------------------------------------------------------------------------------------------|
| (2) | Loans held in DFR MM  CLO classified as loans held for investment reported gross of $20.0 million  allowance for loan losses.    |
| (3) | Commercial real estate  loans classified as loans held for investment reported gross of $4.1 million  allowance for loan losses. |

 

The following summarizesthe Company’s allowance for loan losses as of September 30, 2009:

 
| ** **                    | ** ** | **Number**   | ** ** | **Par**            | ** ** | **Allowance**       | ** ** |
|-------------------------------|------------|--------------|------------|--------------------|------------|---------------------|------------|
| **Type of Loan**              | ** ** | **of Loans** | ** ** | **Value**          | ** ** | **for Loan Losses** | ** ** |
| ** **                    | ** ** | ** **   | ** ** | **(In thousands)** | ** ** |
| ** **                    | ** ** | ** **   | ** ** | ** **         | ** ** | ** **          | ** ** |
| Loans  held in DFR MM CLO     |       | 5            |       | $                  | 30,536     |                | $          | 20,037 |   |
| Commercial  real estate loans |       | 3            |       | 8,058              |       | 4,094               |       |
| Total                         |       | 8            |       | $                  | 38,594     |                | $          | 24,131 |   |

 

As of September 30,2009, the Company’s loans held for sale and loans held for investment totaled$280.8 million, net of allowance for loan losses. Loans classified as heldfor sale and carried at the lower of cost or estimated fair value totaled$9.1 million, net of a valuation allowance of $5.0 million, as of September 30,2009. Loans classified as held for investment and carried at amortized costtotaled $295.9 million, less an allowance for loan losses of$24.1 million, as of September 30, 2009. As of September 30,2009, the Company held certain loans that settle interest accruals byincreasing the principal balance of the loan outstanding. For the three andnine months ended September 30, 2009, the Company settled interestreceivables through increases to the loans’ outstanding principal balances inthe amount of $0.5 million and $2.4 million, respectively.

 

Loans held in DFR MM CLOconsist partially of loans which are not broadly syndicated and are, therefore,less liquid. These loans are primarily considered to be held for investment andare reported at amortized cost with an allowance for loan losses, if necessary,unless the Company decides to sell one of these loans, in which case the loanis transferred to loans held for sale.

 

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During the year ended December 31,2008, the Company began actively seeking to sell all of the other corporateleveraged loans held in the Company’s alternative asset revolving warehousefunding facility with Wachovia Capital Markets, LLC (the “Wachovia Facility”),as the Company triggered an acknowledged termination event thereunder on November 30,2008. The Company sold a significant portion of the loans held within theWachovia Facility during the year ended December 31, 2008 and transferredall loans held within the Wachovia Facility from loans held for investment toloans held for sale.  During the three months ended March 31, 2009,the Company sold loans held within the Wachovia Facility with a par value of$31.5 million for $10.8 million, net of interest of $0.2 million.  TheCompany realized a loss of $6.2 million reported in net gain (loss) on loansheld for investment and loans held for sale in the condensed consolidatedstatements of operations during the three months ended March 31, 2009 as aresult of these sales. The Wachovia Facility was fully repaid and all ofthe Company’s obligations thereunder were satisfied during the third quarter of2009.

 

As of September 30,2009, the Company’s commercial real estate loans consisted of four loansclassified as held for investment totaling $9.4 million less an allowancefor loan losses of $4.1 million. The Company did not recognize interestincome on these loans for the three and nine months ended September 30,2009.

 

The following summarizesthe activity within the allowance for loan losses for the nine months ended September 30,2009 and 2008:

 
| ** **                                      | ** ** | **Allowance for Loan Losses** | ** ** |
|-------------------------------------------------|------------|-------------------------------|------------|
| ** **                                      | ** ** | **2009**                      | ** ** | **2008** | ** ** |
| ** **                                      | ** ** | **(In thousands)**            | ** ** |
| Allowance  for loan losses at January 1    |       | $                             | 19,979     |   | $ | 5,300 |   |
| Provision  for loan losses                      |       | 15,452                        |       | 19,961 |   |
| Charge-offs                                     |       | (11,385                       | )          | (625 | ) |
| Recoveries                                      |       | 85                            |       | — |   |
| Transfers  to loans held for sale               |       | —                        |       | (3,040 | ) |
| Allowance  for loan losses at September 30 |       | $                             | 24,131     |   | $ | 21,596 |   |

 

The Company recordedrealized gains on loans held for sale and loans held for investment of $0.7million and realized losses of $6.4 million in net gain (loss) on loans on thecondensed consolidated statements of operations for the three and nine monthsended September 30, 2009, respectively.  The Company recordedrealized gains on loans held for sale and loans held for investment of $0.6million and realized losses of $12.0 million in net gain (loss) on loans on thecondensed consolidated statements of operations for the three and nine monthsended September 30, 2008, respectively.  The Company recordedunrealized losses on loans held for sale of $0.2 million and unrealized gainsof $37.6 million in net gain (loss) on loans in the condensed consolidatedstatements of operations for the three and nine months ended September 30,2009, respectively.  The Company recorded unrealized losses on loans heldfor sale of $15.0 million and unrealized losses of $23.4 million in net gain(loss) on loans in the condensed consolidated statements of operations for thethree and nine months ended September 30, 2008, respectively. Unrealized gains on loans held for sale include recoveries up to original costor value on the date the loan was transferred from loans held for investment toloans held for sale.

 

Prior to the Company’ssale of all of its preference shares in Market Square CLO on June 30,2009, the Company consolidated all of the assets and liabilities of MarketSquare CLO.  Loans held in Market Square CLO primarily consisted ofsyndicated bank loans classified as held for sale.  During the nine monthsended September 30, 2009, the Company recorded unrealized gains of $45.2million and realized losses of $2.1 million on loans held in Market Square CLOin net gain (loss) on loans in the condensed consolidated statements ofoperations.  During the three and nine months ended September 30,2008, the Company recorded unrealized losses of $15.2 million and $26.6million, respectively, and realized gains of $0.2 million and realized lossesof $1.9 million, respectively, on loans held in Market Square CLO in net gain(loss) on loans in the condensed consolidated statements of operations.

 

The Company did notrecognize $0.9 million and $2.8 million, respectively, of interest incomeearned, but not yet received, on loans held for investment for the three andnine months ended September 30, 2009. In addition, the Company did notrecognize $2.0 million and $5.6 million, respectively, of interest incomeearned, but not yet received, on loans held for sale for the three and ninemonths ended September 30, 2009.

 

**7.****  ****DERIVATIVE INSTRUMENTSAND HEDGING ACTIVITIES**

 

The Company seeks tomanage a portion of its exposure to the effects of interest rate changes. Suchexposure may arise from the issuance and forecasted rollover of short termliabilities or from liabilities with a contractual variable rate based on theLondon Interbank Offered Rate (“LIBOR”). As of September 30, 2009, theCompany did not have any derivative instruments designated as hedginginstruments, and all derivative instruments are carried at fair value.

 

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The following table is asummary of the Company’s derivative instruments as of September 30, 2009:

 
| ** **             | ** ** | ** ** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|------------------------|------------|------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **             | ** ** | **Count**  | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **             | ** ** | ** ** | ** ** | **(In thousands)** | ** ** |
| Interest  rate swaps   |       | 2          |       | $                  | 30,000     |       | $          | —          |       | $                 | 761        |   | $ | (761 | ) |
| Interest  rate cap (1) |       | 1          |       | 40,000             |       | —     |       | 71              |       | (71               | )          |
| Warrants               |       | 2          |       | n/a                |       | 74         |       | —          |       | 74                |       |
|                   |       | 5          |       | $                  | 70,000     |       | $          | 74              |       | $                 | 832        |   | $ | (758 | ) |

 

----

(1) The interestrate cap is held in DFR MM CLO.

n/a — not applicable

 

The following table is asummary of the net (loss) gain on derivatives included in the statements ofoperations:

 
| ** **                      | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                      | ** ** | **2009**                                  | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                      | ** ** | **(In thousands)**                        | ** ** |
| Interest  rate swaps            |       | $                                         | (71        | )                                        | $          | (1,578 | ) | $ | 2,696 |   | $ | (216,129 | ) |
| Credit  default swaps           |       | —                                    |       | (35                                      | )          | (119 | ) | (1,969 | ) |
| Total  return swaps             |       | —                                    |       | (600                                     | )          | — |   | (1,004 | ) |
| Interest  rate floors and caps  |       | 1                                         |       | (26                                      | )          | 1 |   | (539 | ) |
| Warrants                        |       | 13                                        |       | —                                   |       | (58 | ) | 257 |   |
| Net  (loss) gain on derivatives |       | $                                         | (57        | )                                        | $          | (2,239 | ) | $ | 2,520 |   | $ | (219,384 | ) |

 

***Interest Rate Swaps***

 

In general, when afixed-rate or hybrid adjustable-rate RMBS is funded by a short term borrowing,the Company may enter into an interest rate swap agreement that effectivelyfixes a portion of the borrowing costs for a period close to the anticipatedweighted-average life of the fixed-rate portion of the related RMBS. Thisstrategy is designed to protect a portion of the Company’s portfolio fromincreased funding costs due to rising interest rates because the borrowingcosts are not fixed for the duration of the fixed-rate period of the relatedRMBS. The Company did not enter into any interest rate swaps during thethree and nine months ended September 30, 2009.  The Companyterminated two interest rate swaps with a notional value of $75.0 million, andone interest rate swap with a notional value of $60.0 million matured, duringthe nine months ended September 30, 2009.

 

The weighted averagefixed rate payable on the interest rate swaps as of September 30, 2009 was4.07%.  The Company is currently in violation of substantially all of itsInternational Swap Dealers Association (“ISDA”) agreements with its interestrate swap counterparties. Each of these ISDA agreements contains an equitydecline trigger that the Company breached during the first quarter of 2008.This violation generally gives the counterparties the right to terminate theISDA agreements and the related interest rate swaps. The Company has notifiedits active counterparties of the breach, and none of those counterparties hasexpressed an intention to terminate the ISDA agreements. To date, theviolations of the Company’s ISDA agreements have not had a material adverseeffect on its operations.

 

As of January 1,2008, in conjunction with the adoption of ASC Topic 825, the Companyde-designated $3.8 billion (notional) of interest rate swaps previouslydesignated as a hedge with a net negative fair value of $85.9 million atde-designation, including accrued interest. Prior to the de-designation,designated interest rate swaps were carried at fair value with changes in valuerecorded directly into equity through other comprehensive loss, to the extent theywere effective as a hedge, in accordance with the guidance under ASC Topic 815 —*Derivatives and Hedging*(“ASC Topic 815”).  As ofthe adoption date, the other comprehensive loss related to the de-designationof interest rate hedges was $69.9 million. To the extent that theforecasted rolls on repurchase agreement transactions continued as anticipated,the Company would have amortized this loss and the $27.3 million in othercomprehensive loss related to previously de-designated swaps from other comprehensiveloss into interest expense over the remaining original hedge period, and allfuture changes in fair value of the interest rate swaps would be reflected inthe consolidated statements of operations. However, due to the significant RMBSsales activity and corresponding repurchase agreement repayment during thethree months ended March 31, 2008, forecasted rolls on the repaidrepurchase agreements did not continue as anticipated. As a result, a loss of$91.7 million was recognized during the three months ended March 31,2008 in the consolidated statements of operations in net loss on derivatives,and a corresponding cumulative net loss relating to newly and previouslyde-designated interest rate swaps in other comprehensive loss was removed. Theremaining $63,000 in other comprehensive loss related to the terminated andde-designated swaps as of September 30, 2009 will be amortized over theremaining original hedge period. Additionally, the Company recorded a 

 

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net increase to interestexpense of $41,000 and $31,000 during the three months ended September 30,2009 and 2008, respectively, and a net increase to interest expense of $0.1million and $5.3 million during the nine months ended September 30, 2009and 2008, respectively, related to the amortization of de-designated andterminated interest rate swaps.

 

***Interest Rate Cap***

 

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

 

***Warrants***

 

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

 

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

 

Repurchase agreements areshort term borrowings from financial institutions that bear interest rates thathave historically moved in close relationship to the one-month, two-month orthree-month LIBOR. As of September 30, 2009, the Company had repurchaseagreements outstanding in the amount of $306.3 million (including $74,000of accrued interest). The repurchase agreements had remaining maturitiesbetween 2 and 30 days and a weighted-average borrowing rate of 0.68%.

 

As of September 30,2009, the Company had amounts at risk with the following repurchase agreementcounterparties:

 
| ** **                                | ** ** | ** **             | ** ** | **Weighted-Average**       | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | ** **             | ** ** | **Maturity of Repurchase** | ** ** |
| ** **                                | ** ** | **Amount at Risk (1)** | ** ** | **Agreements**             | ** ** |
| **Repurchase Agreement  Counterparties:** | ** ** | **(In thousands)**     | ** ** | **(In days)**              | ** ** |
| Deutsche  Bank Securities Inc.            |       | $                      | 4,223      |                       | 6          |   |
| Fortis  Securities LLC                    |       | 4,714                  |       | 7                          |       |
| Total                                     |       | $                      | 8,937      |                       | 7          |   |

 

----

(1)  Equal to the fair value of securitiespledged, minus repurchase agreement liabilities and related accrued interestpayable.

 

During the three monthsended September 30, 2009, repurchase agreement liabilities increased by$11.8 million, primarily as a result of net RMBS purchases, which resulted inassociated repurchase agreement borrowings. For the nine months ended September 30, 2009, repurchase agreementliabilities declined by $19.8 million as a result of net RMBS sales and RMBSprincipal paydowns, which resulted in associated repayments of repurchaseagreement liabilities. The Company’s repurchase agreement liabilities are significantlyconcentrated with one counterparty that provides financing for 85.1% of the$306.3 million of repurchase agreement liabilities as of September 30,2009. See Note 9 for additional discussion concerning securities received andpledged as collateral.

 

**9.****  ****SECURITIES RECEIVED ANDPLEDGED AS COLLATERAL**

 

To the extent that theCompany receives collateral in connection with derivative and repurchaseagreement transactions, it is generally permitted to sell or repledge thesesecurities. As of September 30, 2009, the Company did not have anysecurities held as collateral.

 

The Company also pledgesits own assets to collateralize its repurchase agreements and in connectionwith derivative transactions. These securities owned and pledged, where thecounterparty has the right by contract or custom to sell or repledge thefinancial instruments, were approximately $315.2 million as of September 30,2009 and consisted of RMBS pledged as initial collateral on repurchaseagreements. In addition, as of September 30, 2009, the Company had $1.0million of cash with counterparties as collateral on derivatives, which isincluded in due from broker on the condensed consolidated balance sheet.

 

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**10. LONG TERM DEBT**

 

The following tablesummarizes the Company’s long term debt as of September 30, 2009:

 
| ** **                             | ** ** | ** **         | ** ** | **Weighted** | ** ** |
|----------------------------------------|------------|--------------------|------------|--------------|------------|
| ** **                             | ** ** | **Carrying**       | ** ** | **Average**  | ** ** |
| ** **                             | ** ** | **Value**          | ** ** | **Rate**     | ** ** |
| ** **                             | ** ** | **(In thousands)** | ** ** | ** **   | ** ** |
| **Recourse:**                          |       |               |       |         |       |
| Trust  Preferred Securities            |       | $                  | 123,717    |         | 3.26       | % |
| Series A  and Series B Notes |       | 72,178             |       | 5.60         | %          |
| Total  Recourse                        |       | 195,895            |       | 4.12         | %          |
| **Non-Recourse:**                      |       |               |       |         |       |
| DFR  MM CLO (1)                        |       | 222,026            |       | 1.22         | %          |
| Total  Non-Recourse                    |       | 222,026            |       | 1.22         | %          |
| Total  long term debt                  |       | $                  | 417,921    |         | 2.58       | % |

 

----

| (1) | Excludes $19.0 million  of DFR MM CLO debt that is owned by the Company and eliminated upon  consolidation. Had this debt been included, the weighted-average borrowing  rate would be 1.48%. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Recourse debt refers to debtthat is a general obligation of the Company.  Non-recourse debt refers todebt with recourse only to specific assets pledged as collateral to thelenders, such as warehouse facilities and the debt issued by CDOs that areconsolidated as VIEs. The creditors of the non-recourse debt have no recourseto the other assets of the Company. None of the Company’s long term debt issubject to potential margin calls for additional pledges of cash or assets.

 

*TrustPreferred Securities.* On July 31, 2009, the Company entered into the three supplementalindentures (the “Supplemental Indentures”) with the holders of the TrustPreferred Securities.  The Supplemental Indentures amend the consolidatednet worth covenants (the “Net Worth Covenants”) contained in the indenturesgoverning the Trust Preferred Securities to (i) permanently decrease thenet worth required by the Net Worth Covenants from $175.0 million to $50.0million and (ii) provide that the initial measurement date for compliancewith the Net Worth Covenants will be September 30, 2012.  Inaddition, the Supplemental Indentures contain provisions prohibiting theCompany from (i) incurring additional indebtedness for the life of theTrust Preferred Securities, except for indebtedness permitted to be incurred inaccordance with provisions that are substantially similar to the provisions ofthe agreements governing the Series A Senior Secured Notes and Series BSenior Secured Notes issued in connection with the Merger (the “Series Aand Series B Notes”) and (ii) declaring additional dividends ordistributions on its capital stock for the life of the Trust PreferredSecurities, except as permitted in accordance with provisions that aresubstantially similar to the provisions of the agreements governing the Series Aand Series B Notes.  The Supplemental Indentures also provide therepresentative of the holders of the Trust Preferred Securities with certaininspection rights.  The Supplemental Indentures supersede the temporarywaiver of the Net Worth Covenants obtained from the holders of the TrustPreferred Securities in 2008.  The Company paid the holders of the TrustPreferred Securities a fee of $250,000 on July 31, 2009 and committed topay such holders an additional fee of $250,000 on or before July 31, 2010in connection with the Supplemental Indentures.

 

*DFR MMCLO.* During the three months ended September 30,2009, DFR MM CLO paid down $9.0 million of its outstanding debt as a result ofcertain structural provisions contained in its indenture. The carryingvalue of the collateral held in DFR MM CLO, which are the only assets to whichthe DFR MM CLO debt holders have recourse for repayment, was $280.1 million asof September 30, 2009.

 

*WachoviaFacility.* TheWachovia Facility was fully repaid during the three months ended September 30,2009, and all of the Company’s obligations thereunder were satisfied.

 

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**11.STOCKHOLDERS’ EQUITY**

 

***Performance Shares***

 

During the second quarterof 2009, the Company granted 12,019 restricted stock units (the “PerformanceShares”) to each of the five non-employee directors of the Company’s board ofdirectors (the “Board”) as a component of their compensation.  The Companyrecorded $250,000 in expense within other general and administrative expense onthe condensed consolidated income statement during the three months ended June 30,2009 related to these grants.  Each of the Performance Shares representsthe right to receive one share of the Company’s common stock on May 19,2012, subject to forfeiture and acceleration upon the occurrence of certainspecified events. The number of Performance Shares granted to each non-employeedirector is subject to adjustment for dividends or other distributions paidbetween June 11, 2009 and May 19, 2012 and may also be adjusted, asdetermined by the Board, in connection with any stock dividends, stock splits,subdivisions or consolidations of shares (including reverse stock splits) orsimilar changes in the Company’s capitalization.

 

The following tablesummarizes Performance Shares activity for the nine months ended September 30,2009:

 
| Performance  shares as of January 1, 2009    |   | 248,069 |   |
|---------------------------------------------------|--------|---------|--------|
| Granted                                           |   | 60,095  |   |
| Performance  shares as of September 30, 2009 |   | 308,164 |   |

 

***Restricted Stock Grants***

 

During the three monthsended March 31, 2009, vesting was accelerated on 541 shares of commonstock for an employee terminated in 2009 as a result of the November 2008Plan. See Note 15 for further information regarding the November 2008Plan.  In addition, during the three months ended March 31, 2009, anadditional 541 shares of common stock vested under the terms of thegrant.  During the three months ended June 30, 2009, an employeeforfeited 108 shares of common stock.   The unamortized amount of theshare-based payments totaled $20,000 as of September 30, 2009, and isbeing recognized on a straight-line basis over the remaining vesting period asan expense to compensation and benefits in the condensed consolidatedstatements of operations and an off-setting credit to additional paid-incapital.

 

The following tablesummarizes changes in restricted stock grants (number of shares) granted byDeerfield prior to the Merger and obtained as a result of the Merger for thenine months ended September 30, 2009:

 
| Nonvested,  January 1, 2009    |   | 1,623  |   |
|-------------------------------------|--------|--------|--------|
| Vested                              |   | (1,082 | )      |
| Forfeited                           |   | (108   | )      |
| Nonvested,  September 30, 2009 |   | 433    |   |

 

***Unvested Warrants***

 

In connection with theformation of DPLC, the Company issued to Pegasus Deerfield (AIV), LLC, anaffiliate of Pegasus (“Pegasus Deerfield”), (i) a five-year warrant topurchase 2,500,000 shares of the Company’s common stock at an exercise price of$4.25 per share (“Warrant A”) and (ii) a five-year warrant to purchase500,000 shares of the Company’s common stock at an exercise price of $10.00 pershare (“Warrant B” and, together with Warrant A, the “Warrants”).  TheWarrants are subject to certain vesting conditions, including that none of theWarrants vest prior to July 9, 2011 and that the Warrants will vest onlyif Pegasus maintains a certain minimum investment in DPLC.  In addition,Pegasus will be required by a certain specified date to make an election toeither retain the Warrants or receive a share of the incentive allocations andinvestment advisory fees paid to the Company and DCM in respect of certainfuture investment funds and separately managed accounts managed by DCM thatinvest primarily in syndicated bank loans to and bonds issued by non-investmentgrade borrowers.  In the event that Pegasus elects to receive thesesubsequent fund economics, they will forfeit the Warrants.  Simultaneouslywith the execution of the Warrants, the Company entered into a registrationrights agreement, dated as of April 9, 2009, with Pegasus Deerfield thatprovides registration rights with respect to the shares of the Company’s commonstock underlying the Warrants.

 

On September 23,2009, the Company and Pegasus Deerfield entered into certain amendments to theWarrants (“the Warrant Amendments”) to (i) delay the earliest possiblevesting date of the Warrants from April 9, 2011 to July 9, 2011 and (ii) movethe time period during which the Warrant holder’s average invested capital inDPLC and DPLC GP is required to be at least equal to $50.0 million in order forany of the Warrants to vest back from October 9, 2009 through April 9,2011 to January 9, 2010 through July 9, 2011. As consideration forthe Warrant Amendments, Pegasus Deerfield agreed to move the first date onwhich it can withdraw its capital contributions from DPLC back by three monthsto July 1, 2011.

 

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In addition, to allowPegasus and the Company to explore a new business opportunity outside of DPLC,the Company has released Pegasus Deerfield from $1.0 million of its initialcommitment to invest $75.0 million in DPLC. The Company expects to receive afuture financial benefit should this new business opportunity prove to besuccessful. However, the Company can provide no assurance that this businessopportunity will be successful or that it will receive any such futurefinancial benefit.

 

The Warrants have not yetvested, and a measurement date has not yet been established, because PegasusDeerfield has not yet met the performance requirements and a sufficiently largedisincentive for nonperformance of such requirements does not exist; therefore,no expense associated with the Warrants has been recorded for the three andnine months ended September 30, 2009.

 

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

 

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

 
| ** **                                                                            | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                            | ** ** | **2009**                                  | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                            | ** ** | **(In thousands, except per share data)** | ** ** |
|                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| **Net income (loss)**                                                                 |       | $                                         | 1,924      |                                     | $          | (156,883 | ) | $ | 63,369 |   | $ | (614,801 | ) |
| Less:  Cumulative convertible preferred stock dividends and accretion                 |       | —                                    |       | —                                   |       | — |   | 2,393 |   |
| **Net income (loss) attributable to common stockholders**                             |       | 1,924                                     |       | (156,883                                 | )          | 63,369 |   | (617,194 | ) |
| Net  (income) loss attributable to noncontrolling interest                            |       | (108                                      | )          | —                                   |       | 2,852 |   | — |   |
| **Net income (loss) attributable to Deerfield Capital Corp.**                         |       | $                                         | 1,816      |                                     | $          | (156,883 | ) | $ | 66,221 |   | $ | (617,194 | ) |
|                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Weighted  average shares used in basic and diluted calculations                       |       | 6,763                                     |       | 6,878                                    |       | 6,732 |   | 6,437 |   |
|                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| **Net income (loss) attributable to Deerfield Capital Corp.****per share  - basic**   |       | $                                         | 0.27       |                                     | $          | (22.81 | ) | $ | 9.84 |   | $ | (95.89 | ) |
|                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| **Net income (loss) attributable to Deerfield Capital Corp.****per  share - diluted** |       | $                                         | 0.27       |                                     | $          | (22.81 | ) | $ | 9.84 |   | $ | (95.89 | ) |

 

For the three and ninemonths ended September 30, 2009, restricted stock grants for 433 shares ofthe Company’s common stock are not included in the calculation of diluted netincome (loss) per share because their effect was anti-dilutive under thetreasury stock method.  For the three and nine months ended September 30,2008, restricted stock grants for 6,363 shares of the Company’s common stockare not included in the calculation of diluted net income (loss) per sharebecause their effect was anti-dilutive under the treasury stock method. For thethree and nine months ended September 30, 2009, the Warrants, issued inconnection with the formation of DPLC, are not included in the calculation ofdilutive net income (loss) per share because their effect wasanti-dilutive.  For the nine months ended September 30, 2008, the14,999,992 shares of Series A Preferred Stock (not adjusted to reflect the1-for-10 reverse stock split effected on October 16, 2008) are notincluded in calculation of diluted net loss per share because their effect wasanti-dilutive. On March 11, 2008, the Series A Preferred Stockconverted into 14,999,992 shares of common stock (not adjusted to reflect the1-for-10 reverse stock split effected on October 16, 2008), which areincluded in the calculation of basic and diluted net income (loss) per share.

 

**13.         ACCUMULATED OTHER COMPREHENSIVE LOSS**

 

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

 
| ** **                                   | ** ** | **For the nine months ended September 30, 2009** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                   | ** ** | **Available-for-**                                    | ** ** | **Cash Flow** | ** ** | **Foreign Currency** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Sale Securities**                                   | ** ** | **Hedges** | ** ** | **Translation** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                    | ** ** |
| Beginning  balance - January 1, 2009    |       | $                                                     | (4,055     | ) | $ | (199 | ) | $ | (2 | ) | $ | (4,256 | ) |
| Unrealized  net gain for the period          |       | 1,452                                                 |       | — |   | — |   | 1,452 |   |
| Deconsolidation  of Market Square CLO        |       | 2,603                                                 |       | — |   | — |   | 2,603 |   |
| Foreign  currency translation loss           |       | —                                                |       | — |   | (46 | ) | (46 | ) |
| Reclassification  adjustments:               |       |                                                  |       |   |   |   |   |   |   |
| Hedging  amortization recognized in earnings |       | —                                                |       | 136 |   | — |   | 136 |   |
| Ending  balance - September 30, 2009    |       | $                                                     | —     |   | $ | (63 | ) | $ | (48 | ) | $ | (111 | ) |

 

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**14.         INCOME TAXES**

 

The Company has recordeddeferred income taxes as of September 30, 2009 in accordance with ASCTopic 740 —*Income Taxes* (“ASCTopic 740”). The Company records deferred tax assets and liabilities for thefuture tax consequences attributable to differences between the GAAP carryingamounts and their respective income tax bases.  As required by ASC Topic740, DFR evaluated the likelihood of realizing tax benefits in future periods,which requires the recognition of a valuation allowance to reduce any deferredtax assets to an amount that is more likely than not to be realized.

 

As of September 30,2009, the Company continued to record a full valuation allowance on thedeferred tax asset. Accordingly, as of September 30, 2009, the Company hasrecognized a gross deferred tax asset of $356.0 million, a deferred taxliability of $2.6 million and a valuation allowance for deferred tax assets inthe amount of $353.4 million. As such, the Company recognized no net deferredtax asset as of September 30, 2009. In future reporting periods, theCompany will continue to reassess its ability to recognize additional deferredtax assets, which will impact the Company’s recorded income tax expense orbenefit on the condensed consolidated statements of operations at that time.

 

As of September 30,2009 the Company had a federal net operating loss (“NOL”) of approximately$204.5 million, which will be available to offset future taxable income,subject to the limitations described below. If not used, this NOL will begin toexpire in 2028. The Company also had net capital losses (“NCLs”) in excess ofcapital gains of $421.6 million as of September 30, 2009, which can becarried forward to offset future capital gains, subject to the limitationsdescribed below. If not used, this carryforward will begin to expire in 2012.No assurance can be provided that the Company will have future taxable incomeor future capital gains to benefit from its NOL and NCL carryovers. Inaddition, the Company’s NOL and NCL carryovers may be limited by Sections 382and 383 of the Code, if the Company undergoes an ownership change as defined inthose sections (“Ownership Change”).  Generally, there is an OwnershipChange if, at any time, one or more 5.0% shareholders (as defined in the Code)have aggregate increases in their ownership of the Company of more than 50percentage points looking back over the relevant testing period, which can occuras a result of acquisitions and certain dispositions of common stock by theCompany’s 5.0% shareholders.  If an Ownership Change occurs, the Company’sability to use its NOLs, NCLs and certain recognized built-in losses to reduceits taxable income in a future year would generally be limited to an annualamount (the “Section 382 Limitation”) equal to the fair value of theCompany immediately prior to the Ownership Change multiplied by the “long termtax-exempt interest rate.” In the event of an Ownership Change, NOLs and NCLsthat exceed the Section 382 Limitation in any year will continue to beallowed as carryforwards for the remainder of the carryforward period, and suchNOLs and NCLs can be used to offset taxable income for years within thecarryforward period subject to the Section 382 Limitation in each year.However, if the carryforward period for any NOL or NCL were to expire beforethat loss was fully utilized, the unused portion of that loss would be lost.

 

For the three and ninemonths ended September 30, 2009, the Company recognized income tax expenseof $75,000 and $0.3 million, respectively, primarily as a result of differencesin the calculation of alternative minimum taxable income versus regular taxableincome.

 

On May 19, 2009, theCompany held an annual stockholders meeting (the “Annual Meeting”) at which theCompany’s stockholders approved an amendment to the Company’s charter torestrict certain acquisitions and dispositions of the Company’s securities andto remove references to the Company’s operation as a REIT as one of thepurposes of the Company (the “Charter Amendment”). The restrictions onacquisitions and dispositions of the Company’s securities contained in theCharter Amendment are intended to preserve the benefit of the Company’s NOLs,NCLs and certain other tax attributes for tax purposes. The Charter Amendmentwas filed with the Maryland State Department of Assessments and Taxation on May 20,2009.   In connection with the Charter Amendment, the Company’sstockholder rights plan that was adopted on March 11, 2009 automaticallyterminated.

 

The Charter Amendment isdesigned to prevent an Ownership Change.  The Charter Amendment generallyprohibits any direct or indirect sale, transfer, assignment, exchange,issuance, grant, redemption, repurchase, conveyance, pledge or otherdisposition of shares of the Company’s common stock or rights or options topurchase the Company’s common stock or any other interests that would betreated as stock of the Company under the income tax regulations promulgatedunder the Code, if as a result of such sale, transfer, assignment, exchange,issuance, grant, redemption, repurchase, conveyance, pledge or otherdisposition, any person or group becomes a 5% shareholder (as defined in theCode), which generally includes a person or group that beneficially owns 5% ormore of the market value of the total outstanding shares of the Company’scommon stock, or the percentage of the Company’s common stock owned by a 5%shareholder (as defined in the Code) would be increased. As a result of theserestrictions, certain transfers of stock by existing 5% shareholders areprohibited. In addition to other exceptions, a person will not be treated asviolating the Charter Amendment as a result of acquiring shares of stock,directly or indirectly, as a result of the issuance of a warrant, the exercisethereof or the transfer or acquisition of such warrant or stock acquiredthereby, where such warrant had first been issued upon approval of the Boardunless and until the person to whom such warrant was issued thereafter acquiresany stock that is unrelated to the warrant. The Board has granted limitedexemptions to the Charter Amendment as disclosed in its Current Report on Form 8-Kfiled with the SEC on May 19, 2009.

 

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If the Board determinesthat a transfer would be prohibited, then, upon the Company’s written demand,the purported transferee will transfer the securities that are the subject ofthe prohibited transfer, or cause such securities to be transferred, to anagent designated by the Board. The agent will sell the securities to a buyer orbuyers, which may include the Company, in one or more arm’s-length transactionsthat comply with the Charter Amendment. If the purported transferee has resoldthe securities before receiving the Company’s demand to surrender them to theagent, the purported transferee will be deemed to have sold the securities forthe agent and will be required to transfer to the agent any distributionsreceived with respect to such securities and any proceeds of the sale of suchsecurities (except for any proceeds which the Company grants the purported transfereewritten permission to retain and which do not exceed the amount that thepurported transferee would have received from the agent if the agent had resoldsuch securities). The proceeds of the sale of any such securities will beapplied first to the agent to cover its costs and expenses, second to thepurported transferee, up to the lesser of the amount paid by the purportedtransferee for the securities or the fair market value of the securities at thetime of the attempted transfer, and third to one or more charitableorganizations selected by the Board. In no event will the proceeds of the saleof such securities inure to the Company’s benefit.

 

**15.         COST SAVINGS INITIATIVES**

 

On March 1, 2008, inresponse to the adverse credit markets the Company implemented an initial costsaving initiative (the “March 2008 Plan”) and reduced the Company’sheadcount by 13 employees, or approximately 10% of the then current workforce,across a broad range of functions. This resulted in severance expense of $0.3million during the three months ended March 31, 2008. In November 2008,in response to the continued deterioration in market conditions, the Companyimplemented a second cost saving initiative (the “November 2008 Plan”).The November 2008 Plan involved reducing headcount by 24 employees, orapproximately 26% of the then current workforce, reducing bonus compensationand instituting a salary freeze. The compensation payable to those 24 employeesaccounted for approximately 37% of the Company’s annual compensation expense in2008. The November 2008 Plan headcount reductions were largely related tothe fixed income arbitrage trading business and the associated back-officeinfrastructure.

 

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

 
| ** **                         | ** ** | **Employee Severance  Accrual** | ** ** | **Exit Costs  Accrual** | ** ** | **Total** | ** ** |
|------------------------------------|------------|---------------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                         | ** ** | **(In thousands)**              | ** ** |
| Balance  - January 1, 2009    |       | $                               | 1,083      |                    | $          | 175       |       | $ | 1,258 |   |
| Provisions                         |       | 194                             |       | 42                      |       | 236       |       |
| Payments                           |       | (1,245                          | )          | (168                    | )          | (1,413    | )          |
| Balance  - September 30, 2009 |       | $                               | 32         |                    | $          | 49        |       | $ | 81 |   |

 

**16.         SEGMENT REPORTING**

 

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

 

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

 
| ** **                                                     | ** ** | **For the three months ended September 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                                     | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                             | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                                   |       |   |   |   |   |   |   |
| Interest  income                                               |       | $                                                      | 10         |   | $ | 10,829 |   | $ | — |   | $ | 10,839 |   |
| Interest  expense                                              |       | 1,191                                                  |       | 2,675 |   | — |   | 3,866 |   |
| Net  interest (expense) income                                 |       | (1,181                                                 | )          | 8,154 |   | — |   | 6,973 |   |
| Provision  for loan losses                                     |       | —                                                 |       | 4,226 |   | — |   | 4,226 |   |
| Net  interest (expense) income after provision for loan losses |       | (1,181                                                 | )          | 3,928 |   | — |   | 2,747 |   |
| Investment  advisory fees                                      |       | 5,264                                                  |       | — |   | (1,315 | )(1) | 3,949 |   |
| Total  net revenues                                            |       | $                                                      | 4,083      |   | $ | 3,928 |   | $ | (1,315 | ) | $ | 6,696 |   |
| Depreciation  and amortization                                 |       | $                                                      | 1,630      |   | $ | — |   | $ | — |   | $ | 1,630 |   |
| Income  tax expense                                            |       | $                                                      | —     |   | $ | 75 |   | $ | — |   | $ | 75 |   |
| Net  (loss) income                                             |       | $                                                      | (1,142     | ) | $ | 3,066 |   | $ | — |   | $ | 1,924 |   |

 

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| ** **                                                     | ** ** | **For the three months ended September 30, 2008** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                                     | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                             | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                                   |       |   |   |   |   |   |   |
| Interest  income                                               |       | $                                                      | 127        |   | $ | 20,379 |   | $ | — |   | $ | 20,506 |   |
| Interest  expense                                              |       | 1,719                                                  |       | 9,952 |   | — |   | 11,671 |   |
| Net  interest (expense) income                                 |       | (1,592                                                 | )          | 10,427 |   | — |   | 8,835 |   |
| Provision  for loan losses                                     |       | —                                                 |       | 15,459 |   | — |   | 15,459 |   |
| Net  interest (expense) income after provision for loan losses |       | (1,592                                                 | )          | (5,032 | ) | — |   | (6,624 | ) |
| Investment  advisory fees                                      |       | 11,158                                                 |       | — |   | (2,143 | )(1) | 9,015 |   |
| Total  net revenues                                            |       | $                                                      | 9,566      |   | $ | (5,032 | ) | $ | (2,143 | ) | $ | 2,391 |   |
| Depreciation  and amortization                                 |       | $                                                      | 2,498      |   | $ | — |   | $ | — |   | $ | 2,498 |   |
| Income  tax expense (benefit)                                  |       | $                                                      | 8,302      |   | $ | (3,584 | ) | $ | — |   | $ | 4,718 |   |
| Net  loss                                                      |       | $                                                      | (119,183   | ) | $ | (37,700 | ) | $ | — |   | $ | (156,883 | ) |

 
| ** **                                                     | ** ** | **For the nine months ended September 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                                    | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                            | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                                  |       |   |   |   |   |   |   |
| Interest  income                                               |       | $                                                     | 72         |   | $ | 38,647 |   | $ | — |   | $ | 38,719 |   |
| Interest  expense                                              |       | 3,849                                                 |       | 12,682 |   | — |   | 16,531 |   |
| Net  interest (expense) income                                 |       | (3,777                                                | )          | 25,965 |   | — |   | 22,188 |   |
| Provision  for loan losses                                     |       | —                                                |       | 15,452 |   | — |   | 15,452 |   |
| Net  interest (expense) income after provision for loan losses |       | (3,777                                                | )          | 10,513 |   | — |   | 6,736 |   |
| Investment  advisory fees                                      |       | 16,893                                                |       | — |   | (4,198 | )(1) | 12,695 |   |
| Total  net revenues                                            |       | $                                                     | 13,116     |   | $ | 10,513 |   | $ | (4,198 | ) | $ | 19,431 |   |
| Depreciation  and amortization                                 |       | $                                                     | 4,894      |   | $ | — |   | $ | — |   | $ | 4,894 |   |
| Income  tax expense                                            |       | $                                                     | 28         |   | $ | 225 |   | $ | — |   | $ | 253 |   |
| Net  (loss) income                                             |       | $                                                     | (5,047     | ) | $ | 68,416 |   | $ | — |   | $ | 63,369 |   |

 
| ** **           | ** ** | **As of September 30, 2009** | ** ** |
|----------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **(In thousands)**                | ** ** |
| Identifiable  assets |       | $                                 | 49,898     |   | $ | 692,480 |   | $ | (2,246 | )(2) | $ | 740,132 |   |
|                      |            |                                   |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                     | ** ** | **For  the nine months ended September 30, 2008** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In  thousands)**                                    | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                             | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                                   |       |   |   |   |   |   |   |
| Interest  income                                               |       | $                                                      | 624        |   | $ | 103,056 |   | $ | — |   | $ | 103,680 |   |
| Interest  expense                                              |       | 5,273                                                  |       | 66,419 |   | — |   | 71,692 |   |
| Net  interest (expense) income                                 |       | (4,649                                                 | )          | 36,637 |   | — |   | 31,988 |   |
| Provision  for loan losses                                     |       | —                                                 |       | 19,961 |   | — |   | 19,961 |   |
| Net  interest (expense) income after provision for loan losses |       | (4,649                                                 | )          | 16,676 |   | — |   | 12,027 |   |
| Investment  advisory fees                                      |       | 44,018                                                 |       | — |   | (10,525 | )(1) | 33,493 |   |
| Total  net revenues                                            |       | $                                                      | 39,369     |   | $ | 16,676 |   | $ | (10,525 | ) | $ | 45,520 |   |
| Depreciation  and amortization                                 |       | $                                                      | 7,765      |   | $ | — |   | $ | — |   | $ | 7,765 |   |
| Income  tax expense                                            |       | $                                                      | 111        |   | $ | 273 |   | $ | — |   | $ | 384 |   |
| Net  loss                                                      |       | $                                                      | (139,229   | ) | $ | (475,572 | ) | $ | — |   | $ | (614,801 | ) |

 
| ** **           | ** ** | **As  of September 30, 2008** | ** ** |
|----------------------|------------|------------------------------------|------------|
| ** **           | ** ** | **(In  thousands)**                | ** ** |
| Identifiable  assets |       | $                                  | 71,588     |   | $ | 1,150,131 |   | $ | (465 | )(2) | $ | 1,221,254 |   |
|                      |            |                                    |            |  |  |  |  |  |  |  |  |  |  |

 

----

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

 

The Principal Investingsegment results of operations include the financial results of DFR MM CLO forthe three and nine months ended September 30, 2009 and 2008, and thefinancial results of DPLC for the three and nine months ended September 30,2009.  The Principal Investing segmentresults of operations also include the financial results of Market Square CLOfor the three and nine months ended September 30, 2008. On June 30,2009, the Company sold all of its preference shares in Market Square CLO to anunrelated third party in exchange for an upfront payment and a delayed purchaseprice 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, the Companydetermined it was no longer the primary beneficiary of Market Square CLO andtherefore deconsolidated Market Square CLO.  As of September 30,2009, none of the Market 

 

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Square CLO assets,liabilities or equity are included in the Company’s condensed consolidatedbalance sheet; however, all of the financial impacts to the condensedconsolidated statements of operations from the previous consolidation of MarketSquare CLO were recognized through June 30, 2009.

 

**17.  COMMITMENTSAND CONTINGENCIES**

 

***Legal Proceedings***

 

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

 

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

 

***2009 Interim Chairman Compensation Agreement***

 

On March 5, 2009,the Company entered into a letter agreement (the “2009 Rothschild CompensationAgreement”) with Peter H. Rothschild setting forth the fees payable to him forhis services as Interim Chairman of the Board for the year ended December 31,2009. The 2009 Rothschild Compensation Agreement provides for two discretionaryfees, a “Capital Transaction Success Fee” not to exceed $1,000,000 and a “Non-CapitalTransaction Success Fee” not to exceed $500,000, which may be paid if certainspecified conditions are met.   In addition, the 2009 RothschildCompensation Agreement provides for a “Fund Success Fee” of $250,000 relatingto a new investment vehicle, provided the closing of initial capitalcommitments to the investment vehicle occurred on or before June 30, 2009and the total amount of such commitments exceeded $50.0 million.  The FundSuccess Fee was paid on April 17, 2009 as a result of the investmentventure with Pegasus announced on April 14, 2009.

 

***Resolution of Notice of Non-Compliance with NYSE AmexContinued Listing Standard***

 

On April 15, 2009,the Company was notified by the NYSE Amex LLC (the “NYSE Amex”), that it wasnot in compliance with a NYSE Amex continued listing standard applicable to itscommon stock. On June 29, 2009, the Company received notification from theNYSE Amex that the Company had resolved the continued listing deficiencyreferenced in the NYSE Amex’s letter dated April 15, 2009.  TheCompany’s believes DFR’s listing is currently in good standing with the NYSEAmex.

 

***Other Commitments***

 

The Company has aremaining unfunded commitment of $11.0 million to DPLC, which is subject tonumerous conditions, any or all of which may not be satisfied. Pegasus has aliquidation preference related to DPLC which prevents the Company fromreceiving certain distributions from DPLC unless and until Pegasus has receivedan amount equal to its initial capital contributions to DPLC.

 

**18.  SUBSEQUENTEVENTS**

 

In connection with thepreparation of the condensed consolidated financial statements and inaccordance with ASC Topic 855, the Company evaluated subsequent events afterthe balance sheet date of September 30, 2009 through November 9,2009, the date of issuance of the financial statements. The Company had nosubsequent events which required disclosure.

 

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

 

The statements in thisdiscussion regarding the industry outlook and our expectations regarding thefuture performance of our business and the other non-historical statements areforward-looking statements. These forward-looking statements are subject tonumerous risks and uncertainties, including, but not limited to, the risks anduncertainties described in this quarterly report on Form 10-Q, orQuarterly Report, beginning on page 3 under the title “Special NoteRegarding Forward Looking Statements” and in “*Part II— Item 1A. Risk Factors”*  andin our Annual Report on Form 10-K for the fiscal year ended December 31,2008, as filed with the Securities and Exchange Commission on March 16,2009, or our Annual Report,  in “*Part I— Item 1A. Risk Factors.”*   You should read the followingdiscussion together with our condensed consolidated financial statements andnotes thereto included in*“Part I —Item 1. Financial Statements”* of this Quarterly Report. Unlessotherwise noted or the context otherwise requires, we refer to DeerfieldCapital Corp. as “DFR,” to DFR and its subsidiaries as “we,” “us,” “our” or “ourcompany,” to Deerfield & Company LLC, one of our indirect wholly-ownedsubsidiaries, as “Deerfield” and to Deerfield Capital Management LLC, ourformer external manager and another of our indirect wholly-owned subsidiaries,as “DCM.” We refer to our acquisition of Deerfield pursuant to a mergeragreement, dated as of December 17, 2007, among us, DFR Merger Company,LLC (our wholly-owned subsidiary that was merged into Deerfield), Deerfield andTriarc Companies, Inc., or Triarc (as sellers’ representative) by whichDFR Merger Company, LLC was merged with and into Deerfield on December 21,2007 as the “Merger.”

 

**Overview**

 

We are a Marylandcorporation with an Investment Management segment that manages approximately$9.6 billion of client assets as of October 1, 2009, including bank loansand other corporate debt, residential mortgage-backed securities, or RMBS,government securities and asset-backed securities, or ABS. In addition, ourPrincipal Investing segment has an investment portfolio of approximately $620.2million as of September 30, 2009, comprised of fixed income investments,including bank loans and other corporate debt and RMBS. Historically, we hadelected to be taxed as a real estate investment trust, or REIT. However, ourstatus as a REIT terminated in 2008 when we converted to a C corporation tomaximize the use of potential significant tax benefits and provide moreflexibility with respect to future capital investment.

 

We and our subsidiarieshave operated, and intend to continue to operate, in such a way as to beexcluded from registration under the Investment Company Act of 1940, asamended, or 1940 Act. DFR and its wholly-owned subsidiary Deerfield CapitalLLC, or DC LLC, are excluded from registration under the 1940 Act because nomore than 40% of their assets, on an unconsolidated basis, excluding cash andgovernment securities, are investment securities. We intend to continue toqualify for this exclusion by monitoring the value of all our subsidiaries andany investment securities we own to ensure that at all times, no more than 40%of their assets, on an unconsolidated basis, excluding certain items, will beinvestment securities under the 1940 Act.

 

After the close ofbusiness on October 16, 2008, we effected a 1-for-10 reverse stock splitof our common stock. All share and per share amounts throughout this QuarterlyReport have been retroactively restated to reflect the reverse stock split,unless otherwise noted.

 

On April 14, 2009,we announced the formation of Deerfield Pegasus Loan Capital LP, or DPLC, ourinvestment venture with Pegasus Capital Advisors L.P., or Pegasus. Pegasus is a U.S.-based private equity firm.  Pegasus and DFR arecurrently committed to invest $74.0 million and $15.0 million, respectively, inDPLC.  We initially expected such amountsto be invested primarily in corporate bank loans and other senior securedcorporate loans. However, as a result of the rapid recovery of corporate loanprices, the return thresholds we initially expected for DPLC are no longerattainable, and we are currently evaluating other investmentstrategies. DPLC is managed by DCM.  The commitments of each ofPegasus and DFR are subject to numerous conditions, any or all of which may notbe satisfied.  As of September 30, 2009, Pegasus and DFR have funded$20.0 million and $4.0 million, respectively, of such commitments.

 

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

 

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On September 23,2009, DFR and Pegasus Deerfield entered into certain amendments to theWarrants, or the Warrant Amendments, to (i) delay the earliest possiblevesting date of the Warrants from April 9, 2011 to July 9, 2011 and (ii) movethe time period during which the Warrant holder’s average invested capital inDPLC and DPLC’s general partner, DPLC General Partner LLC, or DPLC GP, isrequired to be at least equal to $50.0 million in order for any of the Warrantsto vest back from October 9, 2009 through April 9, 2011 to January 9,2010 through July 9, 2011. As consideration for the Warrant Amendments,Pegasus Deerfield agreed to move the first date on which it can withdraw itscapital contributions from DPLC back by three months to July 1, 2011.

 

In addition, to allowPegasus and DFR to explore a new business opportunity outside of DPLC, we havereleased Pegasus Deerfield from $1.0 million of its initial commitment toinvest $75.0 million in DPLC. We expect to receive a future financial benefitshould this new business opportunity prove to be successful. However, we canprovide no assurance that this business opportunity will be successful or thatwe will receive any such future financial benefit.

 

The Warrants have not yetvested, and no expense associated with the Warrants has been recorded for thethree and nine months ended September 30, 2009.

 

As of September 30,2009 and for the three and nine months ended September 30, 2009 and 2008,we consolidated DFR Middle Market CLO Ltd., or DFR MM CLO, as we are deemed tobe the primary beneficiary of this variable interest entity, or VIE.  Wealso consolidated Market Square CLO Ltd., or Market Square CLO, as of December 31,2008 and for the three and nine months ended September 30, 2008.  On June 30,2009, we sold all of our preference shares in Market Square CLO to an unrelatedthird party in exchange for an upfront payment and a delayed purchase price inthe form of a right to receive a portion of the future distributions, if any,on the preference shares.  As a result of the sale, we determined that weare no longer the primary beneficiary of Market Square CLO and thereforedeconsolidated Market Square CLO.  We are, however, deemed to retain abeneficial interest in the preference shares of Market Square CLO as a resultof the delayed purchase price.  The carrying value of the beneficialinterest was de minimis as of June 30, 2009 and was $1.4 million as of September 30,2009.  As of September 30, 2009, none of the Market Square CLOassets, liabilities or equity are included in our condensed consolidatedbalance sheet; however, all of the financial impacts to our condensedconsolidated statements of operations from our previous consolidation of MarketSquare CLO were recognized through June 30, 2009.  We recognized again on the deconsolidation of Market Square CLO of $29.6 million in ourcondensed consolidated statements of operations for the nine months ended September 30,2009.

 

During the three and ninemonths ended September 30, 2009, we also consolidated DPLC as a result ofour controlling interest therein pursuant to the consolidation guidance inFinancial Accounting Standards Board, or FASB, Accounting StandardsCodification, or ASC, Topic 810 — *Consolidation*,or ASC Topic 810.  We consolidated 100% of the assets and liabilities ofDPLC and DPLC GP, through which we made our investment in DPLC.  We have acontrolling financial interest in DPLC and DPLC GP as a result of our owningmore than 50% of the outstanding voting interests in DPLC GP.  Although weconsolidate 100% of the assets and liabilities and the results of operations ofDPLC and DPLC GP, our maximum exposure to loss on our investment in theseentities is limited to our investment in DPLC GP, which as of September 30,2009 totaled approximately $4.0 million. Pegasus has a liquidation preferencerelated to DPLC which prevents DFR from receiving certain distributions fromDPLC unless and until Pegasus has received an amount equal to its initialcapital contributions to DPLC. Net income (loss) attributable to DFR in ourcondensed consolidated statements of operations excludes the net lossattributable to the noncontrolling interest in DPLC.  We consolidatedassets of $23.8 million and liabilities of $3.2 million related to DPLC asof September 30, 2009.

 

***Our Business***

 

Our business is managedin two operating segments: Investment Management and Principal Investing. OurInvestment Management segment involves earning investment advisory fees formanaging a variety of investment products including collateralized debtobligations, or CDOs, separately managed accounts and other investmentvehicles. Our Principal Investing segment involves maintaining an investmentportfolio comprised primarily of bank loans and other corporate debt, Agency RMBS(as defined below) and non-Agency RMBS. Agency RMBS are backed by mortgageloans and are guaranteed as to principal and interest by federally charteredentities such as the Federal National Mortgage Association, or Fannie Mae, orthe Federal Home Loan Mortgage Corporation, or Freddie Mac, and, in the case ofthe Government National Mortgage Association, or Ginnie Mae, the U.S.government. We refer to these entities as “Agencies” and to RMBS guaranteed orissued by the Agencies 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, typically in middle market companiesacross a range of industries, as “Corporate Loans.”

 

*InvestmentManagement Segment*

 

Our Investment Managementsegment is operated through DCM. DCM manages investment accounts for varioustypes of clients, including separately managed accounts (separate, non-pooledaccounts established by clients), CDOs and other investment vehicles. Exceptfor the separately managed accounts, these clients are collective investmentvehicles that pool the capital contributions of multiple investors, which aretypically financial institutions, such as insurance companies and banks,employee benefits plans and “funds of funds” (investment funds that in turnallocate their assets to a variety of other investment funds). Our teams thatmanage 

 

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these accounts aresupported by various other groups within DCM, such as risk management, systems,accounting, operations and legal. DCM enters into an investment managementagreement with each client, pursuant to which the client grants DCM discretionto purchase and sell securities and other financial instruments.

 

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

 

*Assets Under Management*

 

As of October 1,2009, DCM’s total assets under management, or AUM, was approximately $9.6billion held in 28 CDOs, one other investment vehicle and six separatelymanaged accounts.

 

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

 
| ** **                       | ** ** | **Number of** | ** ** | **AUM as of**            | ** ** |
|----------------------------------|------------|---------------|------------|--------------------------|------------|
| ** **                       | ** ** | **Accounts**  | ** ** | **October 1, 2009** | ** ** |
| ** **                       | ** ** | ** **    | ** ** | **(In thousands)**       | ** ** |
| CDOs  (1):                       |       |          |       |                     |       |
| CLOs                             |       | 12            |       | $                        | 4,164,083  |   |
| Asset-backed  securities         |       | 12            |       | 4,244,704                |       |
| Corporate  bonds                 |       | 4             |       | 833,840                  |       |
| Total  CDOs                      |       | 28            |       | 9,242,627                |       |
| Other  investment vehicle (2)    |       | 1             |       | 22,175                   |       |
| Separately  managed accounts (3) |       | 6             |       | 318,577                  |       |
| Total  AUM (4)                   |       |          |       | $                        | 9,583,379  |   |

 

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| (1) | CDO AUM numbers  generally reflect the aggregate principal or notional balance of the  collateral and, in some cases, the cash balance held by the CDOs and are as  of the date of the last trustee report received for each CDO prior to  October 1, 2009. The AUM for our Euro-denominated CDOs has been  converted into U.S. dollars using the spot rate of exchange on  September 30, 2009. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Other investment  vehicle AUM represents the AUM of DPLC.                                                                                                                                                                                                                                                                                                                                                 |
| (3) | AUM for certain of the  separately managed accounts is a multiple of the capital actually invested in  such account. Management fees for these accounts are paid on this higher AUM  amount.                                                                                                                                                                                                              |
| (4) | Included in Total AUM  is $286.3 million related to DFR MM CLO. DCM manages DFR MM CLO but is not  contractually entitled to receive any management fees so long as 100% of the  equity is held by DC LLC or an affiliate thereof.                                                                                                                                                                        |

 

*PrincipalInvesting Segment*

 

Income from our PrincipalInvesting segment is influenced by four factors: (i) the net spread, ordifference, between the interest income we earn on our investment portfolio andthe cost of our borrowings net of hedging derivatives, (ii) the netrecognized gains and losses, if any, on our investment portfolio, (iii) provisionfor loan losses, if any, and (iv) the volume or aggregate amount of suchinvestments. We use leverage to seek to enhance our returns, which can alsomagnify losses. The cost of borrowings to finance our investments comprises asignificant portion of our operating expenses.

 

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

 
| ** **                                   | ** ** | **September 30, 2009** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | **Carrying**                | ** ** | **% of Total** | ** ** |
| **Principal Investments**                    | ** ** | **Value**                   | ** ** | **Investments** | ** ** |
| ** **                                   | ** ** | **(In thousands)**          | ** ** | ** ** | ** ** |
|                                         |       |                        |       |   |   |
| RMBS                                         |       | $                           | 316,920    |   | 49.2 | % |
| Corporate  leveraged loans:                  |       |                        |       |   |   |
| Loans  held in DFR MM CLO                    |       | 286,540                     |       | 44.5 | % |
| Other  corporate leveraged loans             |       | 9,053                       |       | 1.4 | % |
| Loans  held in DPLC                          |       | 14,807                      |       | 2.3 | % |
| Commercial  real estate loans and securities |       | 9,376                       |       | 1.4 | % |
| Equity  securities                           |       | 4,287                       |       | 0.7 | % |
| Other  investments                           |       | 3,362                       |       | 0.5 | % |
| **Total Investments**                        |       | 644,345                     |       | 100.0 | % |
| Allowance  for loan losses                   |       | (24,131                     | )          |   |   |
| **Net Investments**                          |       | $                           | 620,214    |   |   |   |

 

**OurStrategy**

 

We are focused on growingthe Investment Management segment of our business by launching new investmentproducts that will diversify our revenue streams and take advantage of our corecompetencies of credit analysis and asset management. We intend to makeinvestments in certain of these new investment products. We believe that thegrowth of fee-based income through the management of alternative investmentproducts will provide the most attractive risk-adjusted return oncapital.  On April 14, 2009, we announced DPLC, our investmentventure with Pegasus.  Pegasus and DFR are currently committed to invest$74.0 million and $15.0 million, respectively, in DPLC. DPLC is managed byDCM.  The commitments of each of Pegasus and DFR are subject to numerousconditions, any or all of which may not be satisfied.

 

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

 

We are focused onmanaging our Principal Investing segment by opportunistically selling CorporateLoans held outside of DFR MM CLO and redeploying our capital into otherfee-based strategies. In the near term, we expect to continue to hold our RMBSportfolio both for the net interest income it provides and as a source ofliquidity.

 

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

 

**CharterAmendment**

 

On May 19, 2009, weheld an annual stockholders meeting, or the Annual Meeting, at which ourstockholders approved an amendment to our charter to restrict certainacquisitions and dispositions of our securities and to remove references to ouroperation as a REIT as one of our purposes, or the Charter Amendment. Therestrictions on acquisitions and dispositions of our securities contained inthe Charter Amendment are intended to preserve the benefit of our federal netoperating losses, or NOLs, net capital losses, or NCLs and certain other taxattributes for tax purposes. The Charter Amendment was filed with the MarylandState Department of Assessments and Taxation on May 20, 2009.  In connection with the Charter Amendment, our stockholder rights plan that wasadopted on March 11, 2009 automatically terminated.

 

The Charter Amendment isdesigned to prevent an ownership change, or Ownership Change, as defined inSections 382 and 383 of the Internal Revenue Code of 1986, as amended, or theCode.  Sections 382 and 383 of the Code impose significant limitations onthe ability of a corporation to use its NOLs and NCLs to offset income incircumstances where such corporation has experienced an Ownership Change, andmay also limit a corporation’s ability to use any built-in losses recognizedwithin five years of any Ownership Change. Generally, there is an Ownership Changeif, at any time, one or more 5.0% shareholders (as defined in the Code) haveaggregate increases in their ownership of DFR of more than 50 percentage pointslooking back over the relevant testing period, which can occur as a result ofacquisitions and certain dispositions of common stock by our 5.0% shareholders.

 

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The Charter Amendmentgenerally prohibits any direct or indirect sale, transfer, assignment,exchange, issuance, grant, redemption, repurchase, conveyance, pledge or otherdisposition of shares of our common stock or rights or options to purchase ourcommon stock or any other interests that would be treated as stock under theincome tax regulations promulgated under the Code, if as a result of such sale,transfer, assignment, exchange, issuance, grant, redemption, repurchase,conveyance, pledge or other disposition, any person or group becomes a 5% shareholder(as defined in the Code), which generally includes a person or group thatbeneficially owns 5% or more of the market value of the total outstandingshares of our common stock, or the percentage of our common stock owned by a 5%shareholder (as defined in the Code) would be increased. As a result of theserestrictions, certain transfers of stock by existing 5% shareholders areprohibited. In addition to other exceptions, a person will not be treated asviolating the Charter Amendment as a result of acquiring shares of stock,directly or indirectly, as a result of the issuance of a warrant, the exercisethereof or the transfer or acquisition of such warrant or stock acquiredthereby, where such warrant had first been issued upon approval of our Board ofDirectors, or Board, unless and until the person to whom such warrant wasissued thereafter acquires any stock that is unrelated to the warrant. OurBoard has granted limited exemptions to the Charter Amendment as disclosed inour Current Report on Form 8-K filed with the SEC on May 19, 2009.

 

If our Board determinesthat a transfer would be prohibited, then, upon our written demand, thepurported transferee will transfer the securities that are the subject of theprohibited transfer, or cause such securities to be transferred, to an agentdesignated by our Board. The agent will sell the securities to a buyer orbuyers, which may include us, in one or more arm’s-length transactions thatcomply with the Charter Amendment. If the purported transferee has resold thesecurities before receiving our demand to surrender them to the agent, thepurported transferee will be deemed to have sold the securities for the agentand will be required to transfer to the agent any distributions received withrespect to such securities and any proceeds of the sale of such securities(except for any proceeds which we grant the purported transferee writtenpermission to retain and which do not exceed the amount that the purportedtransferee would have received from the agent if the agent had resold suchsecurities). The proceeds of the sale of any such securities will be appliedfirst to the agent to cover its costs and expenses, second to the purportedtransferee, up to the lesser of the amount paid by the purported transferee forthe securities or the fair market value of the securities at the time of theattempted transfer, and third to one or more charitable organizations selectedby our Board. In no event will the proceeds of the sale of such securitiesinure to our benefit.

 

**Resolutionof Notice of Non-Compliance with NYSE Amex Continued Listing**

 

On April 15, 2009,we were notified by the NYSE Amex LLC, or the NYSE Amex, that we were not incompliance with a NYSE Amex continued listing standard applicable to our commonstock. On June 29, 2009, we received notification from the NYSE Amex thatwe had resolved the continued listing deficiency referenced in the NYSE Amex’sletter dated April 15, 2009.  We believe our listing is currently ingood standing with the NYSE Amex.

 

**Trends**

 

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

 

*Creditmarket dislocation.* The well-publicized disruptions in the financial markets that began in 2007 andescalated throughout 2008 have significantly improved through the third quarterof 2009.   The numerous programs implemented by the U.S. governmentaimed at stabilizing credit markets and improving overall financial systemliquidity show 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 the S&P 500both advancing by 15% during the third quarter of 2009.  Another sign that markets may be resumingmore normal operations was an increased pace of mergers and acquisitions.Further contributing to a sense of returning normalcy was relative stability intreasury yields.  On balance, rates alongthe yield curve moved by 25 bps or less from the beginning to the end of Q3. Thetrailing 100 day volatility on the 10 year Treasury bond declined from 52.6% atJune 30, 2009 to 37.3% by the end of the quarter.  While we certainly cannot predict thelong-term effect that these programs will have on financial markets or ourbusiness, we have observed that the massive liquidity provided by thegovernment via the numerous programs implemented had the effect of raisingprices and lowering risk premiums.

 

*Liquidity.*  A significant portion of theinvestments in our Principal Investing portfolio are financed.  We dependon a variety of financial institutions to provide that financing. Historically, we have financed our RMBS portfolio using repurchase agreements.Events in 2008 caused many financial institutions to change their credit standardsand generally reduced the amount of repurchase agreements available toborrowers, resulting in a decrease in overall market liquidity. This trend hasreduced the number of financial institutions with which we conduct repurchasefinancings and, in 2008, prompted us to sell a significant portion of our RMBSportfolio at a time when we would not otherwise have chosen to do so. Promptedin part by the impact of the government actions noted above, we believe someadditional capacity in repurchase financing is now returning to themarket.  However, if our current lenders are unwilling or unable toprovide us with continued financing and we can not secure financing elsewhere,we could be forced to sell a large portion of our RMBS portfolio at an inopportunetime or on unfavorable terms. Because the majority of our current RMBSportfolio consists of Agency RMBS, we believe that we are better positioned toconvert our investment securities to cash or to negotiate an extended borrowingterm should our lenders reduce the amount of the financing available to us.

 

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*Corporatecredit performance.* Corporate default rates have increased over the past year as the U.S. economyweakened and financial markets deteriorated. As noted above, stock prices haverecently risen, and corporate earnings reports for many companies point toimproving economic conditions.  Although there may be some furthercyclical increase in corporate defaults over the coming months, we expect thestimulus programs and improving economic conditions to begin moderating thepace of such defaults.  If the stimulus packages are not effective inpromoting growth, it is possible that recent signs of improvement will give wayto renewed economic weakness.  A further weakening of the U.S. economywould likely result in further increases in corporate default rates. Such anincrease would likely further reduce the returns associated with certain of ourinvestments, particularly the Corporate Loans held in both our PrincipalInvesting portfolio and in certain of the vehicles managed within ourInvestment Management segment. Increases in defaults could also cause us totrigger certain structural provisions in the CDOs that we own and manage. Thesestructural provisions include, but are not limited to, overcollateralizationrequirements that are meant to protect investors from deterioration in thecredit quality of the underlying collateral pool.

 

*Creditspreads.* Beginning in the second half of 2007, credit markets experienced significantlyhigher yields and wider spreads versus Treasury securities.  For example,the yield spread on the Barclay’s High Yield Bond Index increased from 295basis points over Treasuries at June 30, 2007 to a peak of 1830 basispoints in November of 2008.  The widening of credit spreads evidencedby that index was pervasive and resulted in a decline over that period in thefair value for most of our investments and in the securities we manage, whichresulted in a decline in our book value and a reduction in our AUM. Morerecently, credit spreads have narrowed somewhat as evidenced by the spread onthe Barclay’s High Yield Bond Index falling from 945 basis points as of June 30,2009 to 764 basis points as of September 30, 2009.  This furthernarrowing of spreads has had a positive influence on the value of many of ourinvestments, but may also have the effect of reducing the future attractivenessof such investments and reducing future net interest income.

 

*YieldCurve.* Thedifference in yields offered on similar securities of different maturity(commonly referred to as the yield curve) can have an important influence onour financial results.  Our earnings are derived in part from the ratedifference between the cost of our funding sources (such as repurchaseagreements) and the earning rate of the assets purchased (such as RMBS). To the extent that there is a mismatch in the maturity of our funding sourcesin relation to the assets purchased, we may have exposure to a change in theshape of the yield curve.  Historically, we attempted to limit ourexposure to this risk by engaging in various types of hedging activities suchas the use of interest rate swaps.   Due to current market conditionsand the historically large differential between short term and intermediateterm yields, we are now operating with a larger duration gap and have reducedour hedging activities.  This decision has had the near-term effect ofincreasing the net interest income on our RMBS portfolio.  However, ifshort term yields rise in relation to intermediate term yields (a flattening ofthe yield curve), we would likely experience a reduction in net interestincome.  During the most recent quarter,the yield differential between 6 month treasury bills and 10 year treasurynotes declined slightly from 3.18% to 3.13%.

 

*CDOfinancing and management.*  The reduction in liquidity and widening of credit spreads haveresulted in significant downward pressure on the market values of assetstypically held in and financed by CDOs. These decreased market values, alongwith increased default rates on assets held in CDOs and significant ratingagency downgrades of the collateral underlying certain of our CDOs, have causedour CDOs to trigger certain of their structural provisions and potentiallyevents of default, either of which reduce our management fees and our AUM. See “*Results of Operations — Investment Management**Segment* —*CDOs*”for further information.

 

We anticipate that, givencurrent market conditions, it will be significantly more difficult to createnew CDOs in the near term than it has been in the past. Conditions in thecredit markets have led to a significant reduction in the number of bankswilling to provide financing to warehouse collateral and, in cases wherefinancing is available, those banks are charging significantly higher fees andinterest rates to warehouse collateral and are requiring more capital fromborrowers.  Similarly, potentialinvestors are demanding significantly higher interest rates on CDO liabilities.To the extent that we are successful in creating new CDOs, the management feeswe earn from managing those CDOs may be significantly lower. This maynegatively affect our ability to grow our AUM and revenue.

 

During 2008 and 2009, theCDO management market experienced some consolidation, evidenced by CDOmanagement contracts being transferred to or acquired by other investmentmanagers. On July 17, 2008, we acquired the management contract for RobecoCDO, and, on February 11, 2009, we assumed the management contract forMayfair Euro CDO. We expect this consolidation trend to continue in the nearterm, and we continue to pursue the acquisition and assumption of additionalmanagement contracts.

 

*MarketEnvironment.*  Inresponse to a rapidly deteriorating economic and credit environment, theFederal Reserve lowered the targeted Federal Funds rate from 4.25% to 0.25%during 2008. As a result, the yield curve steepened, with the yield on thethree-month U.S. Treasury bill decreasing by 316 basis points, whilethe yield on the five-year U.S. Treasury note decreased by only189 basis points.  During the first six months of 2009, the shape ofthe yield curve steepened further with short yields remaining relatively stablewhile yields on intermediate maturities experienced marked increases. During this period, the yield on the three-month U.S. Treasury bill increasedfrom 11 basis points to a yield of 19 basis points, while the yield on thefive-year U.S. Treasury note increased by 100 basis points, from 1.55% to a yieldof 2.54%. However, since the end of the second quarter the spread between thethree month Treasury bill and the five-year Treasury note narrowed slightlyfrom 2.36% to 2.20%.   Such a decrease inthe spread 

 

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between short and longermaturities generally results in a decrease in our net interest income on ourRMBS, as the financing of our RMBS is usually shorter in term than the fixedrate period of our RMBS, which is heavily weighted towards hybrid adjustablerate RMBS. Conversely, if the curve spread increased, our net interest incomewould likely increase.

 

*Valuationof investments.*  Fewerfinancing options and tighter lending standards had the wide-spread effect offorcing investors to offer for sale a significant amount of investment assetsunder distressed market circumstances. This increase in investment assets forsale, together with investors’ diminished confidence in their ability to assessthe quality of credit-sensitive investments, caused significant pricevolatility in previously stable asset classes. As a result, the valuationprocess for certain types of investments has become more uncertain and subjective,and prices obtained through such process may not necessarily represent what wewould receive in an actual sale of a given investment.

 

**CriticalAccounting Policies**

 

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

 

*RecentAccounting Updates*

 

In December 2007,the FASB issued amendments to ASC Topic 810 which established accounting andreporting standards for the noncontrolling interest in a subsidiary and for thedeconsolidation of a subsidiary.  During the three and nine months ended September 30,2009, we applied the amendments to ASC Topic 810 to the consolidation ofDPLC.  In addition, we applied theamendments to ASC Topic 810 to the deconsolidation of Market Square CLO duringthe nine months ended September 30, 2009.

 

In February 2008,the FASB issued amendments to ASC Topic 860 — *Transfersand Servicing*, or ASC Topic 860, in order to address certainsituations where assets purchased from a particular counterparty and financedthrough a repurchase agreement with the same counterparty can be considered andaccounted for as separate transactions. Historically, we recorded such assetsand the related financing on a gross basis in the condensed consolidatedbalance sheet and the corresponding interest income and interest expense in ourcondensed consolidated statements of operations. ASC Topic 860 assumes that aninitial transfer of a financial asset and a repurchase financing are consideredpart of the same arrangement, or a linked transaction. However, if certaincriteria are met, the initial transfer and repurchase financing are not treatedas a linked transaction but rather be evaluated separately under ASC Topic 860.We adopted the amendments to ASC Topic 860 on January 1, 2009, and theadoption has had no impact on our condensed consolidated financial statementsas no linked transactions have occurred since adoption.

 

In March 2008, theFASB issued amendments to ASC Topic 815 — *Derivatives and Hedging*,or ASC Topic 815. The amendments to ASC Topic 815 require qualitativedisclosures regarding objectives and strategies for using derivatives,quantitative disclosures regarding fair value amounts of gains and losses onderivative instruments and disclosures regarding credit-risk-related contingentfeatures in derivative contracts. We adopted the amendments to ASC Topic 815and included the required disclosures in our condensed consolidated financialstatements in this Quarterly Report.

 

In June 2008, theFASB issued amendments to ASC Topic 260 — *Earnings Per Share*,or ASC Topic 260.  The amendments to ASCTopic 260 address whether instruments granted in share-based paymenttransactions are participating securities prior to vesting and need to beincluded in the earnings allocation in computing earnings per share under thetwo-class method. We adopted the amendments to ASC Topic 260 on January 1,2009, and the adoption had no impact on our condensed consolidated financialstatements.

 

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In April 2009, theFASB issued amendments to ASC Topic 820 — *Fair Value Measurementsand Disclosures*, or ASC Topic 825.  The amendments to ASC Topic825 were issued to provide additional guidance for estimating fair value whenthe volume and level of activity have significantly decreased and to provideguidance on identifying circumstances that indicate a transaction is notorderly.  In addition, the amendments to ASC Topic 825 require an entityto disclose, in interim and annual periods, the inputs and valuation techniquesused to measure fair value and provide a discussion of changes in valuationtechniques and related inputs, if any, during the period.  The amendmentsto ASC Topic 825 also require disclosures regarding fair value of financialinstruments for interim and annual reporting periods. We adopted the amendmentsto ASC Topic 825 and considered this guidance in determining and disclosing thefair values included in our condensed consolidated financial statements andincluded the required disclosures in our notes to our condensed consolidatedfinancial statements in this Quarterly Report.

 

In April 2009, theFASB issued amendments to ASC Topic 320 — *Investments — Debt andEquity Securities*, or ASC Topic 320.  The amendments to ASCTopic 320 were issued to amend the other-than-temporary impairment guidance inGAAP for debt securities to make the guidance more operational and to improvethe presentation and disclosure of other-than-temporary impairments on debt andequity securities in the financial statements.  The amendments to ASCTopic 320 do not amend existing recognition and measurement guidance related toother-than-temporary impairments of equity securities.  We adopted theamendments to ASC Topic 320 in the preparation of our condensed consolidatedfinancial statements in this Quarterly Report.

 

In May 2009, theFASB issued amendments to ASC Topic 855 — *Subsequent Events*,or ASC Topic 855.  The amendments to ASC Topic 855 establish generalstandards of accounting for, and disclosure of, events that occur after thebalance sheet date but before financial statements are issued or are availableto be issued.  In particular, the amendments set forth: (i) theperiod after the balance sheet date during which management of a reportingentity should evaluate events or transactions that may occur for potentialrecognition or disclosure in the financial statements, (ii) thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements and (iii) thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date.  We adopted the amendments to ASCTopic 855 and included the required disclosures in our notes to the condensedconsolidated financial statements in this Quarterly Report.

 

In June 2009,the FASB issued Statement of Financial Accounting Standards, or SFAS, No. 166,*Accounting for Transfers of Financial Assets — anamendment of FASB Statement No. 140*, or SFAS No. 166. This statement was issued to address concerns about the previously existingguidance governing transfers of financial assets.  SFAS No. 166provides clarification concerning measuring whether a transferor and all of theentities included in the transferor’s financial statements have surrenderedcontrol over transferred financial assets and states that a determination mustconsider the transferor’s continuing involvements in the transferred financialassets.  In addition, this statement removes the concept of a qualifyingspecial-purpose entity from SFAS No. 140 and removes the exception fromapplying FASB Interpretation No. 46 (revised 2004),*Consolidation of Variable Interest Entities*,or FIN 46(R), to qualifying special-purpose entities.  SFAS No. 166is effective for transfers of financial assets that occur during our interimand annual reporting periods that begin after November 15, 2009.  Weare currently evaluating the effects that SFAS No. 166 will have on ourcondensed consolidated financial statements and disclosures included in thosecondensed consolidated financial statements.

 

In June 2009, theFASB issued SFAS No. 167,*Amendments toFASB Interpretation No. 46(R)*, or SFAS No. 167.  Thisstatement was issued to address concerns about financial statement preparers’ability to structure transactions to avoid consolidation, balanced with theneed for more relevant, timely and reliable information about an entity’sinvolvement in a VIE.  This statement requires an enterprise to perform ananalysis to determine whether the enterprise’s variable interest or interestsgive it a controlling financial interest in a VIE.  This analysisidentifies the primary beneficiary of a VIE as the enterprise that has both thepower to direct the activities of a VIE that most significantly impact theentity’s economic performance and the obligation to absorb losses of the entitythat could potentially be significant to the VIE or the right to receivebenefits from the entity that could potentially be significant to the VIE.Additionally, an enterprise is required to assess whether it has an implicitfinancial responsibility to ensure that a VIE operates as designed whendetermining whether it has the power to direct the activities of the VIE thatmost significantly impacts the entity’s economic performance. * * SFAS No. 167 also amends FIN46(R) to eliminate the quantitative approach to determining the primarybeneficiary of a VIE and requires ongoing reassessments of VIE status. SFAS No. 167 is effective for our interim and annual reporting periodsthat begin after November 15, 2009.  We are currently evaluating theeffects that SFAS No. 167 will have on our condensed consolidatedfinancial statements and disclosures included in those condensed consolidatedfinancial statements. Our initial conclusion, based on current guidance, isthat a significant number of the CDOs that we manage would need to beconsolidated as a result of the adoption of SFAS No. 167. We are not yetable to finalize our assessment because the FASB is currently discussingpotential exemptions, deferrals and/or modifications to the application of thisrule for certain investment managers.

 

In June 2009, theFASB issued amendments to ASC Topic 105 — *Generally AcceptedAccounting Principles*, or ASC Topic 105, to establish the FASBAccounting Standards Codification, or the Codification.  The Codification is now the single source ofauthoritative nongovernmental U.S. GAAP. Rules and interpretive releasesof the SEC under authority of federal securities laws are also sources ofauthoritative GAAP for SEC registrants. All existing accounting standards aresuperseded as described in the amendments to ASC Topic 105. All otheraccounting literature not included in the Codification is nonauthoritative. Weadopted the amendments to ASC Topic 105 and have included the appropriatereferences to the Codification within the disclosures included in thisQuarterly Report.

 

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In August 2009, theFASB issued Accounting Standards Update, or ASU, No. 2009-05 — *Fair Value Measurements and Disclosures, ASC Topic 820 — MeasuringLiabilities at Fair Value*, or ASU 2009-05.  ASU 2009-05 provides clarification andguidance with respect to the estimation of the fair value of liabilities incircumstances where a quoted price in an active market for an identicalliability is not available. A reporting entity is required to measure fair valueusing one of the following techniques: (i) a valuation technique that usesthe quoted price of the identical liability when traded as an asset, (ii) avaluation technique that uses quoted prices for similar liabilities or similarliabilities when traded as assets or (iii) another valuation techniquethat is consistent with the ASC Topic 820. ASU 2009-05 also clarifies that, when estimating the fair value of aliability, a reporting entity is not required to include a separate input oradjustment to other inputs relating to the existence of a restriction thatprevents the transfer of the liability. We adopted ASU 2009-05 and have taken this guidance into account indetermining the estimated fair values for our liabilities presented in therequired disclosures in our notes to the condensed consolidated financialstatements in this Quarterly Report.

 

**FinancialCondition**

 

The following tablesummarizes the carrying value of our investment portfolio by balance sheetclassification as of September 30, 2009:

 
| ** **                                       | ** ** | **Investments at** | ** ** | **Other**       | ** ** | **Loans Held** | ** ** | **Loans Held**     | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-----------------|------------|----------------|------------|--------------------|------------|------------|------------|
| **Security Description**                         | ** ** | **Fair Value**     | ** ** | **Investments** | ** ** | **For Sale**   | ** ** | **For Investment** | ** ** | **Total**  | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** |
| RMBS                                             |       | $                  | 316,920    |            | $          | —         |       | $                  | —     |       | $          | — |   | $ | 316,920 |   |
| Corporate  leveraged loans:                      |       |               |       |            |       |           |       |               |       |       |       |
| Loans  held in DFR MM CLO (1)                    |       | —             |       | —          |       | —         |       | 286,540            |       | 286,540    |       |
| Other  corporate leveraged loans                 |       | —             |       | —          |       | 9,053          |       | —             |       | 9,053      |       |
| Loans  held in DPLC                              |       | 14,807             |       | —          |       | —         |       | —             |       | 14,807     |       |
| Commercial  real estate loans and securities (2) |       | —             |       | —          |       | —         |       | 9,376              |       | 9,376      |       |
| Equity  securities                               |       | —             |       | 4,287           |       | —         |       | —             |       | 4,287      |       |
| Other  investments                               |       | 4,443              |       | —          |       | —         |       | —             |       | 4,443      |       |
| Total  invested assets                           |       | $                  | 336,170    |            | $          | 4,287          |       | $                  | 9,053      |       | 295,916    |   | 645,426 |   |
|                                             |       |               |       |            |       |           |       |               |       |       |       |
| Allowance  for loan losses                       |       |               |       |            |       |           |       | (24,131            | )          | (24,131    | )          |
|                                             |       |               |       |            |       |           |       |               |       |       |       |
|                                             |       |               |       |            |       |           |       | $                  | 271,785    |       | $          | 621,295 |   |

 

----

| (1) | Loans held in DFR MM CLO  classified as loans held for investment are reported gross of the  $20.0 million allowance for loan losses as of September 30, 2009.    |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Commercial real estate  loans classified as loans held for investment are reported gross of the  $4.1 million allowance for loan losses as of September 30, 2009. |

 

***Residential Mortgage-Backed Securities***

 

As of September 30,2009, our Agency RMBS and non-Agency RMBS portfolios decreased to a fair valueof $314.0 million and $2.9 million, respectively, from$342.4 million and $5.4 million, respectively, as of December 31,2008.  For the three and nine months ended September 30, 2009, we hadnet purchases of $24.3 million and $11.5 million of RMBS, respectively, andreceived RMBS principal paydowns of $18.2 million and $48.2 million,respectively.

 

As of September 30,2009, our RMBS portfolio had a net amortized cost of 101.25% of its faceamount.  As of September 30, 2009 and 2008, we had unamortized netpremium of $4.0 million and unamortized net discount of $0.7 million, respectively,included in the cost basis of our RMBS portfolio. As of September 30, 2009and 2008, the current weighted average life of the portfolio was 7.2 yearsand 5.8 years, respectively, which represents the average number of yearsfor which each dollar of unpaid principal remains outstanding.

 

Net portfolio duration,which is the difference between the duration of the RMBS portfolio and theduration of repurchase agreements adjusted for the effects of our interest rateswap portfolio, was 1.8 years as of September 30, 2009 based onmodel-driven modified duration results. However, based on actual pricemovements observed in the market, we believe the empirical duration issignificantly lower. In order to fully assess the possible impact of a changein interest rates on the RMBS portfolio, one should consider not only theduration, but also the portfolio’s leverage and spread risk.

 

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The following tabledetails our RMBS holdings as of September 30, 2009:

 
| ** **                        | ** ** | ** **          | ** ** | ** **      | ** ** | **Weighted  Average** | ** ** |
|-----------------------------------|------------|---------------------|------------|-----------------|------------|-----------------------|------------|
| ** **                        | ** ** | ** **          | ** ** | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | **Contractual** | ** ** | **Constant** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Par**             | ** ** | **Estimated**   | ** ** | ** **            | ** ** | **Months  to** | ** ** | **Yield  to** | ** ** | **Maturity** | ** ** | **Prepayment** | ** ** | **Modified** | ** ** |
| **Security Description**          | ** ** | **Amount**          | ** ** | **Fair  Value** | ** ** | **Coupon**            | ** ** | **Reset  (1)** | ** ** | **Maturity** | ** ** | **(Month/Year)** | ** ** | **Rate  (2)** | ** ** | **Duration  (3)** | ** ** |
| ** **                        | ** ** | **(In  thousands)** | ** ** | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hybrid  Adjustable Rate RMBS:     | ** ** | ** **          | ** ** | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Rate  reset in 1 year or less     |       | $                   | 159,720    |            | $          | 163,806               |       | 4.70 | % | 8 |   | 2.37 | % | 02/35 |   | 9.2 |   | 1.1 |   |
| Rate  reset in 1 to 3 years       |       | 131,217             |       | 137,676         |       | 5.42                  | %          | 28 |   | 2.65 | % | 05/36 |   | 10.2 |   | 1.7 |   |
| Rate  reset in 5 to 7 years       |       | 23,145              |       | 11,725          |       | 5.10                  | %          | 75 |   | 46.82 | % | 10/35 |   | 16.5 |   | 12.5 |   |
| Fixed  Rate RMBS:                 |       |                |       |            |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| 30  year                          |       | 10,157              |       | 3,713           |       | 6.14                  | %          | n/a |   | 113.13 | % | 02/35 |   | 26.9 |   | 5.4 |   |
| Total  hybrid and fixed rate RMBS |       | $                   | 324,239    |            | $          | 316,920               |       |   |   |   |   |   |   |   |   |   |   |   |   |

 

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| (1) | Represents number of  months before conversion to floating rate.                                                                                                                                                                                                        |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Constant prepayment  rate refers to the expected average annualized percentage rate of  principal prepayments over the remaining life of the security. The  values represented in this table are estimates only and the results of a  third party financial model. |
| (3) | Modified duration  represents the approximate percentage change in fair value per 100 basis  point change in interest rates.                                                                                                                                       |

n/a —not applicable

 

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

 

The constant prepaymentrate, or CPR, attempts to predict the average annualized percentage rate ofprincipal prepayments over the remaining life of the security. As interestrates rise, the rate of refinancing typically declines, which we believe mayresult in lower rates of prepayment and, as a result, a lower portfolio CPR.

 

As of September 30,2009, the mortgages underlying our hybrid adjustable-rate RMBS had fixedinterest rates for a weighted average period of approximately 19 monthsafter which time the interest rates reset and become adjustable. The averagelength of time until contractual maturity of those mortgages was approximately26 years from date of issuance as of September 30, 2009.

 

After the reset date,interest rates on our hybrid adjustable-rate RMBS float based on spreads overvarious LIBOR and U.S. Treasury indices. These interest rates are subjectto caps that limit the amount the applicable interest rate can increase duringany year, known as an annual cap, and through the maturity of the applicablesecurity, known as a lifetime cap. As of September 30, 2009, the weightedaverage lifetime rate cap for the portfolio was 10.3%, the weighted averagemaximum increase in the first year that the rates are adjustable, or initialcap, was 4.7% and the weighted average maximum annual increase for yearssubsequent to the first year was 1.95%.

 

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

 
| ** **                                       | ** ** | ** **         | ** ** | ** **     | ** ** |
|--------------------------------------------------|------------|--------------------|------------|----------------|------------|
| ** **                                       | ** ** | **Amortized**      | ** ** | **Estimated**  | ** ** |
| **Weighted Average Life**                        | ** ** | **Cost**           | ** ** | **Fair Value** | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** |
| Greater  than one year and less than five years  |       | $                  | 32,456     |           | $          | 15,438 |   |
| Greater  than five years and less than ten years |       | 289,504            |       | 295,068        |       |
| Greater  than ten years                          |       | 6,337              |       | 6,414          |       |
| Total                                            |       | $                  | 328,297    |           | $          | 316,920 |   |

 

The weighted averagelives in the table above are primarily based on a prepayment model thatconsiders current yields, forward yields, the slope of the yield curve, currentmortgage rates and the contractual rate of the outstanding loans, the loan’sage, margin and volatility. Most of the data used in this model is providedthrough subscription-based financial information services. Weighted averagelife is an estimate of how many years it will take to pay half of theoutstanding principal.  Actual lives of RMBS are generally shorter thanstated contractual maturities, are affected by the contractual maturities ofthe underlying mortgages, periodic payments of principal and prepayments ofprincipal and differ materially from those set forth above.

 

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***Loans***

 

The following summarizesour loan portfolio, by loan classification, as of September 30, 2009:

 
| ** **                        | ** ** | **Carrying Value** | ** ** |
|-----------------------------------|------------|--------------------|------------|
| ** **                        | ** ** | **Investments at** | ** ** | **Loans Held** | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Type of Loan**                  | ** ** | **Fair Value**     | ** ** | **for Sale (1)** | ** ** | **for Investment** | ** ** | **Total** | ** ** |
| ** **                        | ** ** | **(In thousands)** | ** ** |
| Corporate  leveraged loans:       |       |               |       |   |   |   |   |   |   |
| Loans  held in DFR MM CLO (2)     |       | $                  | —     |   | $ | — |   | $ | 286,540 |   | $ | 286,540 |   |
| Other  corporate leveraged loans  |       | —             |       | 9,053 |   | — |   | 9,053 |   |
| Loans  held in DPLC (3)           |       | 14,807             |       | — |   | — |   | 14,807 |   |
| Commercial  real estate loans (4) |       | —             |       | — |   | 9,376 |   | 9,376 |   |
|                              |       | $                  | 14,807     |   | $ | 9,053 |   | 295,916 |   | 319,776 |   |
| Allowance  for loan losses        |       |               |       |   |   | (24,131 | ) | (24,131 | ) |
|                              |       |               |       |   |   | $ | 271,785 |   | $ | 295,645 |   |

 

----

| (1) | Carrying value of loans  held for sale is lower of cost or estimated fair value.                                                       |
|-----|----------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Loans held in DFR MM  CLO classified as loans held for investment reported gross of  $20.0 million allowance for loan losses.     |
| (3) | Loans held in DPLC are  syndicated bank loans.  We elected to record these loans at fair value  in accordance with ASC Topic 825. |
| (4) | Commercial real estate  loans classified as loans held for investment reported gross of  $4.1 million allowance for loan losses.  |

 

The following summarizesour allowance for loan losses as of September 30, 2009:

 
| ** **                    | ** ** | **Number**   | ** ** | **Par**            | ** ** | **Allowance**       | ** ** |
|-------------------------------|------------|--------------|------------|--------------------|------------|---------------------|------------|
| **Type of Loan**              | ** ** | **of Loans** | ** ** | **Value**          | ** ** | **for Loan Losses** | ** ** |
| ** **                    | ** ** | ** **   | ** ** | **(In thousands)** | ** ** |
| Loans  held in DFR MM CLO     |       | 5            |       | $                  | 30,536     |                | $          | 20,037 |   |
| Commercial  real estate loans |       | 3            |       | 8,058              |       | 4,094               |       |
| Total                         |       | 8            |       | $                  | 38,594     |                | $          | 24,131 |   |

 

We did not recognize$0.9 million and $2.8 million, respectively, of interest income earned,but not yet received, on loans held for investment for the three and ninemonths ended September 30, 2009. In addition, we did not recognize$2.0 million and $5.6 million, respectively, of interest income earned,but not yet received, on loans held for sale for the three and nine monthsended September 30, 2009.

 

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

 

DFR MM CLO is a VIE underASC Topic 810. We are the primary beneficiary of the VIE, causing us toconsolidate the entity. We own 100% of the equity interests, issued assubordinated notes and ordinary shares, in DFR MM CLO, which we purchased for$50.0 million. We also purchased all of the “BBB/Baa2” rated notes of DFRMM CLO for $19.0 million. As of September 30, 2009, DFR MM CLO had$302.5 million of loans outstanding, with a carrying value of$286.5 million, which is included in loans on the condensed consolidatedbalance sheet, reduced by an allowance for loan losses of $20.0 million.As of September 30, 2009, DFR MM CLO has restricted cash and cashequivalents of $11.4 million, which are generally utilized to purchaseadditional loans and pay distributions to debt and equity holders, and$222.0 million of notes payable to third party investors, which isincluded in long term debt. The weighted average coupon on the loan portfoliowas 6.43%, and the weighted average contractual maturity of the loanportfolio was 4.2 years as of September 30, 2009. DFR MM CLO is abankruptcy remote entity, and, although we consolidate 100% of the assets andliabilities of DFR MM CLO, our maximum exposure to loss on our investment inDFR MM CLO is limited to our initial investment of $69.0 million. As of September 30,2009, we have received distributions from DFR MM CLO equal to$26.7 million since its inception.

 

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

 
| **Type of Loan**           | ** ** | **September 30, 2009** | ** **    |
|----------------------------|------------|-----------------------------|---------------|
| ** **                 | ** ** | **(In thousands)**          | ** **    |
| First  lien secured        |       | $                           | 133,432       | (1) |
| Second  lien secured       |       | 139,503                     | (2)           |
| Mezzanine                  |       | 13,605                      |          |
| ** **                 | ** ** | 286,540                     | ** **    |
| Allowance  for loan losses |       | (20,037                     | )             |
| ** **                 | ** ** | $                           |  266,503 | ** ** |

 

----

(1) Presentedgross of $10.6 million allowance for loan losses.

(2) Presentedgross of $9.4 million allowance for loan losses.

 

***Loans Held in DPLC***

 

DPLC is a bankruptcyremote entity that we are required to consolidate pursuant to ASC Topic 810 asa result of our controlling interest therein. Although we consolidate 100%of the assets and liabilities of DPLC, our maximum exposure to loss on ourinvestment in this entity is limited to our investment in the entity, which, asof September 30, 2009, totaled approximately $4.0 million. As of September 30,2009, DPLC had $15.7 million of loans outstanding, with an estimated fairvalue of $14.8 million, which is included in investments at fair value onthe condensed consolidated balance sheet. We elected to record allinvestments held in DPLC at fair value in accordance with ASC Topic 825. As of September 30, 2009, DPLC had $8.0 million of restricted cashand cash equivalents, which are generally utilized to purchase additional loansand pay expenses. The weighted average coupon on the DPLC loan portfolio was5.39% and the weighted average contractual maturity of the loan portfolio was4.27 years as of September 30, 2009.

 

***Other Corporate Leveraged Loans***

 

The following tablesummarizes the carrying value of our other corporate leveraged loan portfolio:

 
| **Type of Loan**     | ** ** | **September 30, 2009** | ** **  |
|----------------------|------------|-----------------------------|-------------|
| ** **           | ** ** | **(In thousands)**          | ** **  |
| First  lien secured  |       | $                           | 1,841       |   |
| Second  lien secured |       | 503                         |        |
| Mezzanine            |       | 320                         |        |
| Holding  company     |       | 6,389                       |        |
|                 |       | $                           |  9,053 |   |

 

We had other corporateleveraged loans totaling $9.1 million classified as loans held for sale on thecondensed consolidated balance sheet as of September 30, 2009. Thecarrying value of loans held for sale is lower of cost or fair value.  The weighted average coupon on our othercorporate leveraged loans was 1.88% as of September 30, 2009.  We had performing loans with a par value anda lower of cost or fair value of $7.5 million and $2.2 million, respectively,with a weighted average coupon of 12.32% as of September 30, 2009.

 

During the year ended December 31,2008, we began actively seeking to sell all of the other corporate leveragedloans held in our alternative asset revolving warehouse funding facility withinWachovia Capital Markets, LLC, or the Wachovia Facility, as we triggered anacknowledged termination event thereunder on November 30, 2008. We sold asignificant portion of the loans held within the Wachovia Facility during theyear ended December 31, 2008 and transferred all loans held within theWachovia Facility from loans held for investment to loans held for sale. During the three months ended March 31, 2009, we sold loans held withinthe Wachovia Facility with a par value of $31.5 million for $10.8 million, netof interest of $0.2 million.  We realized a loss of $6.2 million reported innet gain (loss) on loans in the condensed consolidated statements of operationsduring the three months ended March 31, 2009 as a result of thesesales.  The Wachovia Facility was fullyrepaid and all of our obligations thereunder were satisfied during the thirdquarter.

 

***Commercial Real Estate Loans***

 

As of September 30,2009, we held four commercial real estate loans with a carrying value of $9.4million, which is included in loans on the condensed consolidated balancesheet, reduced by an allowance for loan losses of $4.1 million.

 

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***Derivatives and Hedging***

 

The following table is asummary of our derivative instruments as of September 30, 2009:

 
| ** **             | ** ** | ** ** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|------------------------|------------|------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **             | ** ** | **Count**  | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **             | ** ** | ** ** | ** ** | **(In thousands)** | ** ** |
| Interest  rate swaps   |       | 2          |       | $                  | 30,000     |       | $          | —          |       | $                 | 761        |   | $ | (761 | ) |
| Interest  rate cap (1) |       | 1          |       | 40,000             |       | —     |       | 71              |       | (71               | )          |
| Warrants               |       | 2          |       | n/a                |       | 74         |       | —          |       | 74                |       |
|                   |       | 5          |       | $                  | 70,000     |       | $          | 74              |       | $                 | 832        |   | $ | (758 | ) |

 

----

(1) The interest rate cap is held in DFR MM CLO.

n/a —not applicable

 

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

 

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

 

**Resultsof Operations**

 

The following sectionprovides a comparative discussion of our condensed consolidated results ofoperations as of and for the three months and nine months ended September 30,2009 and 2008.

 

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***Summary***

 

The following tablesummarizes selected historical consolidated financial information:

 
| ** **                                                                     | ** ** | **Three  Months Ended September 30,**    | ** ** | **Nine  Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                     | ** ** | **2009**                                      | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                     | ** ** | **(In  millions, except for per share data)** | ** ** |
| ** **                                                                     | ** ** | ** **                                    | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Consolidated Statements of Operations Data:**                                |       |                                          |       |                                      |       |   |   |   |   |
| Net  interest income                                                           |       | $                                             | 7.0        |                                      | $          | 8.8 |   | $ | 21.2 |   | $ | 32.0 |   |
| Net  interest income (expense) after provision for loan losses                 |       | $                                             | 2.7        |                                      | $          | (6.6 | ) | $ | 6.7 |   | $ | 12.0 |   |
| Investment  advisory fees                                                      |       | $                                             | 3.9        |                                      | $          | 9.0 |   | $ | 12.7 |   | $ | 33.5 |   |
| Total  expenses                                                                |       | $                                             | 7.7        |                                      | $          | 122.8 |   | $ | 28.0 |   | $ | 183.8 |   |
| Net  other income and gain (loss)                                              |       | $                                             | 3.0        |                                      | $          | (31.8 | ) | $ | 72.2 |   | $ | (476.1 | ) |
| Net  income (loss)                                                             |       | $                                             | 1.9        |                                      | $          | (156.9 | ) | $ | 63.4 |   | $ | (614.8 | ) |
| Net  income (loss) attributable to common stockholders                         |       | $                                             | 1.9        |                                      | $          | (156.9 | ) | $ | 63.4 |   | $ | (617.2 | ) |
| Net  (income) loss attributable to noncontrolling interest                     |       | $                                             | (0.1       | )                                         | $          | — |   | $ | 2.9 |   | $ | — |   |
| Net  income (loss) attributable to Deerfield Capital Corp.                     |       | $                                             | 1.8        |                                      | $          | (156.9 | ) | $ | 66.2 |   | $ | (617.2 | ) |
| Net  income (loss) attributable to Deerfield Capital Corp. per share - diluted |       | $                                             | 0.27       |                                      | $          | (22.81 | ) | $ | 9.84 |   | $ | (95.89 | ) |
| Core  earnings (1)                                                             |       | $                                             | 5.2        |                                      | $          | 7.9 |   | $ | 15.8 |   | $ | 29.0 |   |
| Core  earnings per share - diluted (1)                                         |       | $                                             | 0.77       |                                      | $          | 1.14 |   | $ | 2.34 |   | $ | 4.51 |   |
|                                                                           |       |                                          |       |                                      |       |   |   |   |   |
|                                                                           | ** ** | **As  of September 30,**                 | ** ** | ** **                                | ** ** | ** ** | ** ** |
|                                                                           | ** ** | **2009**                                      | ** ** | **2008**                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                     | ** ** | **(In  millions, except for per share data)** | ** ** | ** **                                | ** ** | ** ** | ** ** |
| **Consolidated Balance Sheet Data:**                                           |       |                                          |       |                                      |       |   |   |   |   |
| Residential  mortgage-backed securities                                        |       | $                                             | 316.9      |                                      | $          | 414.5 |   |   |   |   |   |
| Total  assets                                                                  |       | $                                             | 740.1      |                                      | $          | 1,221.3 |   |   |   |   |   |
| Repurchase  agreements                                                         |       | $                                             | 306.3      |                                      | $          | 383.6 |   |   |   |   |   |
| Long  term debt:                                                               |       |                                          |       |                                      |       |   |   |   |   |
| Recourse:                                                                      |       |                                          |       |                                      |       |   |   |   |   |
| Trust  preferred securities                                                    |       | $                                             | 123.7      |                                      | $          | 123.7 |   |   |   |   |   |
| Series A  and Series B Notes                                         |       | $                                             | 72.2       |                                      | $          | 71.6 |   |   |   |   |   |
| Non-Recourse:                                                                  |       |                                          |       |                                      |       |   |   |   |   |
| Wachovia  Facility                                                             |       | $                                             | —     |                                      | $          | 34.1 |   |   |   |   |   |
| DFR  MM CLO                                                                    |       | $                                             | 222.0      |                                      | $          | 231.0 |   |   |   |   |   |
| Market  Square CLO                                                             |       | $                                             | —     |                                      | $          | 276.0 |   |   |   |   |   |
| Deerfield  Capital Corp. stockholders’ (deficit) equity                   |       | $                                             | (11.4      | )                                         | $          | 63.4 |   |   |   |   |   |
| Total  stockholders’ equity                                               |       | $                                             | 5.9        |                                      | $          | 63.4 |   |   |   |   |   |
|                                                                           |       |                                          |       |                                      |       |   |   |   |   |
| **AUM:**                                                                       |       |                                          |       |                                      |       |   |   |   |   |
| Investment  Management segment (2) (3)                                    |       | $                                             | 9,583.4    |                                      | $          | 11,915.1 |   |   |   |   |   |
| Principal  Investing segment (3) (4)                                      |       | $                                             | 620.2      |                                      | $          | 1,026.9 |   |   |   |   |   |

 

----

| (1) | Core earnings  represents a non-GAAP financial measure. Please see the “Reconciliation of  Non-GAAP Financial Measure,” which follows, for a reconciliation between  the comparable GAAP measure and a discussion of the importance placed on this  measure by management.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | AUM for our Investment  Management segment includes CDO AUM numbers, which generally reflect the  aggregate principal or notional balance of the collateral and, in some cases,  the cash balances held by the CDOs as of the date of the last trustee report  received for each CDO prior to the relevant measurement date. The AUM for our  Euro-denominated CDOs has been converted into U.S. dollars using the  appropriate spot rate of exchange. AUM for our Investment Management segment  also includes AUM for our separately managed accounts, which, in certain  cases, is a multiple of the capital actually invested in such account.  Management fees for these accounts are paid on this higher AUM amount.  Included in Investment Management segment AUM is $286.3 million related to  DFR MM CLO for October 1, 2009, and $300.9 million and $294.1 million  related to DFR MM CLO and Market Square CLO, respectively, for  October 1, 2008. DCM manages DFR MM CLO but is not contractually  entitled to receive any management fees so long as 100% of the equity is held  by DC LLC or an affiliate thereof. |
| (3) | AUM for DFR MM CLO and  DPLC is included in both Investment Management segment AUM and Principal  Investing segment AUM for October 1, 2009. AUM for DFR MM CLO and Market  Square CLO is included in both Investment Management segment AUM and  Principal Investing segment AUM for October 1, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (4) | AUM for the Principal  Investing segment is reflected net of allowance for loan losses of $24.1  million and $21.6 million as of September 30, 2009 and 2008,  respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |

 

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**Reconciliationof Non-GAAP Financial Measure**

 

We believe that coreearnings, a non-GAAP financial measure, is a useful metric for evaluating andanalyzing our performance. The calculation of core earnings, which we use tocompare our own financial results from period to period, eliminates the impactof certain non-cash and special charges and income tax. The core earningsprovided herein may not be comparable to similar measures presented by othercompanies as it is a non-GAAP financial measure and may therefore be defineddifferently by other companies.  Core earnings includes the earnings fromour VIE, DFR MM CLO, and from Market Square CLO, which was a consolidated VIEuntil we sold all of our preference shares in and deconsolidated that entity asof June 30, 2009. Core earnings is not indicative of cash flows receivedfrom these VIEs.  We have previously disclosed another non-GAAP financialmeasure, economic book value per share, which eliminated losses in excess ofthe equity at risk in Market Square CLO because those losses would be bornesolely by the debt holders of Market Square CLO.  As a result of the deconsolidationof Market Square CLO, these losses in excess of our equity at risk wereeliminated, and therefore, we no longer believe that economic book value pershare is a useful metric for evaluating and analyzing our performance.

 

**CoreEarnings**

 

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

 
| ** **                                               | ** ** | **Three Months Ended September 30,**              | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                               | ** ** | **2009**                                               | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                               | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| ** **                                               | ** ** | ** **                                             | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  income (loss)                                       |       | $                                                      | 1,924      |                                     | $          | (156,883 | ) | $ | 63,369 |   | $ | (614,801 | ) |
| Add  back:                                               |       |                                                   |       |                                     |       |   |   |   |   |
| Provision  for loan losses                               |       | 4,226                                                  |       | 15,459                                   |       | 15,452 |   | 19,961 |   |
| Cost  savings initiatives                                |       | 11                                                     |       | (2                                       | )          | 236 |   | 325 |   |
| Depreciation  and amortization                           |       | 1,630                                                  |       | 2,498                                    |       | 4,894 |   | 7,765 |   |
| Impairment  of intangible assets and goodwill            |       | —                                                 |       | 110,268                                  |       | 126 |   | 139,302 |   |
| Net  other income and (gain) loss                        |       | (3,022                                                 | )          | 31,795                                   |       | (72,224 | ) | 476,105 |   |
| Income  tax expense                                      |       | 75                                                     |       | 4,718                                    |       | 253 |   | 384 |   |
| Noncontrolling  interest core earnings (1)               |       | 379                                                    |       | —                                   |       | 3,676 |   | — |   |
| Core  earnings                                           |       | $                                                      | 5,223      |                                     | $          | 7,853 |   | $ | 15,782 |   | $ | 29,041 |   |
|                                                     |       |                                                   |       |                                     |       |   |   |   |   |
| Core  earnings per share - diluted                       |       | $                                                      | 0.77       |                                     | $          | 1.14 |   | $ | 2.34 |   | $ | 4.51 |   |
| Weighted-average  number of shares outstanding - diluted |       | 6,763,088                                              |       | 6,878,260                                |       | 6,732,272 |   | 6,436,583 |   |

 

----

| (1) | Noncontrolling interest  core earnings represents the portion of net interest income and expenses of  DPLC that are attributable to third party investors in DPLC, calculated using  each investor’s ownership percentage in DPLC during the measurement period. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**ExecutiveSummary of Results of Operations**

 

During the three and ninemonths ended September 30, 2009, we recorded net income of $1.9 millionand $63.4 million, respectively, as compared to net losses of $156.9 millionand $614.8 million during the same periods in 2008, respectively. Although core earnings, calculated in the table above, declined during thethree and nine months ended September 30, 2009 as compared to the sameperiods in 2008, it remained positive at $5.2 million and $15.8 millionfor the three and nine months ended September 30, 2009, respectively.

 

During the three and ninemonths ended September 30, 2009, we experienced an increase of $4.3million and a decrease of $26.1 million in net revenues as compared to the sameperiods in 2008, respectively, comprised of decreases in net interest income of$1.9 million and $9.8 million, respectively, decreases in the provision forloan losses of $11.2 million and $4.5 million, respectively, and decreases ininvestment advisory fees of $5.1 million and $20.8 million, respectively. The decrease in net interest income is primarily a result of the significantRMBS sales and associated repayment of repurchase agreement liabilities duringthe three months ended March 31, 2008, reductions in the overall interestrate environment, the deconsolidation of the Market Square CLO as of June 30,2009, the sale of a significant amount of loans held in the Wachovia Facilityduring 2008 and the first quarter of 2009 and the placement of certain loans onnon-accrual status during 2008 and during the nine months ended September 30,2009.

 

The decrease ininvestment advisory fees is primarily driven by the liquidation of theinvestment funds we previously managed during 2008, which provided $1.7 millionand $7.6 million of fee revenue during the three and nine months ended September 30,2008, respectively, and a reduction in CDO investment advisory fee revenue of$3.5 million and $13.4 million during the three and nine months ended September 30,2009, respectively, as compared to the same periods during 2008. The reductionin CDO investment advisory fee revenues is primarily the result of theliquidation of five CDOs we previously managed and the deferral of subordinatedmanagement fees during the three and nine months ended September 30, 2009as a result of substantially all of the CLOs that we currently manage failingcertain overcollateralization tests.

 

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During the three and ninemonths ended September 30, 2009, expenses decreased by $115.0 million and$155.8 million, respectively, as compared to the same periods in 2008,primarily driven by reductions in impairment charges on intangible assets andgoodwill and compensation and benefits expense.  During the three and ninemonths ended September 30, 2008, our Investment Management segmentrecorded $110.3 million and $139.3 million in impairment charges onintangible assets and goodwill, respectively, related to the deterioration inthe credit markets, the liquidation of the investment funds that we previouslymanaged and the liquidation of several of our CDOs.  During the three and nine months ended September 30,2009, we reduced our compensation and benefits expense by $2.3 million and$12.7 million, respectively, primarily as a result of headcount reductionsduring 2008 and a revision to our incentive compensation plan during 2009.

 

During the three and ninemonths ended September 30, 2009, net other income and gain (loss) improvedby $34.8 million and $548.3 million, respectively, as compared to the sameperiods in 2008.  During the three months ended September 30, 2009,we recorded net gains on investments at fair value and loans of $3.0 millionand $0.5 million, respectively, as compared to net losses on loans, investmentsat fair value and derivatives of $14.4 million, $13.7 million and $2.2 million,respectively, during the three months ended September 30, 2008. During the nine months ended September 30, 2009, we recorded net gains onloans, the deconsolidation of Market Square CLO, investments at fair value andderivatives of $31.2 million, $29.6 million, $9.3 million and $2.5 million,respectively.  The most recent nine month period is in sharp contrast tothe nine month period in 2008, during which we were adversely impacted by thecontinuing deterioration of global credit markets, which resulted in a loss of$476.1 million in net other income and gain (loss), largely a result of netlosses on derivatives, investments at fair value and loans of$219.4 million, $216.1 million and $35.4 million, respectively.  The most pronounced impact was on ournon-Agency RMBS portfolio. This portfolio experienced an unprecedented decreasein value during the nine months ended September 30, 2008 fueled by theongoing liquidity crisis. This negative environment impacted our ability tosuccessfully finance and hedge this portfolio. As a result, we sold asignificant portion of our RMBS portfolio to improve our liquidity. Inconjunction with the sale of RMBS, we also repaid our repurchase agreementsused to finance the RMBS sold and terminated the associated interest rate swapsused to hedge the interest rate exposure on those repurchase agreements.

 

**Resultsof Operations by Segment**

 

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

 
| ** **             | ** ** | **Three months ended September 30, 2009** | ** ** |
|------------------------|------------|------------------------------------------------|------------|
| ** **             | ** ** | **Investment  Management**                     | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **             | ** ** | **(In thousands)**                             | ** ** |
| Net  revenues          |       | $                                              | 4,083      |   | $ | 3,928 |   | $ | (1,315 | )(1) | $ | 6,696 |   |
| Expenses               |       | (5,706                                         | )          | (3,328 | ) | 1,315 | (1) | (7,719 | ) |
| Other  income and gain |       | 481                                            |       | 2,541 |   | — |   | 3,022 |   |
| Income  tax expense    |       | —                                         |       | (75 | ) | — |   | (75 | ) |
| Net  (loss) income     |       | $                                              | (1,142     | ) | $ | 3,066 |   | $ | — |   | $ | 1,924 |   |

 
| ** **                    | ** ** | **Three months ended September 30, 2008** | ** ** |
|-------------------------------|------------|------------------------------------------------|------------|
| ** **                    | ** ** | **Investment Management**                      | ** ** | **Principal Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(In thousands)**                             | ** ** |
| Net  revenues                 |       | $                                              | 9,566      |   | $ | (5,032 | ) | $ | (2,143 | )(1) | $ | 2,391 |   |
| Expenses                      |       | (119,895                                       | )          | (5,009 | ) | 2,143 | (1) | (122,761 | ) |
| Other  income and loss        |       | (552                                           | )          | (31,243 | ) | — |   | (31,795 | ) |
| Income  tax (expense) benefit |       | (8,302                                         | )          | 3,584 |   | — |   | (4,718 | ) |
| Net  loss                     |       | $                                              | (119,183   | ) | $ | (37,700 | ) | $ | — |   | $ | (156,883 | ) |

 

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| ** **             | ** ** | **Nine months ended September 30, 2009** | ** ** |
|------------------------|------------|-----------------------------------------------|------------|
| ** **             | ** ** | **Investment Management**                     | ** ** | **Principal Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **             | ** ** | **(In thousands)**                            | ** ** |
| Net  revenues          |       | $                                             | 13,116     |   | $ | 10,513 |   | $ | (4,198 | )(1) | $ | 19,431 |   |
| Expenses               |       | (18,395                                       | )          | (13,836 | ) | 4,198 | (1) | (28,033 | ) |
| Other  income and gain |       | 260                                           |       | 71,964 |   | — |   | 72,224 |   |
| Income  tax expense    |       | (28                                           | )          | (225 | ) | — |   | (253 | ) |
| Net  (loss) income     |       | $                                             | (5,047     | ) | $ | 68,416 |   | $ | — |   | $ | 63,369 |   |

 
| ** **             | ** ** | **Nine months ended September 30, 2008** | ** ** |
|------------------------|------------|-----------------------------------------------|------------|
| ** **             | ** ** | **Investment Management**                     | ** ** | **Principal Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **             | ** ** | **(In thousands)**                            | ** ** |
| Net  revenues          |       | $                                             | 39,369     |   | $ | 16,676 |   | $ | (10,525 | )(1) | $ | 45,520 |   |
| Expenses               |       | (174,953                                      | )          | (19,404 | ) | 10,525 | (1) | (183,832 | ) |
| Other  income and loss |       | (3,534                                        | )          | (472,571 | ) | — |   | (476,105 | ) |
| Income  tax expense    |       | (111                                          | )          | (273 | ) | — |   | (384 | ) |
| Net  loss              |       | $                                             | (139,229   | ) | $ | (475,572 | ) | $ | — |   | $ | (614,801 | ) |

 

----

(1)           Represents the fees charged to the PrincipalInvesting segment by the Investment Management segment on a cost plus basis forinvestment advisory, management and operational services.

 

Our Principal Investingsegment results of operations include the financial results of DFR MM CLO forthe three and nine months ended September 30, 2009 and 2008 and thefinancial results of DPLC for the three and nine months ended September 30,2009.  The Principal Investing segmentresults of operations also includes the financial results of Market Square CLOfor the three and nine months ended September 30, 2008. On June 30,2009, we sold all of our preference shares in Market Square CLO to an unrelatedthird party in exchange for an upfront payment and a delayed purchase price inthe form of a right to receive a portion of the future distributions, if any,on the preference shares.  As a result of the sale, we determined we wereno longer the primary beneficiary of Market Square CLO and thereforedeconsolidated Market Square CLO.  As of September 30, 2009, none ofthe Market Square CLO assets, liabilities or equity are included in ourcondensed consolidated balance sheet; however, all of the financial impacts tothe condensed consolidated statements of operations from the previousconsolidation of Market Square CLO were recognized through June 30, 2009.

 

**InvestmentManagement Segment**

 

***Revenues***

 

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

 
| ** **                                    | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                                    | ** ** | **2009**                                                 | ** ** | **2008**     | ** ** | **2009  vs. 2008**                                      | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                                    |       | **(In  thousands)**                                      |       |
| **Investment Management Segment Revenues**    |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Interest  income                              |       | $                                                        | 10         |         | $          | 127                                                     |       | $            | (117       | ) | $ | 72 |   | $ | 624 |   | $ | (552 | ) |
| Interest  expense                             |       | 1,191                                                    |       | 1,719        |       | (528                                                    | )          | 3,849        |       | 5,273 |   | (1,424 | ) |
| Net  interest expense                         |       | (1,181                                                   | )          | (1,592       | )          | 411                                                     |       | (3,777       | )          | (4,649 | ) | 872 |   |
| Investment  advisory fees (1)                 |       | 5,264                                                    |       | 11,158       |       | (5,894                                                  | )          | 16,893       |       | 44,018 |   | (27,125 | ) |
| Total  Investment Management segment revenues |       | $                                                        | 4,083      |         | $          | 9,566                                                   |       | $            | (5,483     | ) | $ | 13,116 |   | $ | 39,369 |   | $ | (26,253 | ) |

 

----

(1)          Investment advisory fees includeintercompany investment advisory fees of $1.3 million and $2.1 millionfor the three months ended September 30, 2009 and 2008, respectively, and$4.2 million and $10.5 million for the nine months ended September 30,2009 and 2008, respectively, calculated in conjunction with DCM’s managementagreement with DFR, which are eliminated upon consolidation.

 

*NetInterest Income*

 

Interest income for thethree months and nine months ended September 30, 2009 is primarilycomprised of interest earned from our cash balances.  Interest income forthe three and nine months ended September 30, 2008 is primarily comprisedof interest earned on preferred shares of CDOs of $0.1 million and $0.5million, respectively.  We owned preferred shares issued by two and nineof the 

 

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CDOs that we managed asof September 30, 2009 and 2008, respectively.  The primary driver inthe reduction in interest income during the three and nine months ended September 30,2009, as compared to the same period in 2008, was the termination of equitydistributions from our only remaining interest earning investment in preferredshares of CDOs during the first quarter of 2009.  Interest expense isprimarily comprised of interest expense on the Series A Senior SecuredNotes and Series B Senior Secured Notes issued in connection with theMerger, or the Series A and Series B Notes, for the three and ninemonths ended September 30, 2009 and 2008.  The reduction in interestexpense during the three and nine months ended September 30, 2009, ascompared to the same period in 2008, was the result of a reduced interest rateenvironment.

 

*InvestmentAdvisory Fees*

 

For the three monthsended September 30, 2009 and 2008, investment advisory fees were$5.3 million and $11.2 million, respectively, on a segment basis, and$3.9 million and $9.0 million, respectively, on a consolidated basisdue to the $1.3 million and $2.1 million, respectively, of feesearned by the Investment Management segment from the Principal Investingsegment, which are eliminated upon consolidation.  During the nine monthsended September 30, 2009 and 2008, investment advisory fees were $16.9million and $44.0 million, respectively, on a segment basis, and $12.7 millionand $33.5 million, respectively on a consolidated basis due to the $4.2 millionand $10.5 million, respectively, of fees earned on the Principal Investingsegment, which are eliminated upon consolidation.  Our investment advisoryfee revenue during the periods presented was generated by our CDOs, ourinvestment funds, which were liquidated during 2008, our separately managedaccounts and DPLC.

 

***CDOs***

 

The following tablesummarizes our investment advisory fee revenues from CDOs for the periodspresented:

 
| ** **                           | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **2009**                                                 | ** ** | **2008**     | ** ** | **2009  vs. 2008**                        | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                           |       | **(In  thousands)**                                      |       |
| **Senior Management Fees:**          |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| CLOs                                 |       | $                                                        | 1,900      |         | $          | 2,027                                     |       | $            | (127       | ) | $ | 4,953 |   | $ | 6,822 |   | $ | (1,869 | ) |
| ABS                                  |       | 782                                                      |       | 1,331        |       | (549                                      | )          | 2,594        |       | 4,157 |   | (1,563 | ) |
| Corporate  Bonds                     |       | 412                                                      |       | 279          |       | 133                                       |       | 1,377        |       | 731 |   | 646 |   |
| **Total Senior Mangement Fees**      |       | 3,094                                                    |       | 3,637        |       | (543                                      | )          | 8,924        |       | 11,710 |   | (2,786 | ) |
|                                 |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| **Subordinated Management Fees:**    |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| CLOs                                 |       | 441                                                      |       | 3,376        |       | (2,935                                    | )          | 1,945        |       | 10,139 |   | (8,194 | ) |
| ABS                                  |       | —                                                   |       | 64           |       | (64                                       | )          | 152          |       | 352 |   | (200 | ) |
| Corporate  Bonds                     |       | —                                                   |       | —       |       | —                                    |       | 272          |       | 137 |   | 135 |   |
| **Total Subordinate Mangement Fees** |       | 441                                                      |       | 3,440        |       | (2,999                                    | )          | 2,369        |       | 10,628 |   | (8,259 | ) |
|                                 |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| **Performance Fees (1):**            |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| CLOs                                 |       | 67                                                       | (2)        | —       |       | 67                                        |       | 239          | (2)        | — |   | 239 |   |
| ABS                                  |       | —                                                   |       | —       |       | —                                    |       | —       |       | 2,774 | (3) | (2,774 | ) |
| Corporate  Bonds                     |       | —                                                   |       | —       |       | —                                    |       | 225          | (4)        | — |   | 225 |   |
| **Total Performance Fees**           |       | 67                                                       |       | —       |       | 67                                        |       | 464          |       | 2,774 |   | (2,310 | ) |
|                                 |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| **Total CDO Advisory Fees:**         |       |                                                     |       |         |       |                                      |       |         |       |   |   |   |   |
| CLOs                                 |       | 2,408                                                    |       | 5,403        |       | (2,995                                    | )          | 7,137        |       | 16,961 |   | (9,824 | ) |
| ABS                                  |       | 782                                                      |       | 1,395        |       | (613                                      | )          | 2,746        |       | 7,283 |   | (4,537 | ) |
| Corporate  Bonds                     |       | 412                                                      |       | 279          |       | 133                                       |       | 1,874        |       | 868 |   | 1,006 |   |
| **Total CDO Advisory Fees**          |       | $                                                        | 3,602      |         | $          | 7,077                                     |       | $            | (3,475     | ) | $ | 11,757 |   | $ | 25,112 |   | $ | (13,355 | ) |

 

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(1)             Performance fees are generally earnedafter certain investors’ returns exceed a specified internal rate of return, orIRR. For purposes of this and the following table, and in accordance with ouraccounting policies, we also classify any previously deferred senior orsubordinated management fees that are subsequently paid as performance fees.

(2)             Performance fees on CLOs for the threeand nine months ended September 30, 2009 represent previously deferredsubordinated management fees.

(3)             Performance fees on ABS CDOs for the ninemonths ended September 30, 2008 included a non-recurring performance feeof $2.7 million received from one of our ABS CDOs.

(4)             Performance fees on Corporate Bonds CDOsfor the nine months ended September 30, 2009 include $0.2 million in feesrelated to a previously liquidated corporate bond CDO as a result of asettlement received in connection with certain litigation relating to one ofthe assets previously held in the CDO.

 

Our fees differ fromaccount to account, but in general, our fees from CDOs consist of a seniormanagement fee (payable before the interest payable on the debt securitiesissued by the CDO) that ranges from 5 basis points to 25 basis pointsannually of the principal balance of the underlying collateral of the CDO, asubordinate management fee (payable after the interest payable on the debtsecurities issued by the CDO and certain other expenses) that ranges from5 basis points to 45 basis points annually of the 

 

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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, orIRR hurdle. The performance fees generally range from 10% to 20% of residualcash flows above the IRR hurdle and vary by transaction.

 

Under the investmentmanagement agreements between DCM and the CDOs it manages, the payment of DCM’smanagement fees is generally subject to a “waterfall” structure. Pursuant tothese “waterfalls,” all or a portion of DCM’s subordinated management fees maybe deferred if the CDOs do not generate sufficient cash flows to pay therequired interest on the notes that the CDOs have issued to investors andcertain expenses they have incurred. This could occur if, for example, theissuers of the collateral underlying the CDOs default on or defer payments ofprincipal or interest relating to such collateral or the ratings assigned tosuch collateral are downgraded below a specified threshold.  In addition,all or a portion of DCM’s subordinated management fees may be deferred if,among other things, overcollateralization tests and other structural provisionsbuilt into the CDOs divert cashflows to the prepayment of the debt securitiesissued by the CDOs.

 

The following tablesummarizes the average AUM and effective and contractual fee rates of our CDOsfor the periods presented:

 
| ** **           | ** ** | **Three months ended September 30, 2009** | ** ** |
|----------------------|------------|------------------------------------------------|------------|
| ** **           | ** ** | ** **                                     | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **           | ** ** | ** **                                     | ** ** | **Effective Rate (2)** | ** ** | **Contractual Rate (3)** | ** ** |
| ** **           | ** ** | ** **                                     | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **           | ** ** | **Average AUM (1)**                  | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **           | ** ** | **(In thousands)**                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs  (4)            |       | $                                              | 3,918,111  |   | 0.19 | % | 0.05 | % | 0.18 | % | 0.33 | % |
|                 |       |                                           |       |   |   |   |   |   |   |   |   |
| ABS:                 |       |                                           |       |   |   |   |   |   |   |   |   |
| High-grade  ABS      |       | 3,142,059                                      |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other  ABS           |       | 1,297,055                                      |       | 0.12 | % | 0.00 | % | 0.15 | % | 0.22 | % |
| Total  ABS           |       | 4,439,114                                      |       | 0.07 | % | 0.00 | % | 0.08 | % | 0.11 | % |
|                 |       |                                           |       |   |   |   |   |   |   |   |   |
| Corporate  bonds (5) |       | 841,279                                        |       | 0.20 | % | 0.00 | % | 0.18 | % | 0.23 | % |
| Total  CDOs          |       | $                                              | 9,198,504  |   | 0.13 | % | 0.02 | % | 0.13 | % | 0.21 | % |

 
| ** **           | ** ** | **Three months ended September 30, 2008** | ** ** |
|----------------------|------------|------------------------------------------------|------------|
| ** **           | ** ** | ** **                                     | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **           | ** ** | ** **                                     | ** ** | **Effective Rate (2)** | ** ** | **Contractual Rate (3)** | ** ** |
| ** **           | ** ** | ** **                                     | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **           | ** ** | **Average AUM (1)**                  | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **           | ** ** | **(In thousands)**                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs  (4)            |       | $                                              | 4,529,916  |   | 0.18 | % | 0.30 | % | 0.20 | % | 0.30 | % |
|                 |       |                                           |       |   |   |   |   |   |   |   |   |
| ABS:                 |       |                                           |       |   |   |   |   |   |   |   |   |
| High-grade  ABS      |       | 3,558,890                                      |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other  ABS           |       | 2,593,805                                      |       | 0.14 | % | 0.01 | % | 0.14 | % | 0.19 | % |
| Total  ABS           |       | 6,152,695                                      |       | 0.09 | % | 0.00 | % | 0.09 | % | 0.11 | % |
|                 |       |                                           |       |   |   |   |   |   |   |   |   |
| Corporate  bonds (5) |       | 743,599                                        |       | 0.15 | % | 0.00 | % | 0.20 | % | 0.17 | % |
| Total  CDOs          |       | $                                              | 11,426,210 |   | 0.13 | % | 0.12 | % | 0.14 | % | 0.19 | % |

 

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| ** **           | ** ** | **Nine months ended September 30, 2009** | ** ** |
|----------------------|------------|-----------------------------------------------|------------|
| ** **           | ** ** | ** **                                    | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **           | ** ** | ** **                                    | ** ** | **Effective Rate (2)** | ** ** | **Contractual Rate (3)** | ** ** |
| ** **           | ** ** | ** **                                    | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **           | ** ** | **Average AUM (1)**                 | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **           | ** ** | **(In thousands)**                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs  (4)            |       | $                                             | 3,772,753  |   | 0.18 | % | 0.07 | % | 0.18 | % | 0.33 | % |
|                 |       |                                          |       |   |   |   |   |   |   |   |   |
| ABS:                 |       |                                          |       |   |   |   |   |   |   |   |   |
| High-grade  ABS      |       | 3,258,084                                     |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other  ABS           |       | 1,473,043                                     |       | 0.12 | % | 0.01 | % | 0.15 | % | 0.22 | % |
| Total  ABS           |       | 4,731,127                                     |       | 0.07 | % | 0.00 | % | 0.08 | % | 0.11 | % |
|                 |       |                                          |       |   |   |   |   |   |   |   |   |
| Corporate  bonds (5) |       | 851,709                                       |       | 0.22 | % | 0.04 | % | 0.18 | % | 0.23 | % |
| Total  CDOs          |       | $                                             | 9,355,589  |   | 0.13 | % | 0.03 | % | 0.13 | % | 0.21 | % |

 
| ** **           | ** ** | **Nine months ended September 30, 2008** | ** ** |
|----------------------|------------|-----------------------------------------------|------------|
| ** **           | ** ** | ** **                                    | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **           | ** ** | ** **                                    | ** ** | **Effective Rate (2)** | ** ** | **Contractual Rate (3)** | ** ** |
| ** **           | ** ** | ** **                                    | ** ** | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **           | ** ** | **Average AUM (1)**                 | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **           | ** ** | **(In thousands)**                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs  (4)            |       | $                                             | 4,943,179  |   | 0.18 | % | 0.27 | % | 0.20 | % | 0.29 | % |
|                 |       |                                          |       |   |   |   |   |   |   |   |   |
| ABS:                 |       |                                          |       |   |   |   |   |   |   |   |   |
| High-grade  ABS      |       | 3,661,811                                     |       | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other  ABS           |       | 2,822,902                                     |       | 0.13 | % | 0.01 | % | 0.14 | % | 0.19 | % |
| Total  ABS           |       | 6,484,713                                     |       | 0.09 | % | 0.01 | % | 0.09 | % | 0.11 | % |
|                 |       |                                          |       |   |   |   |   |   |   |   |   |
| Corporate  bonds (5) |       | 673,826                                       |       | 0.13 | % | 0.03 | % | 0.20 | % | 0.19 | % |
| Total  CDOs          |       | $                                             | 12,101,718 |   | 0.13 | % | 0.12 | % | 0.14 | % | 0.19 | % |

 

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(1)             Average AUM is calculated as the averageof the AUM on the first day of July, August, September and October forthe three months ended September 30, 2009 and 2008 and the average of thefirst day of January, February, March, April, May, June, July, August, September andOctober for the nine months ended September 30, 2009 and 2008. CDOAUM numbers generally reflect the aggregate principal or notional balance ofthe collateral and, in some cases, the cash balance held by the CDO and are asof the date of the last trustee report received for each CDO prior to the AUMdate, as appropriate. The AUM for our Euro-denominated CDOs has been convertedto U.S. dollars using the spot rate of exchange as of the respective AUM date.

(2)             The effective rate for the three monthsended September 30, 2009 and 2008 is calculated by taking the managementfees earned during the three months ended September 30, 2009 and 2008,respectively, multiplied by four (to annualize) and divided by the average AUM.The effective rate for the nine months ended September 30, 2009 and 2008is calculated by taking management fees earned during the period multiplied by1.33 (to annualize) and divided by the average AUM. The senior and subordinatedmanagement fee effective rates may differ from the contractual fee rates forvarious reasons, including the following: (a) we may have entered intoagreement with specific investors pursuant to which our management fees arepaid to those investors and (b) our senior or subordinated management feesmay be deferred as a result of certain structural provisions built into thedocuments governing the CDO. In certain circumstances, we may at a later date,subject to certain performance triggers, be entitled to repayment of the feespaid to investors described in (a) above. In addition, we may at a laterdate, subject to the satisfaction of certain structural provisions, be entitledto payment of the deferred fees described in (b) above.

(3)             The weighted average contractual seniorand subordinated management fee rates are obtained by multiplying thecontractual fee rates for each CDO by that CDO’s average AUM and dividing thatnumber by the total average AUM for the relevant asset class.

(4)             DFR MM CLO has been excluded from allcategories in this table as DCM manages this CLO, but is not contractuallyentitled to receive any management fees for DFR MM CLO so long as 100% of theequity is held by DC LLC or an affiliate thereof.  In addition, MarketSquare CLO has been excluded from all categories in this table through July 1,2009, when we became entitled to receive management fees from Market Square CLOas a result of the sale of all of our preference shares of Market Square CLO onJune 30, 2009.

(5)             The effective and contractual rates forRobeco CDO are calculated based on the fees that we are entitled to receivepursuant to the asset purchase agreement between DCM and Robeco InvestmentManagement, Inc. and are not the total fees paid by the CDO or thecontractual fee rate set forth in the management agreement.

 

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

 
| ** **                          | ** ** | **Closing Date** | ** ** | **October 1, 2009  AUM (1)** | ** ** | **First Optional  Call Date (2)** | ** ** | **Auction Call  Date (3)** | ** ** | **Termination of  Reinvestment  Period (4)** | ** ** | **Maturity  Year** | ** ** |
|-------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------|------------|---------------------------------------------------|------------|--------------------|------------|
| ** **                          | ** ** | **Month/Year**        | ** ** | **(In thousands)**                     | ** ** | **Month/Year**                                   | ** ** | ** **                           | ** ** |
| **CLOs:**                           |       |                  |       |                                   |       |                                             |       |                                 |       |                                              |       |               |       |
| Rosemont  CLO, Ltd.                 |       | 01/02                 |       | $                                      | 154,038    |                                             | 10/05      |                                 | n/a        |                                              | 01/07      |               | 2013       |   |
| Forest  Creek CLO Ltd.              |       | 05/03                 |       | 283,791                                |       | 07/07                                            |       | n/a                                  |       | 07/08                                             |       | 2015               |       |
| Long  Grove CLO Ltd.                |       | 06/04                 |       | 381,932                                |       | 08/08                                            |       | n/a                                  |       | 05/10                                             |       | 2016               |       |
| Market  Square CLO Ltd.             |       | 05/05                 |       | 288,700                                |       | 07/07                                            |       | n/a                                  |       | 04/11                                             |       | 2017               |       |
| Cumberland  II CLO Ltd.             |       | 09/05                 |       | 380,084                                |       | 02/10                                            |       | n/a                                  |       | 11/11                                             |       | 2019               |       |
| Marquette  Park CLO Ltd.            |       | 12/05                 |       | 297,574                                |       | 04/10                                            |       | n/a                                  |       | 01/12                                             |       | 2020               |       |
| Bridgeport  CLO Ltd.                |       | 06/06                 |       | 499,537                                |       | 10/09                                            |       | n/a                                  |       | 07/13                                             |       | 2020               |       |
| Burr  Ridge CLO Plus Ltd.           |       | 12/06                 |       | 295,316                                |       | 06/12                                            |       | n/a                                  |       | 03/13                                             |       | 2023               |       |
| Schiller  Park CLO Ltd.             |       | 05/07                 |       | 399,153                                |       | 07/11                                            |       | n/a                                  |       | 04/13                                             |       | 2021               |       |
| Bridgeport  CLO II Ltd.             |       | 06/07                 |       | 499,037                                |       | 12/10                                            |       | n/a                                  |       | 09/14                                             |       | 2021               |       |
| DFR  Middle Market CLO Ltd. (5)     |       | 07/07                 |       | 286,310                                |       | 07/10                                            |       | n/a                                  |       | 07/10                                             |       | 2019               |       |
| Gillespie  CLO PLC (6)              |       | 08/07                 |       | 398,611                                |       | 02/13                                            |       | n/a                                  |       | 08/13                                             |       | 2023               |       |
| **Total CLOs**                      |       |                  |       | 4,164,083                              |       |                                             |       |                                 |       |                                              |       |               |       |
|                                |       |                  |       |                                   |       |                                             |       |                                 |       |                                              |       |               |       |
| **ABS CDOs:**                       |       |                  |       |                                   |       |                                             |       |                                 |       |                                              |       |               |       |
| Mid  Ocean CBO 2000-1 Ltd.          |       | 01/01                 |       | 112,970                                |       | 04/06                                            |       | n/a                                  |       | 01/06                                             |       | 2036               |       |
| Mid  Ocean CBO 2001-1 Ltd.          |       | 10/01                 |       | 128,307                                |       | 02/06                                            |       | n/a                                  |       | 01/06                                             |       | 2036               |       |
| Oceanview  CBO I, Ltd.              |       | 06/02                 |       | 170,129                                |       | 06/06                                            |       | 06/12                                |       | 06/06                                             |       | 2032, 2037         | (7)        |
| Northlake  CDO I, Limited           |       | 02/03                 |       | 128,596                                |       | 03/06                                            |       | 03/13                                |       | 03/07                                             |       | 2033               |       |
| Knollwood  CDO Ltd.                 |       | 03/04                 |       | 134,337                                |       | 04/07                                            |       | 04/12                                |       | 04/08                                             |       | 2039               |       |
| River  North CDO Ltd.               |       | 01/05                 |       | 223,892                                |       | 02/09                                            |       | 02/13                                |       | 02/09                                             |       | 2040               |       |
| Buckingham  CDO Ltd.                |       | 07/05                 |       | 811,870                                |       | 08/10                                            |       | 08/13                                |       | 08/10                                             |       | 2040               |       |
| Pinetree  CDO Ltd.                  |       | 11/05                 |       | 194,428                                |       | 01/10                                            |       | 01/14                                |       | 01/10                                             |       | 2045               |       |
| Buckingham  CDO II Ltd.             |       | 12/05                 |       | 1,137,311                              |       | 03/11                                            |       | 03/14                                |       | 03/11                                             |       | 2041               |       |
| Knollwood  CDO II Ltd.              |       | 07/06                 |       | 78,143                                 |       | 07/09                                            |       | 07/13                                |       | n/a                                               |       | 2046               |       |
| Buckingham  CDO III Ltd.            |       | 08/06                 |       | 1,120,691                              |       | 09/11                                            |       | 09/14                                |       | 09/11                                             |       | 2051               |       |
| Aramis  CDO                         |       | 03/07                 |       | 4,030                                  |       | 03/12                                            |       | n/a                                  |       | n/a                                               |       | 2047               |       |
| **Total ABS CDOs**                  |       |                  |       | 4,244,704                              |       |                                             |       |                                 |       |                                              |       |               |       |
|                                |       |                  |       |                                   |       |                                             |       |                                 |       |                                              |       |               |       |
| **Corporate Bond CDOs:**            |       |                  |       |                                   |       |                                             |       |                                 |       |                                              |       |               |       |
| Valeo  Investment Grade CDO Ltd.    |       | 01/01                 |       | 280,589                                |       | 01/05                                            |       | n/a                                  |       | 01/06                                             |       | 2013               |       |
| Valeo  Investment Grade CDO II Ltd. |       | 05/01                 |       | 292,400                                |       | 06/05                                            |       | n/a                                  |       | 06/06                                             |       | 2013               |       |
| Robeco  CDO II Limited              |       | 08/01                 |       | 126,045                                |       | 08/05                                            |       | n/a                                  |       | 02/06                                             |       | 2013               |       |
| Mayfair  Euro CDO I B.V. (6)        |       | 06/01                 |       | 134,806                                |       | 05/06                                            |       | n/a                                  |       | 05/06                                             |       | 2013               |       |
| **Total Corporate Bond CDOs**       |       |                  |       | 833,840                                |       |                                             |       |                                 |       |                                              |       |               |       |
|                                |       |                  |       |                                   |       |                                             |       |                                 |       |                                              |       |               |       |
| **Total CDO AUM**                   |       |                  |       | $                                      | 9,242,627  |                                             |       |                                 |       |                                              |       |               |       |   |

 

----

(1)           CDO AUM numbers generally reflect theaggregate principal or notional balance of the collateral and, in some cases,the cash balance held by the CDOs and are as of the date of the last trusteereport received for each CDO prior to October 1, 2009.

(2)           CDOs are generally callable by equityholders once per quarter beginning on the “first option call date” and subjectto satisfaction of certain conditions.

(3)           ABS CDOs generally contain a provisionrequiring the manager thereof to liquidate the collateral held therein on the “auctioncall date,” subject to certain conditions, generally including that theproceeds from any such liquidation be sufficient to redeem the notes and paycertain additional expenses.

(4)           Termination of reinvestment period refersto the date after which we can no longer use certain principal collections topurchase additional collateral, and such collections are instead used to repaythe outstanding amounts of certain debt securities issued by the CDO.

(5)           We are not contractually entitled toreceive any management fees from this CLO so long as 100% of the equity is heldby DC LLC or an affiliate thereof.

(6)           The AUM for our Euro-denominated CDOs hasbeen converted into U.S. dollars using the spot rate of exchange on September 30,2009.

(7)           Maturity date varies by tranche of notes.

 

The CDOs that we managegenerally contain certain structural provisions, including, but not limited to,overcollateralization requirements that are meant to protect investors fromdeterioration in the credit quality of the underlying collateral pool. Recentincreased defaults and downgrades of the collateral underlying our CDOs haveput downward pressure on overcollateralization ratios and increased thelikelihood that the CDOs we manage will experience events of default or triggerother structural provisions. Noncompliance with overcollateralization tests andother structural provisions may cause cash flows from the CDOs to be divertedto prepay 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.  In addition,in certain cases, noncompliance with these overcollateralization tests or otherstructural provisions can lead to events of default under the indenturesgoverning the 

 

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CDOs and, ultimately,acceleration of the notes issued by the CDO and the liquidation of theunderlying collateral. Certain of our CDOs contain provisions prohibiting theliquidation of the CDO following an event of default unless either the proceedsfrom the liquidation will be sufficient to pay off all of the notes issued bythe CDO along with certain specified expenses or a majority or supermajority ofcertain specified classes of notes vote to liquidate the CDO. We believe thatCDOs that contain these provisions are less likely to liquidate upon theoccurrence of an event of default.

 

CLO investment advisoryfee revenue declined by $3.0 million and $9.8 million for the three and ninemonths ended September 30, 2009, respectively, as compared to the sameperiods in 2008. We managed four market value CLOs during 2008, all of whichcontained liquidation triggers and events of default based on the market valueof the CLO’s assets. The significant decline in liquidity in the credit marketsduring the year ended December 31, 2008 had a negative impact on themarket values of the assets held in our CLOs. All four of our market value CLOsbreached their market value trigger during the year ended December 31,2008 and were subsequently liquidated. For the three and nine months ended September 30,2008, we earned senior management fees of $0.3 million and $1.8 million,respectively, and subordinated management fees of $0.2 million and $0.9million, respectively, on these market value CLOs.  The remainder of our CLOs are cash flow CLOs.Triggers and events of default in these deals are not based on the market valueof the portfolio.

 

Subordinated managementfees on CLOs declined by $2.9 million and $8.2 million during the three andnine months ended September 30, 2009, respectively, as compared to thesame periods in 2008.  This was primarily the result of the failure of theovercollateralization tests for substantially all of our cash flow CLOs duringthe nine months ended September 30, 2009, resulting in the deferral ofsubordinated management fees on those CLOs. We earned subordinated managementfees on our cash flow CLOs of $0.4 million and $3.1 million for the threemonths ended September 30, 2009 and 2008, respectively, and $1.9 millionand $9.2 million for the nine months ended September 30, 2009 and 2008,respectively.  We expect substantially all of our CLO subordinatedinvestment advisory fees to continue to be deferred in the near term. However, over time and with continued improvement in market conditions andeffective portfolio management, we expect the CLOs to regain compliance withtheir overcollateralization tests, and, subject to the satisfaction of certainother conditions, we would expect to recoup at least a portion and potentiallysubstantially all of the deferred subordinated management fees and to receivefuture subordinated management fees on a current basis.

 

ABS CDO revenue declinedby $0.6 million and $4.5 million for the three and nine months ended September 30,2009, respectively, as compared to the same periods in 2008.  The decline in ABS CDO revenue during thethree months ended September 30, 2009, as compared to the same period in2008, was primarily the result of a decline in senior management fees of $0.5million.  The decline in ABS CDO revenueduring the nine months ended September 30, 2009, as compared to the sameperiod in 2008, was the result of a decline in senior management fees of $1.6million, subordinated management fees of $0.2 million and performance fees of$2.8 million.  These declines wereprimarily the result of one of our ABS CDOs liquidating and the reduction inAUM for the remainder of our ABS CDOs, as compared to the same periods in2008.  In addition, during the ninemonths ended September 30, 2008 a non-recurring performance fee of $2.7million was received from one of our ABS CDOs. We expect our ABS CDO AUM and management fees to continue to decline asa result of both the diversion of cash flows to prepay the debt securitiesissued 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.

 

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

 

***Other Investment Advisory Fees***

 

The following tablesummarizes the respective investment advisory fee revenues for our investmentmanagement contracts related to our separately managed accounts, fixed incomearbitrage investment funds and other investment vehicles:

 
| ** **                                      | ** ** | **Average  AUM (1)** | ** ** | **Management  Fees** | ** ** | **Performance  Fees** | ** ** |
|-------------------------------------------------|------------|----------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **(In thousands)**   | ** ** |
| **Three months ended September 30, 2009:** |       |                 |       |                 |       |                  |       |
| Separately  managed accounts                    |       | $                    | 320,159    |                 | $          | 198                   |       | n/a |   |
| Other  investment vehicle (2)                   |       | $                    | 22,105     |                 | $          | 149                   |       | $ | — |   |
|                                            |       |                 |       |                 |       |                  |       |
| **Three months ended September 30, 2008:** |       |                 |       |                 |       |                  |       |
| Fixed  income arbitrage investment funds        |       | $                    | 435,676    |                 | $          | 1,702                 |       | $ | — |   |
| Separately  managed accounts                    |       | $                    | 404,321    |                 | $          | 236                   |       | n/a |   |

 

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| ** **                                     | ** ** | **Average  AUM (3)** | ** ** | **Management  Fees** | ** ** | **Performance  Fees** | ** ** |
|------------------------------------------------|------------|----------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **(In thousands)**   | ** ** |
| **Nine months ended September 30, 2009:** |       |                 |       |                 |       |                  |       |
| Separately  managed accounts                   |       | $                    | 312,400    |                 | $          | 664                   |       | n/a |   |
| Other  investment vehicle (2)                  |       | $                    | 10,786     |                 | $          | 274                   |       | $ | — |   |
|                                           |       |                 |       |                 |       |                  |       |
| **Nine months ended September 30, 2008:** |       |                 |       |                 |       |                  |       |
| Fixed  income arbitrage investment funds       |       | $                    | 550,859    |                 | $          | 6,450                 |       | $ | 1,186 | (4) |
| Separately  managed accounts                   |       | $                    | 410,542    |                 | $          | 745                   |       | n/a |   |

 

----

(1)           Average AUM for the three months ended September 30,2009 and 2008 is calculated as the average of the AUM on the first day of July,August and September 2009 and 2008, respectively.

(2)           Represents management fee revenues earnedon DPLC. We recognize management fee revenues on the portion of the AUM whichis not related to our investment in DPLC.

(3)           Average AUM for the nine months ended September 30,2009 and 2008 is calculated as the average of the AUM on the first day ofJanuary, February, March, April, May, June, July, August and September 2009and 2008, respectively.

(4)           Performance fees were related to oursmaller investment fund, which liquidated on April 30, 2008.

n/a —not applicable

 

The reduction in otherinvestment advisory fees during the three and nine months ended September 30,2009, as compared to the same periods in 2008, was primarily driven by theliquidation of our fixed income arbitrage investment funds during 2008. For the three and nine months ended September 30, 2008, we earnedmanagement fees of $1.7 million and $6.5 million, respectively, andincentive fees of zero and $1.2 million, respectively, related to theseliquidated investment funds.

 

As a result of theformation of DPLC, we earn management fees and may be entitled to incentivefees on the portion of the assets under management which is not related to ourinvestment in DPLC.  We do not expect toearn an incentive fee during 2009 from DPLC.

 

*Intercompanyinvestment advisory fees*

 

As a result of theMerger, we entered into a new management agreement with DCM. Management feespaid pursuant to this agreement are eliminated upon consolidation in accordancewith GAAP. Fees are paid on a cost plus margin basis for investment advisory,management and operational services. All ancillary services, including backoffice support and certain operating expenses, are charged at cost. For thethree months ended September 30, 2009 and 2008, the intercompanyinvestment advisory fees earned were $1.3 million and $2.1 million,respectively.  For the nine months ended September 30,2009 and 2008, the intercompany investment advisory fees earned were $4.2million and $10.5 million, respectively.

 

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***Expenses***

 

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

 
| ** **                                          | ** ** | **Three  months ended September 30,** | ** ** | **Variance** | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                                          | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **2009  vs. 2008**                        | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                                          | ** ** | **(In  millions)**                         | ** ** |
| Salaries                                            |       | $                                          | 1.9        |         | $          | 3.3                                       |       | $            | (1.4       | ) | $ | 6.0 |   | $ | 11.0 |   | $ | (5.0 | ) |
| Incentive  compensation                             |       | 0.5                                        |       | 1.2          |       | (0.7                                      | )          | 2.5          |       | 9.4 |   | (6.9 | ) |
| Employee  benefits                                  |       | 0.2                                        |       | 0.5          |       | (0.3                                      | )          | 0.5          |       | 1.4 |   | (0.9 | ) |
| Total  compensation and benefits                    |       | 2.6                                        |       | 5.0          |       | (2.4                                      | )          | 9.0          |       | 21.8 |   | (12.8 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Audit  and audit-related fees                       |       | 0.2                                        |       | 0.1          |       | 0.1                                       |       | 0.4          |       | 0.5 |   | (0.1 | ) |
| Legal  fees                                         |       | —                                     |       | 0.4          |       | (0.4                                      | )          | —       |       | 0.5 |   | (0.5 | ) |
| Other  professional fees                            |       | 0.1                                        |       | 0.1          |       | —                                    |       | 0.1          |       | 0.2 |   | (0.1 | ) |
| Total  professional services                        |       | 0.3                                        |       | 0.6          |       | (0.3                                      | )          | 0.5          |       | 1.2 |   | (0.7 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Insurance  expense                                  |       | 0.1                                        |       | 0.1          |       | —                                    |       | 0.3          |       | 0.4 |   | (0.1 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Software  and data feeds                            |       | 0.3                                        |       | 0.5          |       | (0.2                                      | )          | 0.9          |       | 1.5 |   | (0.6 | ) |
| Other  general and administrative fees              |       | 0.2                                        |       | 0.3          |       | (0.1                                      | )          | 0.7          |       | 0.8 |   | (0.1 | ) |
| Total  general and administrative expense           |       | 0.5                                        |       | 0.8          |       | (0.3                                      | )          | 1.6          |       | 2.3 |   | (0.7 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Fixed  asset depreciation                           |       | 0.4                                        |       | 0.3          |       | 0.1                                       |       | 1.0          |       | 1.0 |   | — |   |
| Intangible  asset amortization                      |       | 1.3                                        |       | 2.2          |       | (0.9                                      | )          | 4.0          |       | 6.8 |   | (2.8 | ) |
| Total  depreciation and amortization                |       | 1.7                                        |       | 2.5          |       | (0.8                                      | )          | 5.0          |       | 7.8 |   | (2.8 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Occupancy                                           |       | 0.5                                        |       | 0.6          |       | (0.1                                      | )          | 1.7          |       | 1.9 |   | (0.2 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Cost  savings initiative                            |       | —                                     |       | —       |       | —                                    |       | 0.2          |       | 0.3 |   | (0.1 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Impairment  of intangible assets                    |       | —                                     |       | 32.2         |       | (32.2                                     | )          | 0.1          |       | 41.2 |   | (41.1 | ) |
| Impairment  of goodwill                             |       | —                                     |       | 78.1         |       | (78.1                                     | )          | —       |       | 98.1 |   | (98.1 | ) |
| Total  impairment of intangible assets and goodwill |       | —                                     |       | 110.3        |       | (110.3                                    | )          | 0.1          |       | 139.3 |   | (139.2 | ) |
|                                                |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Total  Investment Management segment expenses       |       | $                                          | 5.7        |         | $          | 119.9                                     |       | $            | (114.2     | ) | $ | 18.4 |   | $ | 175.0 |   | $ | (156.6 | ) |

 

The decrease in expensesof $114.2 million for the three months ended September 30, 2009, comparedto the same period in 2008, was primarily attributable to $110.3 million inimpairment charges on intangible assets and goodwill during the three monthsended September 30, 2008, as compared to no impairment charges recordedduring the same period in 2009, and decreases in compensation and benefits anddepreciation and amortization of $2.4 million and $0.8 million, respectively,for the three months ended September 30, 2009, compared to the same periodin 2008.  The decrease in expenses of$156.6 million for the nine months ended September 30, 2009, compared tothe same period in 2008, was primarily attributable to $139.3 million inimpairment charges on intangible assets and goodwill during the nine monthsended September 30, 2008, as compared to $0.1 million of impairmentcharges on intangible assets recorded during the same period in 2009, anddecreases in compensation and benefits and depreciation and amortization of$12.8 million and $2.8 million, respectively, for the three months ended September 30,2009 compared to the same period in 2008.

 

The $2.4 million and$12.8 million decrease in compensation and benefits for the three and ninemonths ended September 30, 2009, respectively, as compared to the sameperiods in 2008, was primarily the result of the implementation of two costsavings initiatives and to a lesser extent a reduction in our projected 2009incentive compensation for existing employees. On March 1, 2008, inresponse to the adverse credit markets, we implemented a cost savingsinitiative and reduced our headcount by 13 employees, or 10% of our thencurrent workforce, across a broad range of functions. In November 2008, inresponse to the continued deterioration in market conditions, we implemented asecond cost savings initiative and reduced our headcount by 24 employees, orapproximately 26% of our then current workforce, and reduced bonuscompensation. The compensation payable to those 24 employees accounted forapproximately 37% of our annual compensation expense in 2008. The headcountreductions were largely related to the fixed income arbitrage trading businessand the associated back-office infrastructure. We believe these cost savingsinitiatives will continue to improve our financial results without adverselyimpacting our ability to operate our business in a prudent manner. As of September 30,2009, we had 67 employees, as compared to 94 employees as of September 30,2008.

 

During the nine monthsended September 30, 2009, we recorded $0.1 million of impairment chargesrelated to the intangible asset associated with the management contract forKnollwood CDO II Ltd. as a result of the decline in expected future managementfee cash flows from this CDO.  During the three and nine months ended September 30,2008, we recorded impairment charges on our intangible assets of $32.2 millionand $41.2 million, respectively.  During the three months ended September 30,2008, the impairment charges were comprised of $30.6 million related to theintangible asset associated with the management contract for our largestinvestment fund, which was subsequently liquidated, and $1.3 million and $0.2million related to the intangible assets associated with the managementcontract for Castle Harbor II CLO Ltd. and Access Institutional Loan Fund,respectively, both of which were subsequently liquidated.  During the nine months ended September 30,2008, the remaining $9.0 million of impairment charges were comprised of $4.6million related to the intangible asset associated with the management contractfor our smallest investment fund, $3.3 million related to the managementcontract for Coltrane CLO PLC, which was subsequently liquidated, and $1.0million related to the intangible asset associated with the management contractfor Western Springs CDO, which was subsequently liquidated.

 

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For the three and ninemonths ended September 30, 2008, we recorded $78.2 million and $98.1million, respectively, of impairment on goodwill recorded in conjunction withthe Merger. Although a significant amount of time had not passed since theMerger, the continued deterioration of global credit markets and significantdecline in our overall market capitalization during the first quarter of 2008was a triggering event for an analysis of possible goodwill impairment. For thefirst quarter 2008, the estimated cash flows generated by the Investment Managementsegment were generally consistent with the estimated cash flows at the time ofthe Merger. However, the market multiple for the companies that we consideredcomparable had decreased. This decline in market multiples largely contributedto the $20.0 million of goodwill impairment recorded during the firstquarter of 2008. As a result of the further decline in our overall marketcapitalization experienced during the third quarter of 2008, we performedanother analysis for possible goodwill impairment as of September 30, 2008and recognized full impairment on the remaining goodwill balance of$78.1 million. This was a result of the combined effect of lower marketmultiples and continued decline in our overall market capitalization andreduced estimated cash flows from the Investment Management segment compared tothose estimated at the time of the Merger due to declines in AUM.

 

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

 

Other income and gain(loss) for the Investment Management segment primarily consisted of the realizedand unrealized losses related to our investments in the preferred shares ofCDOs that are managed by DCM. During the three months ended September 30,2009 and 2008, we recognized unrealized gains of $0.4 million and unrealizedlosses of $0.4 million, respectively, and, during the nine months ended September 30,2009 and 2008, we recognized unrealized gains of $0.2 million and unrealizedlosses of $3.4 million, respectively, in net gain (loss) on investments at fairvalue in the condensed consolidated statements of operations related to theseinvestments.

 

***Income Tax Expense***

 

For the three and ninemonths ended September 30, 2009, the Investment Management segmentrecorded income tax expense of zero and $28,000, respectively, due to oursubsidiary in London. For income tax purposes, impairments of intangibles andgoodwill are not recognized but are amortized straight-line over a 15-year lifefrom the date we established a tax basis. There is a full valuation allowanceon all of our deferred tax assets except for those associated with oursubsidiary in London.

 

**PrincipalInvesting Segment**

 

***Revenues***

 

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

 
| ** **                                  | ** ** | **Three  months ended September 30,** | ** ** | **Variance** | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                                  | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **2009  vs. 2008**                        | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                                  | ** ** | **(In  millions)**                         | ** ** |
| **Principal Investing Segment Revenues**    |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Interest  income                            |       | $                                          | 10.9       |         | $          | 20.4                                      |       | $            | (9.5       | ) | $ | 38.7 |   | $ | 103.1 |   | $ | (64.4 | ) |
| Interest  expense                           |       | 2.6                                        |       | 9.9          |       | 7.3                                       |       | 12.7         |       | 66.4 |   | 53.7 |   |
| Net  interest income                        |       | 8.3                                        |       | 10.5         |       | (2.2                                      | )          | 26.0         |       | 36.7 |   | (10.7 | ) |
| Provision  for loan losses                  |       | 4.3                                        |       | 15.5         |       | 11.2                                      |       | 15.5         |       | 20.0 |   | 4.5 |   |
| Total  Principal Investing segment revenues |       | $                                          | 4.0        |         | $          | (5.0                                      | )          | $            | 9.0        |   | $ | 10.5 |   | $ | 16.7 |   | $ | (6.2 | ) |

 

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The following tablesummarizes our Principal Investing segment interest income:

 
| ** **                                   | ** ** | **Three  months ended September 30,** | ** ** | **Variance** | ** ** | **%  of total interest income** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **2009  vs. 2008**              | ** ** | **Three  months ended September 30,** | ** ** |
|                                         |       | **(In  millions)**                         | ** ** | **2009**     | ** ** | **2008**                        |       |
| **Real Estate Investments:**                 |       |                                       |       |         |       |                            |       |   |   |   |   |
| RMBS                                         |       | $                                          | 3.8        |         | $          | 5.7                             |       | $ | (1.9 | ) | 35.2 | % | 27.9 | % |
| Corporate  loans and securities:             |       |                                       |       |         |       |                            |       |   |   |   |   |
| Loans  held in DFR MM CLO                    |       | 6.0                                        |       | 6.8          |       | (0.8                            | )          | 55.5 | % | 33.3 | % |
| Loans  held in the Wachovia Facility         |       | —                                     |       | 2.2          |       | (2.2                            | )          | 0.0 | % | 10.8 | % |
| Other  corporate leveraged loans             |       | 0.3                                        |       | 0.9          |       | (0.6                            | )          | 2.8 | % | 4.4 | % |
| Assets  held in Market Square CLO            |       | —                                     |       | 4.2          |       | (4.2                            | )          | 0.0 | % | 20.6 | % |
| Assets  held in DPLC                         |       | 0.2                                        |       | —       |       | 0.2                             |       | 1.9 | % | 0.0 | % |
| Commercial  real estate loans and securities |       | —                                     |       | 0.4          |       | (0.4                            | )          | 0.0 | % | 2.0 | % |
| Treasuries  and short term investments       |       | —                                     |       | 0.2          |       | (0.2                            | )          | 0.0 | % | 1.0 | % |
| Equities  and other investments              |       | 0.6                                        |       | —       |       | 0.6                             |       | 4.6 | % | 0.0 | % |
| **Total interest income**                    |       | $                                          | 10.9       |         | $          | 20.4                            |       | $ | (9.5 | ) | 100.0 | % | 100.0 | % |

 
| ** **                                   | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** | **%  of total interest income** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|--------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **2009**                                  | ** ** | **2008**     | ** ** | **2009  vs. 2008**              | ** ** | **Nine  months ended September 30,** | ** ** |
| ** **                                   | ** ** | **(In  millions)**                        | ** ** | **2009**     | ** ** | **2008**                        | ** ** |
| **Real Estate Investments:**                 |       |                                      |       |         |       |                            |       |   |   |   |   |
| RMBS                                         |       | $                                         | 12.5       |         | $          | 53.8                            |       | $ | (41.3 | ) | 32.4 | % | 52.2 | % |
| Corporate  loans and securities:             |       |                                      |       |         |       |                            |       |   |   |   |   |
| Loans  held in DFR MM CLO                    |       | 18.0                                      |       | 22.0         |       | (4.0                            | )          | 46.6 | % | 21.3 | % |
| Loans  held in the Wachovia Facility         |       | 1.2                                       |       | 8.4          |       | (7.2                            | )          | 3.1 | % | 8.1 | % |
| Other  corporate leveraged loans             |       | 0.3                                       |       | 1.6          |       | (1.3                            | )          | 0.8 | % | 1.6 | % |
| Assets  held in Market Square CLO            |       | 6.1                                       |       | 13.7         |       | (7.6                            | )          | 15.8 | % | 13.3 | % |
| Assets  held in DPLC                         |       | 0.2                                       |       | —       |       | 0.2                             |       | 0.5 | % | 0.0 | % |
| Commercial  real estate loans and securities |       | (0.1                                      | )          | 2.2          |       | (2.3                            | )          | -0.3 | % | 2.1 | % |
| Treasuries  and short term investments       |       | 0.1                                       |       | 1.3          |       | (1.2                            | )          | 0.3 | % | 1.3 | % |
| Equities  and other investments              |       | 0.4                                       |       | 0.1          |       | 0.3                             |       | 0.8 | % | 0.1 | % |
| **Total interest income**                    |       | $                                         | 38.7       |         | $          | 103.1                           |       | $ | (64.4 | ) | 100.0 | % | 100.0 | % |

 

The decrease in interestincome of $9.5 million and $64.4 million for the three and nine months ended September 30,2009, respectively, as compared to the same periods in 2008, was attributableprimarily to the reduction of our RMBS and alternative assets portfolios and,to a lesser extent, to a lower interest rate environment. As of September 30,2009, our RMBS and alternative asset portfolios totaled $316.9 million and$303.3 million, respectively, as compared to $414.5 million and $612.4 million,respectively, at September 30, 2008.  RMBS interest income decreasedby $1.9 million and $41.3 million for the three and nine months ended September 30,2009, respectively, as compared to the same periods in 2008. This decline wasprimarily the result of the sale of RMBS with an amortized cost of $6.2 billionduring the three months ended March 31, 2008 combined with a lowerinterest rate environment.  The $7.6 million and $23.1 milliondecrease in alternative assets interest income for the three and nine monthsended September 30, 2009, respectively, compared to the same periods in2008, was primarily the result of lower investment balances and a lower interestrate environment during the three and nine months ended September 30, 2009as compared to the same periods in 2008. Loans held in DFR MM CLO and other corporate leveraged loans totaled$275.6 million as of September 30, 2009 as compared to $348.0 millionof loans held in DFR MM CLO, loans held in the Wachovia Facility and othercorporate leveraged loans as of September 30, 2008.  The WachoviaFacility was fully repaid and all of our obligations thereunder were satisfiedduring the third quarter of 2009. Reductions in interest rates and the placement of certain loans onnon-accrual status also contributed to the reductions in interest income onloans held in DFR MM CLO and commercial real estate loans and securities. The decrease in interest income on loans held in the Wachovia Facility of$2.2 million and $7.2 million for the three and nine months ended September 30,2009, respectively, was the result of the sale of a substantial portion of theloans in the portfolio during 2008 and the first quarter of 2009.  In addition, as a result of the sale of allof our preference shares in Market Square CLO, we deconsolidated Market SquareCLO on June 30, 2009 and subsequent to the sale we no longer include theresults of Market Square CLO in the results of our operations.  Reductions in interest income related toMarket Square CLO were $4.2 million and $7.6 million for the three and ninemonths ended September 30, 2009, respectively, as compared to the sameperiods in 2008.

 

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The following tablesummarizes our Principal Investing segment interest expense:

 
| ** **                          | ** ** | **Three  months ended September 30,** | ** ** | **Variance** | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                          | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **2009  vs. 2008**                        | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                          | ** ** | **(In  millions)**                         | ** ** |
| Repurchase  agreements              |       | $                                          | 0.4        |         | $          | 2.8                                       |       | $            | (2.4       | ) | $ | 1.7 |   | $ | 37.2 |   | $ | (35.5 | ) |
| Hedging  activity                   |       | —                                     |       | —       |       | —                                    |       | 0.1          |       | 5.3 |   | (5.2 | ) |
| Long  term debt:                    |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Recourse:                           |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Trust  preferred securities         |       | 1.1                                        |       | 1.8          |       | (0.7                                      | )          | 3.8          |       | 5.7 |   | (1.9 | ) |
| Non-Recourse:                       |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Wachovia  Facility                  |       | —                                     |       | 0.3          |       | (0.3                                      | )          | —       |       | 1.5 |   | (1.5 | ) |
| Market  Square CLO                  |       | —                                     |       | 2.3          |       | (2.3                                      | )          | 2.7          |       | 8.0 |   | (5.3 | ) |
| DFR  MM CLO                         |       | 0.8                                        |       | 2.0          |       | (1.2                                      | )          | 3.3          |       | 7.1 |   | (3.8 | ) |
| Total  long term debt               |       | 1.9                                        |       | 6.4          |       | (4.5                                      | )          | 9.8          |       | 22.3 |   | (12.5 | ) |
| Amortization  of debt issuance cost |       | 0.3                                        |       | 0.7          |       | (0.4                                      | )          | 1.1          |       | 1.6 |   | (0.5 | ) |
| Total  interest expense             |       | $                                          | 2.6        |         | $          | 9.9                                       |       | $            | (7.3       | ) | $ | 12.7 |   | $ | 66.4 |   | $ | (53.7 | ) |

 

The decrease in interestexpense of $7.3 million and $53.7 million for the three and nine monthsended September 30, 2009, respectively, as compared to the three and ninemonths ended September 30, 2008, was primarily the result of significantlyreduced repurchase agreement balances, decreased interest rates and decreasedlong term debt balances.

 

During the first quarterof 2008, we significantly reduced our RMBS portfolio through sales, which inturn resulted in the repayment of the outstanding repurchase agreements used tofinance that RMBS and the termination of the associated interest rate swapsused to hedge our interest rate risk on those repurchase agreements. Thedecrease in the average outstanding repurchase agreement balance and swapsoutstanding for the three and nine months ended September 30, 2009,combined with a lower interest rate environment during the three and ninemonths ended September 30, 2009, as compared to the three and nine monthsended September 30, 2008, contributed to a decrease in interest expense of$2.4 million and $35.5, respectively.

 

The interest expenserelated to long term debt decreased by $4.9 million and $13.0 million forthe three and nine months ended September 30, 2009, respectively, ascompared to the same periods in 2008. The deconsolidation of Market Square CLOon June 30, 2009 provided a decrease in interest expense of $2.3 millionand $5.3 million for the three and nine months ended September 30, 2009,respectively, as compared to the same periods in 2008. Lower interest rates onour long term debt provided decreases of $1.9 million and $5.7 million for thethree and nine months ended September 30, 2009, respectively, as comparedto the same periods in 2008. In addition, from September 30, 2008 to September 30,2009, we decreased the outstanding balance in the Wachovia Facility from$34.1 million to zero through sales and paydowns on the portfolio. Thisresulted in a reduction to our interest expense of $0.3 million and $1.5million for the three and nine months ended September 30, 2009,respectively, as compared to the same periods in 2008.

 

***Provision for Loan Losses***

 

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

 
| ** **                       | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                  | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(In millions)**                         | ** ** |
| Loans  held in DFR MM CLO        |       | $                                         | 4.2        |                                     | $          | 6.8 |   | $ | 13.9 |   | $ | 6.8 |   |
| Loans  held in Wachovia Facility |       | —                                    |       | 6.2                                      |       | — |   | 6.2 |   |
| Other  corporate leveraged loans |       | —                                    |       | —                                   |       | — |   | 2.2 |   |
| Commercial  real estate loans    |       | —                                    |       | 2.5                                      |       | 1.6 |   | 4.8 |   |
| Total  provision for loan losses |       | $                                         | 4.2        |                                     | $          | 15.5 |   | $ | 15.5 |   | $ | 20.0 |   |

 

During the three and ninemonths ended September 30, 2009, we recognized provisions for loan lossesof $4.2 million and $15.5 million, respectively. During the three monthsended September 30, 2009, we recorded provisions for loan losses of $4.2million related to three loans held in DFR MM CLO with total outstandingprincipal of $20.7 million.  In addition, during the six months ended June 30,2009, we recorded provisions for loan losses of $8.8 million related to twoloans that we further impaired this quarter, $0.9 million related to twoadditional loans held in DFR MM CLO with total outstanding principal of $9.7million, $1.1 million related to three commercial real estate loans stillbeing held for investment with total outstanding principal of $8.1 million and$0.5 million related to one commercial real estate loan which we no longer own.

 

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During the three and ninemonths ended September 30, 2008, we recorded an increase to the provisionsfor loan losses of $15.5 million and $20.0 million, respectively.  During the three months ended September 30,2008, we determined that a provision for loan loss of $6.8 million was requiredon a loan held in DFR MM CLO with an outstanding principal balance of $9.0million. In addition, during the three months ended September 30, 2008, wedetermined that a charge to the provision for loan losses of $4.5 million wasrequired for one loan held in the Wachovia Facility with an outstandingprincipal balance of $6.0 million, and we determined that a charge to theprovision for loan losses of $1.7 million was required as we determined that wehad the intention of selling five loans held in the Wachovia Facility with anoutstanding principal balance of $24.3 million and subsequently transferredthese loans to loans held for sale. During the three months ended September 30,2008, we also recognized a $1.3 million provision for loan losses on acommercial real estate loan with an outstanding principal of $2.1 million, andwe determined that an additional $1.2 million of provision for loan losses wasrequired on another commercial real estate loan for which a $0.4 millionprovision for loan losses was previously taken during the six months ended June 30,2008.  During the six months ended June 30,2008, we determined that a provision for loan losses of $2.2 million wasrequired for one other corporate leveraged loan with an outstanding principalbalance of $10.0 million, and we determined that a provision for loan losses of$2.3 million was required for three commercial real estate loans with a totaloutstanding principal balance of $6.1 million.

 

***Expenses***

 

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

 
| ** **                                   | ** ** | **Three  months ended September 30,** | ** ** | **Variance** | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **2009  vs. 2008**                        | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                                   | ** ** | **(In  millions)**                         | ** ** |
|                                         |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Management  fee expense to related party (1) |       | $                                          | 1.6        |         | $          | 2.1                                       |       | $            | (0.5       | ) | $ | 4.8 |   | $ | 10.5 |   | $ | (5.7 | ) |
|                                         |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Audit  and audit-related fees                |       | 0.2                                        |       | 0.4          |       | (0.2                                      | )          | 0.6          |       | 1.3 |   | (0.7 | ) |
| Legal  fees                                  |       | 0.2                                        |       | 1.1          |       | (0.9                                      | )          | 0.9          |       | 2.8 |   | (1.9 | ) |
| Other  professional fees                     |       | 0.1                                        |       | 0.1          |       | —                                    |       | 0.3          |       | 0.6 |   | (0.3 | ) |
| Total  professional services                 |       | 0.5                                        |       | 1.6          |       | (1.1                                      | )          | 1.8          |       | 4.7 |   | (2.9 | ) |
|                                         |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Insurance  expense                           |       | 0.6                                        |       | 0.6          |       | —                                    |       | 2.0          |       | 1.8 |   | 0.2 |   |
|                                         |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Board  of directors fees                     |       | 0.3                                        |       | 0.4          |       | (0.1                                      | )          | 1.3          |       | 1.5 |   | (0.2 | ) |
| Banking  and other administrative fees       |       | 0.1                                        |       | 0.1          |       | —                                    |       | 0.4          |       | 0.5 |   | (0.1 | ) |
| Software  and data feeds                     |       | —                                     |       | —       |       | —                                    |       | —       |       | 0.2 |   | (0.2 | ) |
| Other  general and administrative fees       |       | 0.1                                        |       | —       |       | 0.1                                       |       | 0.2          |       | 0.2 |   | — |   |
| DPLC  stucturing and organizational expenses |       | 0.1                                        |       | —       |       | 0.1                                       |       | 3.3          |       | — |   | 3.3 |   |
| Total  general and administrative expenses   |       | 0.6                                        |       | 0.5          |       | 0.1                                       |       | 5.2          |       | 2.4 |   | 2.8 |   |
|                                         |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Total  Principal Investing segment expenses  |       | $                                          | 3.3        |         | $          | 4.8                                       |       | $            | (1.5       | ) | $ | 13.8 |   | $ | 19.4 |   | $ | (5.6 | ) |

 

----

(1)             Management fee expense of $1.3 million and$4.2 million for the three and nine months ended September 30, 2009,respectively, and $2.1 million and $10.5 million for the three and nine monthsended September 30, 2008, respectively, is charged in conjunction with ourmanagement agreement with DCM and eliminated in consolidation.

 

The decrease in expensesof $1.5 million for the three months ended September 30, 2009, compared tothe same period in 2008, was attributable to decreases in professional servicesand management fee expense to related party of $1.1 million and $0.5 million,respectively, partially offset by increases in general and administrativeexpenses of $0.1 million.  Management fee expense to related party isprimarily related to our management agreement with DCM and is generallyeliminated upon consolidation.  Ourmanagement agreement with DCM is based upon a cost plus margin basis forinvestment advisory, management and operational services. The decrease in totalprofessional services of $1.1 million was primarily the result of decreasedlegal fees.  The $0.1 million increase in general and administrativeexpenses was primarily driven by $0.1 million in organizational expenses fromthe formation of DPLC.  These fees were borne by DPLC.

 

The decrease in expensesof $5.6 million for the nine months ended September 30, 2009, compared tothe same period in 2008, was attributable to decreases in management feeexpense to related party and professional services of $5.7 million and $2.9million, respectively, partially offset by increases in general andadministrative expenses and insurance expense of $2.8 million and $0.2 million,respectively.  The decrease in total professional services of $2.9 millionwas primarily the result of a $1.9 million decrease in legal fees and a $0.7million decrease in audit and audit-related fees based on a reduction inestimated fees for services during 2009.  The $2.8 million increase ingeneral and administrative expenses was primarily driven by $3.3 million inone-time organizational and structuring fees from the formation of DPLC. These fees were borne by DPLC.  The $0.2 million increase in insuranceexpense reflects an increase in insurance premiums over the prior periodpresented.

 

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

 

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

 
| ** **                                                        | ** ** | **Three  months ended September 30,** | ** ** | **Variance** | ** ** | **Nine  months ended September 30,** | ** ** | **Variance** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                                                        | ** ** | **2009**                                   | ** ** | **2008**     | ** ** | **2009  vs. 2008**                        | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                                                        | ** ** | **(In  millions)**                         | ** ** |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Other-than-temporary  impairment on available-for-sale securities |       | $                                          | —     |         | $          | (0.9                                      | )          | $            | 0.9        |   | $ | — |   | $ | (4.7 | ) | $ | 4.7 |   |
| Net  loss on available-for-sale securities                        |       | —                                     |       | (0.9         | )          | 0.9                                       |       | —       |       | (4.7 | ) | 4.7 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Net  realized gain (loss) on investments at fair value            |       | 2.3                                        |       | 0.1          |       | 2.2                                       |       | 2.0          |       | (169.1 | ) | 171.1 |   |
| Net  unrealized gain (loss) on investments at fair value          |       | 0.2                                        |       | (13.3        | )          | 13.5                                      |       | 7.0          |       | (43.6 | ) | 50.6 |   |
| Net  gain (loss) on investments at fair value                     |       | 2.5                                        |       | (13.2        | )          | 15.7                                      |       | 9.0          |       | (212.7 | ) | 221.7 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Net  realized gain (loss) on loans                                |       | 0.7                                        |       | 0.6          |       | 0.1                                       |       | (6.4         | )          | (12.0 | ) | 5.6 |   |
| Net  unrealized (loss) gain on loans                              |       | (0.2                                       | )          | (15.0        | )          | 14.8                                      |       | 37.6         |       | (23.4 | ) | 61.0 |   |
| Net  gain (loss) on loans                                         |       | 0.5                                        |       | (14.4        | )          | 14.9                                      |       | 31.2         |       | (35.4 | ) | 66.6 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Net  realized (loss) gain on interest rate swaps                  |       | (0.1                                       | )          | 0.2          |       | (0.3                                      | )          | (9.5         | )          | (271.9 | ) | 262.4 |   |
| Net  realized loss on credit default swaps                        |       | —                                     |       | —       |       | —                                    |       | (0.5         | )          | (2.4 | ) | 1.9 |   |
| Net  realized loss on total return swaps                          |       | —                                     |       | (1.5         | )          | 1.5                                       |       | —       |       | (2.2 | ) | 2.2 |   |
| Net  realized loss on interest rate floors and caps               |       | —                                     |       | —       |       | —                                    |       | —       |       | (1.6 | ) | 1.6 |   |
| Net  realized loss on warrants                                    |       | (0.2                                       | )          | —       |       | (0.2                                      | )          | (0.2         | )          | — |   | (0.2 | ) |
| Net  unrealized gain (loss) on interest rate swaps                |       | 0.1                                        |       | (1.8         | )          | 1.9                                       |       | 12.2         |       | 55.8 |   | (43.6 | ) |
| Net  unrealized gain on credit default swaps                      |       | —                                     |       | —       |       | —                                    |       | 0.4          |       | 0.4 |   | — |   |
| Net  unrealized gain on total return swaps                        |       | —                                     |       | 0.9          |       | (0.9                                      | )          | —       |       | 1.2 |   | (1.2 | ) |
| Net  unrealized gain on interest rate floors and caps             |       | —                                     |       | —       |       | —                                    |       | —       |       | 1.1 |   | (1.1 | ) |
| Net  unrealized gain on warrants                                  |       | 0.2                                        |       | —       |       | 0.2                                       |       | 0.1          |       | 0.2 |   | (0.1 | ) |
| Net  (loss) gain on derivatives                                   |       | —                                     |       | (2.2         | )          | 2.2                                       |       | 2.5          |       | (219.4 | ) | 221.9 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Dividend  income                                                  |       | 0.1                                        |       | 0.2          |       | (0.1                                      | )          | 0.2          |       | 0.4 |   | (0.2 | ) |
| Other  net loss                                                   |       | (0.5                                       | )          | (0.9         | )          | 0.4                                       |       | (0.5         | )          | (0.9 | ) | 0.4 |   |
| Dividend  income and other net loss                               |       | (0.4                                       | )          | (0.7         | )          | 0.3                                       |       | (0.3         | )          | (0.5 | ) | 0.2 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Net  gain on the deconsolidation of Market Square CLO             |       | —                                     |       | —       |       | —                                    |       | 29.6         |       | — |   | 29.6 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Net  other income and gain (loss)                                 |       | $                                          | 2.6        |         | $          | (31.4                                     | )          | $            | 34.0       |   | $ | 72.0 |   | $ | (472.7 | ) | $ | 544.7 |   |
|                                                              |       |                                       |       |         |       |                                      |       |         |       |   |   |   |   |
| Total  realized gain (loss)                                       |       | $                                          | 2.8        |         | $          | (1.3                                      | )          | $            | 3.2        |   | $ | 15.2 |   | $ | (459.7 | ) | $ | 474.0 |   |
| Total  unrealized (loss) gain                                     |       | $                                          | (0.2       | )            | $          | (30.1                                     | )          | $            | 29.9       |   | $ | 56.8 |   | $ | (13.0 | ) | $ | 69.8 |   |

 

Net other income and gain(loss) improved by $34.0 million and $544.7 million for the three and ninemonths ended September 30, 2009, respectively, compared to the sameperiods for 2008. The improvement during the three months ended September 30,2009, as compared to the same period in 2008, was primarily attributable toimprovements on investments at fair value and loans of $15.7 million and $14.9million, respectively.  The improvement during the nine months ended September 30,2009, as compared to the same period in 2008, was primarily attributable toimprovements in derivatives, investments at fair value and loans of $221.9million, $221.7 million and $66.6 million, respectively, and a net gain on thedeconsolidation of Market Square CLO of $29.6 million.

 

During the three and ninemonths ended September 30, 2009, the net gains on investments at fairvalue were $2.5 million and $9.0 million, respectively, primarily driven by$2.1 million of unrealized gains on other investments at fair value during thethree and nine months ended September 30, 2009 and net gains on the RMBSportfolio of $5.9 million during the nine months ended September 30 2009.The decrease in net losses on investments at fair value and derivatives wasprimarily the result of the significant sales of our RMBS portfolio andassociated reductions in our outstanding interest rate swaps during the firstquarter of 2008.  During the first quarter of 2008, our RMBS portfolioexperienced a significant decrease in value fueled by the emergent creditcrisis. This reduced our ability to successfully finance and hedge our RMBSportfolio. We sold a substantial portion of our non-Agency RMBS and Agency RMBSto improve liquidity, which resulted in realized trading losses of$212.7 million for the nine months ended September 30, 2008.  Inconjunction with the sale of a substantial portion of our RMBS portfolio duringthe nine months ended September 30, 2008, we terminated 202 interest rateswaps with a notional amount of $5.3 billion, which resulted in net losses oninterest rate swaps during the nine months ended September 30, 2008 of$216.1 million.

 

Prior to these sales, asof January 1, 2008, in conjunction with the adoption of ASC Topic 825, wede-designated $3.8 billion (notional) of interest rate swaps previouslydesignated as a hedge with a net negative fair value of $85.9 million atde-designation, including accrued interest.  As of the adoption date, theother comprehensive loss related to the de-designation of interest rate hedgeswas $69.9 million. To the extent that the forecasted rolls on repurchaseagreement transactions continued as anticipated, we would have amortized thisloss and the $27.3 million in other comprehensive loss related topreviously de-designated swaps from other comprehensive loss into interestexpense over the remaining original hedge period, and all future changes infair value of the interest rate swaps would be reflected in the condensedconsolidated statements of operations. However, due to the significant RMBSsales activity and corresponding repurchase agreement repayment during thethree months ended March 31, 2008, forecasted rolls on the repaidrepurchase agreements did not continue as anticipated. As a result, a loss of$91.7 million (including $69.6 million of accelerated amortization oninterest rate swaps) was recognized during the three months ended March 31,2008 in the condensed consolidated statements of operations in net loss onderivatives, and a corresponding cumulative net loss relating to newly andpreviously de-designated and terminated interest rate swaps in othercomprehensive loss was removed.

 

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The improvement in netgain (loss) on loans during the nine months ended September 30, 2009 wasprimarily the result of stronger market performance, which in turn increasedthe valuation of our held for sale portfolio within Market Square CLO by $45.2million.  Unrealized gains on loans held for sale include recoveries up tooriginal cost or value on the date the loan was transferred from loans held forinvestment to loans held for sale.  The increase in valuation on ourMarket Square CLO loan portfolio was partially offset by decreased performanceon loans held for sale in our structured and syndicated loan portfolio whichdrove down valuations on these loans. In addition, we realized net loss onsales of loans of $6.4 million during the nine months ended September 30,2009 primarily as a result of the sale of loans held within the WachoviaFacility with a par value of $31.5 million for $10.8 million, net of interestof $0.2 million, during the three months ended March 31, 2009.

 

Although substantiallyall of the $31.2 million of net gain on loans for the nine months ended September 30,2009 was related to loans held in Market Square CLO, our future results willnot reflect changes to the values of loans held in Market Square CLO as aresult of its deconsolidation.

 

***Income Tax Expense***

 

For the three and ninemonths ended September 30, 2009, the Principal Investing segment recordedincome tax expense of $75,000 and $225,000, respectively, as a result ofdifferences in the calculation of alternative minimum taxable income versusregular taxable income.

 

**Off-BalanceSheet Arrangements**

 

In September 2005, August 2006and October 2006, we formed Deerfield Capital Trust I, Deerfield CapitalTrust II and Deerfield Capital Trust III, or the Trusts, which are VIEs.Through our wholly-owned subsidiary, DC LLC, we own 100% of the common sharesof the Trusts, which issued, in the aggregate, $120.0 million of preferredshares to unaffiliated investors. DC LLC issued junior subordinated debtsecurities to the Trusts in the aggregate of $123.7 million, which areguaranteed by us. The rights of common shares of the Trusts are subordinate tothe rights of the preferred shares only in the event of a default. Otherwise,the common stockholders’ economic and voting rights rank pari passu with thepreferred stockholders. We record the investment in the Trusts’ common sharesas other investments at cost and record dividend income upon declaration by theTrust. The junior subordinated debt securities are recorded as long term debt,and debt issuance costs are deferred in prepaid and other assets in theconsolidated balance sheet. Interest on the debt securities and amortization ofdebt issuance costs are recorded in the consolidated statements of operationsas interest expense.

 

As of September 30,2009, we did not maintain any other relationships with unconsolidated entitiesor financial partnerships, such as entities often referred to as structuredfinance, special purpose or VIEs, established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes. Further, as of September 30, 2009, we had not guaranteed anyobligations of unconsolidated entities or entered into any commitment or intentto provide additional funding to any such entities, except for the Trusts.

 

**Liquidityand Capital Resources**

 

We held cash and cashequivalents of $47.5 million as of September 30, 2009.

 

Our operating activitiesused cash of $96.5 million for the nine months ended September 30,2009, primarily through the following:

 

Net inflows and non-cashadjustments of $91.1 million, consisting of the following:

 

·                              Net income attributable to DFR —$66.2 million

·                              Provision for loan losses —$15.5 million

·                              Depreciation and amortization— $4.9 million

·                              Net change in operating assets andliabilities — $3.2 million

·                              Unrealized loss from other investments — $0.6million

·                              Share-based compensation —$0.3 million

·                              Impairment of intangible assets— $0.1 million

·                              Non-cash rental expense —$0.1 million

·                              Amortization of net loss on previouslydesignated derivatives — $0.1 million

·                              Deferred tax expense —$0.1 million

 

Net outflows and non-cashadjustments totaled $187.6 million, consisting of the following:

 

·                              Net purchases of investments at fairvalue — $99.6 million

·                              Net gain on loans —$31.2 million

 

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·                              Net gain on the deconsolidation ofMarket Square CLO — $29.6 million

·                              Net changes in undesignated derivatives —$12.9 million

·                              Net gain on investments at fairvalue — $9.3 million

·                              Net loss attributable to noncontrollinginterest — $2.9 million

·                              Net premium and discount amortization oninvestments, loans and debt issuance — $1.2 million

·                              Net purchases of loans held forsale — $0.9 million

 

Our investing activitiesprovided cash of $135.8 million for the nine months ended September 30,2009, primarily from principal payments and proceeds from the sale ofinvestments at fair value previously classified as available-for-sale of $120.8million, the change in restricted cash and cash equivalents of $49.4 million,principal payments and proceeds from the sale of loans held for investment of$35.3 million and proceeds from the sale of loans previously classified as heldfor investment of $12.0 million, partially offset by the origination andpurchase of loans held for investment of $81.7 million.

 

Our financing activitiesused cash of $24.5 million for the nine months ended September 30, 2009,primarily for payments on repurchase agreements of $19.5 million, payments onthe Wachovia Facility of $13.9 million, payments on other long term debtof $11.1 million and debt issuance costs of $0.1 million, partially offsetby contributions of noncontrolling interests of $20.1 million.

 

***Leverage***

 

The sale of a substantialportion of our RMBS portfolio has decreased our reliance on short term debt, inthe form of repurchase agreements, used to finance that portfolio. Our RMBSholdings were $316.9 million, and our repurchase agreement liabilitieswere $306.3 million, as of September 30, 2009. As discussed in moredetail in the following section, “*Liquidity and Sources ofFunds*,” our remaining long term debt of $417.9 million consists of$222.0 million of non-recourse debt, $72.2 million of Series Aand Series B Notes, due in 2012, and $123.7 million of trustpreferred securities with $51.6 million and $72.1 million due in 2035and 2036, respectively.

 

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

 

**Liquidityand Sources of Funds**

 

We believe that ourcurrent cash and cash equivalents, unencumbered liquid assets and net equity inour financed RMBS portfolio, along with cash flows from operations, among otherthings, are adequate to meet anticipated long term (greater than one year)liquidity requirements.  Unencumbered RMBS and unrestricted cash and cashequivalents aggregated $50.6 million at September 30, 2009. Inaddition, net equity in our financed RMBS portfolio (including associatedinterest rate swaps), excluding the unencumbered RMBS included above, totaled$10.8 million at quarter end. In total, we had unrestricted cash and cashequivalents, unencumbered RMBS and net equity in the financed RMBS portfolio of$61.4 million as of September 30, 2009. As of September 30,2009, the fair value of our Agency RMBS and non-Agency RMBS portfolios were$314.0 million and $2.9 million, respectively. Our largest repurchaseagreement counterparty has required that we maintain a minimum of$20.0 million of cash and certain eligible securities in their custody inorder to maintain our current repurchase agreement margin percentages on ourAgency RMBS. If we fail to satisfy this requirement, the counterparty will havethe right to immediately increase the margin percentages under our repurchaseagreements and may exercise other remedies.

 

On July 31, 2009, weentered into three supplemental indentures with the holders of the trustpreferred securities issued by each of Deerfield Capital Trust I,Deerfield Capital Trust II and Deerfield Capital Trust III.  See*“Recourse Debt”* below for additionaldisclosure regarding the supplemental indentures.

 

We attempt to maintainour leverage at a level that we believe ensures that our cash and cashequivalents will be sufficient to satisfy our liquidity requirements. However,if we are not successful, we may be required to sell additional RMBS orCorporate Loans and may be unable to do so on favorable terms or at all. Salesof additional RMBS or Corporate Loans at prices lower than their carrying valuewould result in further realized losses and reduced income. For furtherdiscussions concerning the availability of repurchase agreement financing,which we use to finance our RMBS portfolio, see*“Trends — Liquidity”* above. We may increase our capitalresources by consummating offerings of securities or issuing new debt, possiblyincluding preferred stock, common stock, commercial paper, medium-term notes,CDOs, collateralized mortgage obligations and other borrowings. The ability toexecute these strategies will depend on, among other things, market conditionsfor capital raises and for the investment of any proceeds.

 

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

 

As we focus on growingour Investment Management segment, we expect to utilize our cash and liquidityto invest in new investment products.  We also may use our cash inconnection with the acquisition of CDO management contracts or other InvestmentManagement opportunities. We expect substantially all of our CLO subordinatedinvestment advisory fees to continue to be deferred in the near term. However, over time and with improved market conditions and effective portfoliomanagement, we expect the CLOs to regain compliance with theirovercollateralization tests, and, subject to the satisfaction of certain otherconditions, we would expect to recoup at least a portion and potentiallysubstantially all of the deferred subordinated management fees and to receivefuture subordinated management fees on a current basis.

 

The economic impact ofour investment in DFR MM CLO is determined by the cash flows distributed to usby DFR MM CLO on our investment in $50.0 million of preferred shares and ourinvestment in $19.0 million of debt of DFR MM CLO, subject to diversion of cashflows away from us as provided in accordance with the indenture for DFR MMCLO.  For the three and nine months ended September 30, 2009, the netincome of $1.4 million and $2.2 million, respectively, recorded under GAAP forDFR MM CLO were not indicative of the economic impact to us of cash flowdistributions from DFR MM CLO of $0.2 million and $5.2 million,respectively.  Cash flows from our investment in the preferred shares ofDFR MM CLO began to be diverted during the second quarter of 2009 in accordancewith the DFR MM CLO indenture; however, cash flows are still being received onour investment in DFR MM CLO debt.

 

***Investment Management Segment***

 

The following is asummary of our recourse Investment Management segment borrowings as of September 30,2009:

 
| ** **                                      | ** ** | **Series A and**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **Series B Notes** | ** ** |
| Outstanding  balance (in thousands)             |       | $                       | 72,178     | (1) |
| Weighted  average borrowing rate                |       | 5.60                    | %          |
| Weighted-average  remaining maturity (in years) |       | 3.25                    |       |
|                                                 |            |                         |            |  |

 

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(1) Principal outstanding of $73.9 million is presented net of a$1.7 million discount.

 

***Principal Investing Segment***

 

The following is asummary of our Principal Investing segment borrowings as of September 30,2009:

 
| ** **                                      | ** ** | **Recourse**   | ** ** | **Non-Recourse** | ** ** | ** **     | ** ** |
|-------------------------------------------------|------------|----------------|------------|------------------|------------|----------------|------------|
| ** **                                      | ** ** | ** **     | ** ** | **Trust**        | ** ** | ** **     | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Repurchase** | ** ** | **Preferred**    | ** ** | ** **     | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Agreements** | ** ** | **Securities**   | ** ** | **DFR MM CLO** | ** ** | **Total** | ** ** |
| Outstanding  balance (in thousands)             |       | $              | 306,304    |             | $          | 123,717        |       | $ | 222,026 | (2) | $ | 652,047 |   |
| Weighted  average borrowing rate                |       | 0.68           | %          | 3.26             | %          | 1.22           | %(3)       | 1.35 | % |
| Weighted-average  remaining maturity (in years) |       | 0.02           |       | 26.68            | (1)        | 9.81           |       | 8.41 |   |
|                                                 |            |                |            |                  |            |                |            |  |  |  |  |  |  |

 

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(1)           $51.6 million of the Trust PreferredSecurities are callable by us after October 30, 2010, and$72.1 million are callable by us after October 30, 2011.

(2)           The term financing is callable on July 20,2010 and quarterly thereafter.

(3)           Excludes $19.0 million of DFR MM CLOdebt that is owned by us and eliminated upon consolidation. Had this debt beenincluded, the weighted-average borrowing rate would be 1.48%.

 

*RecourseDebt*

 

Recourse debt refers todebt that is a general obligation of ours. Our Trust Preferred Securities (asdefined below) are not subject to potential margin calls for additional pledgesof our cash or assets.

 

*RepurchaseAgreements.* As ofSeptember 30, 2009, proceeds from repurchase agreements totaling$306.3 million, with a weighted-average current borrowing rate of 0.68%,were used to finance the acquisition of RMBS. We expect to continue borrowingfunds in the form of repurchase agreements. As of September 30, 2009, wehad outstanding repurchase agreement balances with two financial institutions.Our repurchase agreement liabilities are significantly concentrated with onecounterparty that provides financing 

 

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for 85.1% of our$306.3 million of repurchase agreement liabilities as of September 30,2009. Increases in interest rates could reduce the value of our RMBS, whichcould limit our borrowing ability or cause our lenders to initiate additionalmargin calls. An increase in the percentage deduction of fair value of RMBScollateral that we receive in cash at the inception of the repurchaseagreement, which we sometimes refer to as a haircut, imposed by ourcounterparties would limit our borrowing capacity. Amounts due upon maturity ofour repurchase agreements will be funded primarily through the rollover orre-issuance of repurchase agreements and monthly principal and interestpayments received on our RMBS.

 

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

 
| ** **                               | ** ** | ** **             | ** ** | **Weighted-Average**       | ** ** |
|------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | ** **             | ** ** | **Maturity of Repurchase** | ** ** |
| ** **                               | ** ** | **Amount at Risk (1)** | ** ** | **Agreements**             | ** ** |
| ** **                               | ** ** | **(In thousands)**     | ** ** | **(In days)**              | ** ** |
| **Repurchase Agreement Counterparties:** | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Deutsche  Bank Securities Inc.           |       | $                      | 4,223      |                       | 6          |   |
| Fortis  Securities LLC                   |       | 4,714                  |       | 7                          |       |
| Total                                    |       | $                      | 8,937      |                       | 7          |   |

 

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(1)  Equal to the fair value of securitiespledged minus repurchase agreement liabilities and related accrued interestpayable.

 

*TrustPreferred Securities.*On July 31, 2009, we entered into the three supplementalindentures, or the Supplemental Indentures, with the holders of our trustpreferred securities issued by each of Deerfield Capital Trust I, DeerfieldCapital Trust II and Deerfield Capital Trust III, or collectively the TrustPreferred Securities.  The Supplemental Indentures amend the consolidatednet worth covenants, or the Net Worth Covenants, contained in the indenturesgoverning the Trust Preferred Securities to (i) permanently decrease thenet worth required by the Net Worth Covenants from $175 million to $50 millionand (ii) provide that the initial measurement date for compliance with theNet Worth Covenants will be September 30, 2012.  In addition, theSupplemental Indentures contain provisions prohibiting us from (i) incurringadditional indebtedness for the life of the Trust Preferred Securities, exceptfor indebtedness permitted to be incurred in accordance with provisions thatare substantially similar to the provisions of the agreements governing the Series Aand Series B Notes, and (ii) declaring additional dividends ordistributions on our capital stock for the life of the Trust PreferredSecurities, except as permitted in accordance with provisions that aresubstantially similar to the provisions of the agreements governing the Series Aand Series B Notes.  The Supplemental Indentures also provide therepresentative of the holders of the Trust Preferred Securities with certaininspection rights.  The Supplemental Indentures supersede the temporarywaiver of the Net Worth Covenants obtained from the holders of the TrustPreferred Securities in November 2008.  We paid the holders of theTrust Preferred Securities a fee of $250,000 on July 31, 2009 andcommitted to pay such holders an additional fee of $250,000 on or before July 31,2010 in connection with the Supplemental Indentures.

 

*Non-RecourseDebt*

 

Non-recourse debt refersto debt with recourse only to specific assets pledged as collateral to thelenders, such as warehouse facilities and the debt issued by CDOs that areconsolidated by us as VIEs. The creditors of the non-recourse debt have norecourse to our other assets. None of the our non-recourse debt is subject topotential margin calls for additional pledges of our cash or assets.

 

*DFR MMCLO.  *During the three months ended September 30,2009, DFR MM CLO paid down $9.0 million of its outstanding debt as a result ofcertain structural provisions contained in its indenture. The carrying value of the collateral heldin DFR MM CLO, which are the only assets to which the DFR MM CLO debt holdershave recourse for repayment, was $280.1 million as of September 30, 2009.

 

*WachoviaFacility.  *The Wachovia Facility was fully repaid during the three months ended September 30,2009, and all of our obligations thereunder were satisfied.

 

***Distribution Policy***

 

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

 

***Inflation***

 

Virtually all of ourassets and liabilities are interest rate sensitive. As a result, interest ratesand other factors influence our performance more than inflation. Our financialstatements are prepared in accordance with GAAP, and therefore, our activitiesand balance sheet are measured with reference to historical cost or fair valuewithout considering inflation.

 

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***Seasonality***

 

While our InvestmentManagement segment is not directly affected by seasonality, our investmentadvisory fees may be higher in the fourth quarter of our fiscal year as aresult of our revenue recognition accounting policy for performance feesrelated to DPLC. We currently do not expect to have performance fees in thecurrent year related to DPLC.

 

**ITEM 3.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

As of September 30,2009, the primary component of our market risk was interest rate and spreadrisk, as described below. While we do not seek to avoid risk completely, wemanage interest rate risk and regularly assess whether earnings in theportfolio include appropriate compensation for the inherent market risks towhich it is exposed. In light of these risks, we regularly consider our capitallevels and currently are focused on redeploying capital from PrincipalInvesting activities to growing our Investment Management segment.

 

**InterestRate Risk**

 

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

 

**Effecton Net Interest Income**

 

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

 

In order to mitigate ourinterest rate exposure, we have two interest rate swap transactions outstandingas of September 30, 2009. The following table summarizes the expirationdates of these contracts and their notional amounts:

 
| **Year of Expiration** | ** ** | **Notional Amount** | ** ** |
|------------------------|------------|---------------------|------------|
| ** **             | ** ** | **(In thousands)**  | ** ** |
| 2009                   |       | $                   | 20,000     |   |
| 2010                   |       | 10,000              |       |
| Total                  |       | $                   | 30,000     |   |

 

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

 

**ExtensionRisk**

 

The majority of our RMBSportfolio consists of hybrid adjustable-rate RMBS, which have interest ratesthat are fixed for the first several years of the loan (typically three, five,seven or 10 years) and, thereafter, reset periodically on the same basisas adjustable-rate RMBS. We compute the projected weighted-average life of ourRMBS based on assumptions regarding the rate at which the borrowers will prepaythe underlying mortgages. In general, when a fixed-rate or hybridadjustable-rate RMBS is funded by a short term borrowing, we may, but are notrequired to, enter into an interest rate swap agreement or other hedginginstrument that effectively fixes a portion of our borrowing costs for a periodclose to the anticipated weighted-average life of the fixed-rate portion of therelated RMBS. This strategy is designed to protect a portion of our portfoliofrom increased funding costs due to rising interest rates because the borrowingcosts are not fixed for the duration of the fixed-rate period of the related RMBS.

 

However, if prepaymentrates decrease in a rising interest rate environment, the weighted average lifeof the fixed-rate portion of the related RMBS could extend beyond the term ofthe swap agreement or other hedging instrument. This could have a negativeimpact on our results of operations, as borrowing costs would no longer beeffectively fixed after the maturity of the hedging 

 

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instrument, while theincome earned on the remaining hybrid adjustable-rate RMBS would remain fixedfor a period of time. This situation may also cause the market value of ourhybrid adjustable-rate RMBS to decline, with little or no offsetting gain fromthe related hedging transactions. We may be forced to sell assets to maintainadequate liquidity, which could cause us to incur losses, and we may be unableto sell assets on favorable terms or at all.

 

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

 

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

 

**InterestRate Mismatch Risk**

 

We intend to fund asubstantial portion of our purchases of RMBS with borrowings that, after theeffect of hedging, have interest rates based on indices and repricing terms similarto, but of somewhat shorter maturities than, the interest rate indices andrepricing terms of the RMBS. Thus, we anticipate that in most cases theinterest rate indices and repricing terms of our RMBS and our funding sourceswill not be identical, thereby creating an interest rate mismatch betweenassets and liabilities. Therefore, our cost of funds would likely rise or fallmore quickly than would our earnings rate on assets. During periods of changinginterest rates, such interest rate mismatches could negatively impact ourfinancial condition, cash flows and results of operations. To mitigate interestrate mismatches, we may utilize hedging strategies discussed above.

 

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

 

**PrepaymentRisk**

 

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

 

**Effecton Fair Value**

 

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

 

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

 

The following sensitivityanalysis table shows the impact on the estimated fair value of our RMBSinterest rate-sensitive investments and interest rate swaps as of September 30,2009, assuming rates instantaneously fall 100 basis points and rise100 basis points. The below table excludes the securities held in DFR MMCLO because these investments are impacted by cash flows and the terms of theirrespective indentures, rather than fair values.

 

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| ** **                         | ** ** | **Interest Rates**         | ** ** | ** **    | ** ** | **Interest Rates** | ** ** |
|------------------------------------|------------|----------------------------|------------|---------------|------------|--------------------|------------|
| ** **                         | ** ** | **Fall 100**               | ** ** | ** **    | ** ** | **Rise 100**       | ** ** |
| ** **                         | ** ** | **Basis Points**           | ** ** | **Unchanged** | ** ** | **Basis Points**   | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| **RMBS**                           |       |                       |       |          |       |               |       |
| Fair  value                        |       | $                          | 321,377    |          | $          | 316,920            |       | $ | 310,419 |   |
| Change  in fair value              |       | $                          | 4,457      |          |       |               | $          | (6,501 | ) |
| Change  as a percent of fair value |       | 1.41                       | %          |          |       | -2.05              | %          |
| **Interest Rate Swaps**            |       |                       |       |          |       |               |       |
| Fair  value                        |       | $                          | (778       | )             | $          | (761               | )          | $ | (682 | ) |
| Change  in fair value              |       | $                          | (17        | )             |       |               | $          | 79 |   |
| Change  as a percent of fair value |       | -2.22                      | %          |          |       | 10.36              | %          |
| **Net Portfolio Impact**           |       | $                          | 4,440      |          |       |               | $          | (6,422 | ) |

 

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

 

As of September 30,2009, substantially all investments in our alternative investments portfolio(non-RMBS) are instruments with variable interest rates that are indexed toLIBOR. Because the variable rates on these instruments are short term innature, we are not exposed to material changes in fair value as a result ofchanges in interest rates.

 

**RiskManagement**

 

We look at investmentrisk across all of our products specifically as it relates to the product’starget returns or asset/liability management framework. We believe that inorder to achieve long-term investment performance consistent with our clients’expectations, we need an understanding of the investment risks taken, orproposed to be taken, in each portfolio relative to the corresponding liabilityand return profile, as well as those risks inherent in the increasingly complexglobal capital markets. Our risk management process emphasizes trading systemand data integrity, counterparty creditworthiness, adherence to investmentguidelines and client communication.

 

We employ active riskmonitoring for both our portfolio management and operational activities withinthe business. Our risk management program seeks to address not only the risksof unexpected portfolio losses, but also the operational risks that can havemajor adverse impacts on our business results. Portfolio risks include, forexample, potential losses due to price volatility, position sizing andleverage. Operational risks include, for example, settlement and clearing oftransactions, properly recording and valuing positions, supervision of traders,counterparty credit monitoring and approval, custodian reconciliations, traderauthorization, accounting and regulatory.

 

**ITEM4. CONTROLS AND PROCEDURES**

 

**Evaluationof Effectiveness of Disclosure Controls and Procedures**

 

Pursuant to Rule 13a-15(b) underthe Securities Exchange Act of 1934, as amended, or the Exchange Act, wecarried out an evaluation, with the participation of our management, includingour Chief Executive Officer and our Senior Vice President, Chief FinancialOfficer and Treasurer, of the effectiveness of our disclosure controls andprocedures (as defined under Rule 13a-15(e) under the Exchange Act),as of the end of the period covered by this Quarterly Report. Based upon thatevaluation, our Chief Executive Officer and our Senior Vice President, ChiefFinancial Officer and Treasurer concluded that our disclosure controls andprocedures are effective.

 

**Changesin Internal Control Over Financial Reporting**

 

There have been nochanges in our internal control over financial reporting during the threemonths ended September 30, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**InherentLimitations on Effectiveness of Controls**

 

There are inherentlimitations in the effectiveness of any control system, including the potentialfor human error and the circumvention or overriding of the controls andprocedures. Additionally, judgments in decision-making can be faulty andbreakdowns 

 

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can occur because ofsimple errors or mistakes. An effective control system can provide onlyreasonable, not absolute, assurance that the control objectives of the systemare adequately met. Accordingly, our management, including our Chief ExecutiveOfficer and our Senior Vice President, Chief Financial Officer and Treasurer donot expect that our control system can prevent or detect all error or fraud.Finally, projections of any evaluation or assessment of effectiveness of acontrol system to future periods are subject to the risks that, over time,controls may become inadequate because of changes in an entity’s operatingenvironment or deterioration in the degree of compliance with policies orprocedures.

 

**PART II.OTHER INFORMATION**

 

**ITEM1A. RISK FACTORS**

 

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

 

***Pegasus may not invest the full amount of its capitalcommitments into DPLC.***

 

Pegasus is currentlycommitted to invest $74.0 million in DPLC.  However, that capitalcommitment is subject to numerous conditions, any or all of which may beoutside of our control and may not be satisfied.  In the event thatPegasus does not invest the full amount of its $74.0 million capitalcommitment, our revenues from DPLC, both in the form of management fees andincentive allocations and in the form of return on our investment in DPLC, arelikely to be significantly lower than expected, which may adversely affect ourfinancial condition and results of operations.  Furthermore, we arecurrently committed $15.0 million in DPLC, and we may not invest all of suchamount if Pegasus does not invest the full amount of its capital commitment.

 

***DPLC may not perform as anticipated, which may affect futureinvestment advisory fees and/or the loss of some or all of our investment.***

 

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

 

***We may lose some or all of our investment in DPLC as aresult of certain subordination provisions contained in the documents governingDPLC.***

 

Our investment in DPLC issubordinated to Pegasus’ investment in DPLC in that Pegasus has a liquidationpreference with respect to its investment.  The documents governing DPLCprevent us from receiving certain distributions from DPLC unless and untilPegasus has received distributions equal to its initial capital contributionsto DPLC.  DPLC incurred substantial expenses in connection with itsorganization and launch, and, unless revenues from DPLC exceed thoseorganizational expenses and any additional expenses incurred over time, thoseexpenses will have the effect of decreasing the ultimate return on ourinvestment, which would have an adverse effect on our results of operations.

 

***Ownership limitations in our charter may restrict change ofcontrol or business combination opportunities in which our stockholders mightreceive a premium for their shares.***

 

On May 20, 2009,following stockholder approval, we amended our charter to restrict certainacquisitions and dispositions of our securities in order to preserve thebenefit of our NOLs, NCLs and certain other tax attributes for taxpurposes.  As amended, our charter generally restricts the ability of aperson or entity or group from accumulating 5% or more of our commonstock.  The ownership limitations in our charter could have the effect ofimpeding or discouraging an acquisition of common stock, tender offer or othertransaction, even if such a transaction may be favorable to the interests ofsome or all of our stockholders.  This might prevent our commonstockholders from realizing an opportunity to sell all or a portion of theirshares of our stock at higher than market prices.  In addition, theownership limitation contained in our charter may impede the assumption ofcontrol by a holder of a large block of common stock and the removal of incumbentdirectors and management, even if such removal may be beneficial to all of ourstockholders.  The charter restriction could also negatively affect theliquidity of our stock and otherwise decrease the market price of our commonstock.

 

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**ITEM6. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 
| **Exhibit   Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|---------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.1                       |       | Articles of  Amendment and Restatement of Deerfield Capital Corp., as amended and  supplemented (incorporated by reference to Exhibit 3.1 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  June 30, 2009, filed with the SEC on August 10, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2                       |       | Bylaws of Deerfield  Capital Corp. (incorporated by reference to Exhibit 3.2 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  June 30, 2008, filed with the SEC on August 11, 2008).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.1                       |       | Warrant, dated  April 9, 2009, issued by Deerfield Capital Corp. to Pegasus Deerfield  (AIV), LLC (incorporated by reference to Exhibit 4.1 to the Company’s  Current Report on Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2                       |       | Warrant, dated  April 9, 2009, issued by Deerfield Capital Corp. to Pegasus Deerfield  (AIV), LLC (incorporated by reference to Exhibit 4.2 to the Company’s  Current Report on Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.3                       |       | Amendment  No. 1, dated September 23, 2009, to the Warrant, dated  April 9, 2009, issued by Deerfield Capital Corp. to Pegasus Deerfield  (AIV), LLC (incorporated by reference to Exhibit 4.1 to the Company’s  Current Report on Form 8-K filed with the SEC on September 24,  2009).                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.4                       |       | Amendment  No. 1, dated September 23, 2009, to the Warrant, dated  April 9, 2009, issued by Deerfield Capital Corp. to Pegasus Deerfield  (AIV), LLC (incorporated by reference to Exhibit 4.2 to the Company’s  Current Report on Form 8-K filed with the SEC on September 24,  2009).                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.14                     |       | Third  Supplemental Indenture, dated as of July 31, 2009, to and under the  Junior Subordinated Indenture, dated as of September 29, 2005, by and  among Deerfield Capital LLC and The Bank of New York Mellon Trust Company,  National Association (as successor to JPMorgan Chase Bank, National  Association), as trustee, and with respect to certain provisions, each of The  Bank of New York Mellon Trust Company, National Association, in its capacity  as property trustee, Deerfield Capital Trust I, Taberna Preferred Funding  III, Ltd. and Taberna Preferred Funding V, Ltd. (incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with  the SEC on August 5, 2009).   |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.15                     |       | Third  Supplemental Indenture, dated as of July 31, 2009, to and under the  Junior Subordinated Indenture, dated as of August 2, 2006, by and among  Deerfield Capital LLC and The Bank of New York Mellon Trust Company, National  Association (as successor to JPMorgan Chase Bank, National Association), as  trustee, and with respect to certain provisions, each of The Bank of New York  Mellon Trust Company, National Association, in its capacity as property  trustee, Deerfield Capital Trust II and Taberna Preferred Funding VII Ltd.  (incorporated by reference to Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed with the SEC on August 5, 2009).                                           |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.16                     |       | Third  Supplemental Indenture, dated as of July 31, 2009, to and under the  Junior Subordinated Indenture, dated as of October 27, 2006, by and  among Deerfield Capital LLC and The Bank of New York Mellon Trust Company,  National Association (as successor to JPMorgan Chase Bank, National  Association), as trustee, and with respect to certain provisions, each of The  Bank of New York Mellon Trust Company, National Association, in its capacity  as property trustee, Deerfield Capital Trust III, Taberna Preferred Funding  VIII, Ltd. and Taberna Preferred Funding IX, Ltd. (incorporated by reference  to Exhibit 10.3 to the Company’s Current Report on Form 8-K filed  with the SEC on August 5, 2009). |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1                      |       | Certification of  Principal Executive Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2                      |       | Certification of  Principal Financial Officer Pursuant to Rule 13a-14(a) under the Securities  Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.1                      |       | Certification of  Principal Executive Officer and Principal Financial Officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                         | DEERFIELD  CAPITAL CORP.                                   |
|------------------------------|------------------------------------------------------------|
|                         | (Registrant)                                               |
|                         |                                                       |
|                         |                                                       |
| Date:  November 9, 2009 | By: /s/ JONATHAN  W. TRUTTER                               |
|                         | Jonathan W.  Trutter, Chief Executive Officer and Director |
|                         | (Principal  Executive Officer)                             |
|                         |                                                       |
| Date:  November 9, 2009 | By: /s/ FRANCIS  P. STRAUB III                             |
|                         | Francis P.  Straub III, Senior Vice President,             |
|                         | Chief Financial  Officer and Treasurer                     |
|                         | (Principal  Financial and Accounting Officer)              |

 

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