Table ofContents

 

* *

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **x**                                                      | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                       |       |                                                                                                     |
| **For the quarterly period ended September 30, 2010** |
|                                                       |
| **OR**                                                     |
|                                                       |       |                                                                                                     |
| **o**                                                      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**For the transition periodfrom             to             **

 

**Commissionfile number: 1-32551**

 

**DEERFIELD CAPITAL CORP.**

(Exact name of registrant as specified in its charter)

 

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

 

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

**(773) 380-1600**

(Address, including zip code, and telephone number,

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

 

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

 

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

 

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

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

 

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

 

Therewere 11,000,812 shares of the registrant’s Common Stock outstanding as ofNovember 12, 2010.

 

 

 

----

Table ofContents

 

**DEERFIELDCAPITAL CORP.**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010**

 

**INDEX**

 
| ** **                                                                                                            | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------|
|                                                                                                                  |       |     |
| Part I. Financial Information                                                                                    |       |     |
|                                                                                                                  |       |     |
| Item 1.  Condensed Consolidated Financial Statements and Notes (Unaudited)                                       |       | 5        |
|                                                                                                                  |       |     |
| Condensed  Consolidated Balance Sheets — September 30, 2010 and December 31,  2009                     |       | 5        |
|                                                                                                                  |       |     |
| Condensed  Consolidated Statements of Operations — Three and Nine Months Ended  September 30, 2010 and 2009 |       | 6        |
|                                                                                                                  |       |     |
| Condensed  Consolidated Statement of Stockholders’ Equity — Nine Months Ended  September 30, 2010      |       | 7        |
|                                                                                                                  |       |     |
| Condensed  Consolidated Statements of Cash Flows — Nine Months Ended September 30,  2010 and 2009           |       | 8        |
|                                                                                                                  |       |     |
| Notes to  Condensed Consolidated Financial Statements                                                                 |       | 9        |
|                                                                                                                  |       |     |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations             |       | 38       |
|                                                                                                                  |       |     |
| Item 4.  Controls and Procedures                                                                                 |       | 60       |
|                                                                                                                  |       |     |
| Part II. Other  Information                                                                                      |       |     |
|                                                                                                                  |       |     |
| Item 1A. Risk  Factors                                                                                           |       | 61       |
|                                                                                                                  |       |     |
| Item 6.  Exhibits                                                                                                |       | 61       |
|                                                                                                                  |       |     |
| Signatures                                                                                                            |       | 62       |

 

2

----

Table of Contents

 

**CERTAIN DEFINITIONS**

 

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

 

**SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

Certain statements in this Quarterly Report on Form 10-Q (the “QuarterlyReport”) and the information incorporated by reference into this QuarterlyReport are forward-looking as permitted by the Private Securities LitigationReform Act of 1995. These include statements regarding future results orexpectations. Forward-looking statements can be identified by forward-lookinglanguage, including words such as “believes,” “anticipates,” “expects,” “estimates,”“intends,” “may,” “plans,” “projects,” “will” and similar expressions, or thenegative of these words. Such forward-looking statements are based on facts andconditions as they exist at the time such statements are made. Forward-lookingstatements are also based on predictions as to future facts and conditions, theaccurate prediction of which may be difficult and involve the assessment ofevents beyond our control. Forward-looking statements are further based onvarious operating assumptions. Caution must be exercised in relying onforward-looking statements. Due to known and unknown risks, actual results maydiffer materially from expectations or projections. Forward-looking statementscontained in this Quarterly Report are made as of the date hereof, and we donot undertake any obligation to update any forward-looking statement to reflectsubsequent events, new information or circumstances arising after the date ofthis Quarterly Report. All future written and oral forward-looking statementsattributable to us or any person acting on our behalf are expressly qualifiedin their entirety by the cautionary statements contained or referenced above.In addition, it is our policy generally not to make any specific projections asto future earnings, and we do not endorse any projections regarding futureperformance that may be made by third parties.

 

The following factors, among others, could cause actual results todiffer materially from those described in the forward-looking statements:

 

·                  general economic and marketconditions, particularly as they relate to the markets for debt securities,such as residential mortgage-backed securities and collateralized debtobligations (“CDOs”).

 

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

 

·                  our ability to maintainadequate liquidity;

 

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

 

·                  our future operatingresults;

 

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

 

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

 

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

 

3

----

Tableof Contents

 

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

 

·                  our receipt of previouslydeferred collateralized loan obligation (“CLO”) subordinated management feesand receipt of future CLO subordinated management fees on a current basis;

 

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

 

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

 

·                  impact of restrictionscontained in our existing debt instruments;

 

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

 

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

 

·                  our failure to realize the expectedbenefits of the acquisition of Columbus Nova Credit Investments Management,LLC;

 

·                  other risks described inPart I—Item 1A, “Risk Factors,” in our Annual Report on Form 10-K forthe year ended December 31, 2009 and Part II - Item 1A, “Risk Factors,” inthis Quarterly Report, and from time to time in our other filings with the SEC.

 

4

----

Table of Contents

 

**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

** **
| ** **                                                                                                             | ** ** | **September 30,**                         | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                             | ** ** | **2010**                                       | ** ** | **2009**              | ** ** |
| ** **                                                                                                             | ** ** | **(In thousands, except share** | ** ** |
| ** **                                                                                                             | ** ** | **and per share amounts)**      | ** ** |
| ** **                                                                                                             | ** ** | ** **                                     | ** ** |
| **ASSETS**                                                                                                             | ** ** | ** **                                     | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                              |       | $                                              | 37,981     |                  | $          | 48,711 |   |
| Due from broker                                                                                                        |       | 17,502                                         |       | 14,606                |       |
| Restricted cash and cash equivalents                                                                                   |       | 18,593                                         |       | 19,296                |       |
| Investments and derivative assets at fair value, including  $255,442 and $303,763 pledged                              |       | 267,153                                        |       | 326,884               |       |
| Other investments                                                                                                      |       | 1,412                                          |       | 4,287                 |       |
| Loans, net of allowance for loan losses of $9,102  and $15,889                                                         |       | 259,201                                        |       | 263,232               |       |
| Receivables                                                                                                            |       | 12,579                                         |       | 8,427                 |       |
| Prepaid and other assets                                                                                               |       | 8,029                                          |       | 7,043                 |       |
| Equipment and improvements, net                                                                                        |       | 2,155                                          |       | 6,505                 |       |
| Intangible assets, net                                                                                                 |       | 25,094                                         |       | 21,231                |       |
| Goodwill                                                                                                               |       | 10,410                                         |       | —                |       |
| Assets held in Consolidated Investment Products:                                                                       |       |                                           |       |                  |       |
| Due from broker                                                                                                        |       | 15,830                                         |       | —                |       |
| Restricted cash and cash equivalents                                                                                   |       | 212,390                                        |       | —                |       |
| Investments and derivative assets at fair value                                                                        |       | 3,835,919                                      |       | —                |       |
| Receivables                                                                                                            |       | 24,041                                         |       | —                |       |
| Total assets held in Consolidated Investment  Products                                                                 |       | 4,088,180                                      |       | —                |       |
| TOTAL ASSETS                                                                                                           |       | $                                              | 4,748,289  |                  | $          | 720,222 |   |
|                                                                                                                   |       |                                           |       |                  |       |
| **LIABILITIES**                                                                                                        | ** ** | ** **                                     |       |                  |       |
| Repurchase agreements                                                                                                  |       | $                                              | 241,346    |                  | $          | 291,463 |   |
| Due to broker                                                                                                          |       | 17,249                                         |       | 803                   |       |
| Derivative liabilities                                                                                                 |       | 13,899                                         |       | 450                   |       |
| Accrued and other liabilities                                                                                          |       | 17,272                                         |       | 7,317                 |       |
| Long-term debt                                                                                                         |       | 354,731                                        |       | 413,329               |       |
| Liabilities held in Consolidated Investment  Products:                                                                 |       |                                           |       |                  |       |
| Due to broker                                                                                                          |       | 111,092                                        |       | —                |       |
| Derivative liabilities                                                                                                 |       | 5,942                                          |       | —                |       |
| Interest payable                                                                                                       |       | 7,261                                          |       | —                |       |
| Long-term debt                                                                                                         |       | 3,574,098                                      |       | —                |       |
| Total liabilities held in Consolidated Investment  Products                                                            |       | 3,698,393                                      |       | —                |       |
| TOTAL LIABILITIES                                                                                                      |       | 4,342,890                                      |       | 713,362               |       |
|                                                                                                                   |       |                                           |       |                  |       |
| **STOCKHOLDERS’ EQUITY**                                                                                          | ** ** | ** **                                     |       |                  |       |
| Preferred stock, par value $0.001:                                                                                     |       |                                           |       |                  |       |
| 100,000,000 shares authorized; 14,999,992 shares  issued and zero outstanding                                          |       | —                                         |       | —                |       |
| Common stock, par value $0.001:                                                                                        |       |                                           |       |                  |       |
| 500,000,000 shares authorized; 11,000,812 and  6,455,357 shares issued and 11,000,812 and 6,454,924 shares outstanding |       | 11                                             |       | 6                     |       |
| Additional paid-in capital                                                                                             |       | 886,890                                        |       | 866,557               |       |
| Accumulated other comprehensive loss                                                                                   |       | (53                                            | )          | (87                   | )          |
| Accumulated deficit                                                                                                    |       | (867,454                                       | )          | (877,155              | )          |
| Appropriated retained earnings of Consolidated  Investment Products                                                    |       | 380,814                                        |       | —                |       |
| Noncontrolling interest in consolidated entity                                                                         |       | 5,191                                          |       | 17,539                |       |
| TOTAL STOCKHOLDERS’ EQUITY                                                                                        |       | 405,399                                        |       | 6,860                 |       |
|                                                                                                                   |       |                                           |       |                  |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                        |       | $                                              | 4,748,289  |                  | $          | 720,222 |   |

 

Seenotes to condensed consolidated financial statements.

 

5

----

Tableof Contents

 

**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

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

** **
| ** **                                                                                      | ** ** | **Three months ended September 30,**                                  | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2010**                                                                                  | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| **Revenues**                                                                                    | ** ** | ** **                                                                                |       |                                                    | ** ** | ** ** |   |   |   |
| Interest income                                                                                 |       | $                                                                                         | 49,326     |                                                    | $          | 10,839 |   | $ | 118,011 |   | $ | 38,719 |   |
| Interest expense                                                                                |       | 12,814                                                                                    |       | 3,866                                                   |       | 28,780 |   | 16,531 |   |
| Net interest income                                                                             |       | 36,512                                                                                    |       | 6,973                                                   |       | 89,231 |   | 22,188 |   |
| Provision for loan losses                                                                       |       | 3,105                                                                                     |       | 4,226                                                   |       | 7,582 |   | 15,452 |   |
| Net interest income after provision for loan losses                                             |       | 33,407                                                                                    |       | 2,747                                                   |       | 81,649 |   | 6,736 |   |
| Investment advisory fees                                                                        |       | 2,378                                                                                     |       | 3,949                                                   |       | 9,056 |   | 12,695 |   |
| Total net revenues                                                                              |       | 35,785                                                                                    |       | 6,696                                                   |       | 90,705 |   | 19,431 |   |
|                                                                                            |       |                                                                                      |       |                                                    |       |   |   |   |   |
| **Expenses**                                                                                    |       |                                                                                      |       |                                                    |       |   |   |   |   |
| Compensation and benefits                                                                       |       | 4,490                                                                                     |       | 2,637                                                   |       | 10,408 |   | 9,020 |   |
| Professional services                                                                           |       | 1,827                                                                                     |       | 788                                                     |       | 4,747 |   | 2,306 |   |
| Insurance expense                                                                               |       | 766                                                                                       |       | 778                                                     |       | 2,210 |   | 2,313 |   |
| Other general and administrative expenses                                                       |       | 1,412                                                                                     |       | 928                                                     |       | 5,016 |   | 6,688 |   |
| Depreciation and amortization                                                                   |       | 1,931                                                                                     |       | 1,630                                                   |       | 10,694 |   | 4,894 |   |
| Occupancy                                                                                       |       | 418                                                                                       |       | 610                                                     |       | 1,294 |   | 1,818 |   |
| Management and incentive fee expense to related  party                                          |       | —                                                                                    |       | 337                                                     |       | — |   | 632 |   |
| Cost savings initiatives                                                                        |       | —                                                                                    |       | 11                                                      |       | — |   | 236 |   |
| Impairment of intangible assets                                                                 |       | 2,398                                                                                     |       | —                                                  |       | 2,566 |   | 126 |   |
| Total expenses                                                                                  |       | 13,242                                                                                    |       | 7,719                                                   |       | 36,935 |   | 28,033 |   |
|                                                                                            |       |                                                                                      |       |                                                    |       |   |   |   |   |
| **Other Income (Expense) and Gain  (Loss)**                                                     |       |                                                                                      |       |                                                    |       |   |   |   |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities                             |       | (33,024                                                                                   | )          | 3,465                                                   |       | (73,685 | ) | 43,013 |   |
| Strategic transactions expenses                                                                 |       | —                                                                                    |       | —                                                  |       | (4,022 | ) | — |   |
| Net gain on the discharge of the Senior Notes                                                   |       | —                                                                                    |       | —                                                  |       | 17,418 |   | — |   |
| Net gain on the deconsolidation of Market Square  CLO                                           |       | —                                                                                    |       | —                                                  |       | — |   | 29,551 |   |
| Other, net                                                                                      |       | 164                                                                                       |       | (443                                                    | )          | 290 |   | (340 | ) |
| Net other income (expense) and gain (loss)                                                      |       | (32,860                                                                                   | )          | 3,022                                                   |       | (59,999 | ) | 72,224 |   |
| Income (loss) before income tax expense                                                         |       | (10,317                                                                                   | )          | 1,999                                                   |       | (6,229 | ) | 63,622 |   |
| Income tax expense                                                                              |       | 1,699                                                                                     |       | 75                                                      |       | 1,701 |   | 253 |   |
|                                                                                            |       |                                                                                      |       |                                                    |       |   |   |   |   |
| **Net income (loss)**                                                                           |       | (12,016                                                                                   | )          | 1,924                                                   |       | (7,930 | ) | 63,369 |   |
| Net (income) loss attributable to noncontrolling  interest and Consolidated Investment Products |       | 3,997                                                                                     |       | (108                                                    | )          | 17,631 |   | 2,852 |   |
| **Net income (loss) attributable to  Deerfield Capital Corp.**                                  |       | $                                                                                         | (8,019     | )                                                       | $          | 1,816 |   | $ | 9,701 |   | $ | 66,221 |   |
|                                                                                            |       |                                                                                      |       |                                                    |       |   |   |   |   |
| **Net income (loss) attributable to  Deerfield Capital Corp . per share - basic**               |       | $                                                                                         | (0.70      | )                                                       | $          | 0.27 |   | $ | 1.12 |   | $ | 9.84 |   |
| **Net income (loss) attributable to  Deerfield Capital Corp . per share - diluted**             |       | $                                                                                         | (0.70      | )                                                       | $          | 0.27 |   | $ | 1.11 |   | $ | 9.84 |   |
|                                                                                            |       |                                                                                      |       |                                                    |       |   |   |   |   |
| Weighted-average number of shares outstanding -  basic                                          |       | 11,397,864                                                                                |       | 6,763,088                                               |       | 8,698,602 |   | 6,732,272 |   |
| Weighted-average number of shares outstanding -  diluted                                        |       | 11,397,864                                                                                |       | 6,763,088                                               |       | 8,740,244 |   | 6,732,272 |   |

 

See notes to condensedconsolidated financial statements.

 

6

----

Table of Contents

** **

**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

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

** **
| ** **                                                                                                        | ** ** | **Deerfield Capital Corp. Stockholders** | ** ** | **Appropriated** | ** ** | ** **  | ** ** | ** **        | ** ** | ** **               | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|------------------|------------|-------------|------------|-------------------|------------|--------------------------|------------|
| ** **                                                                                                        | ** ** | ** **                                              | ** ** | ** **       | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** **               | ** ** | **retained earnings** | ** ** | **Noncontrolling** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                        | ** ** | **Common Stock**                                   | ** ** | **Additional**   | ** ** | **Other**   | ** ** | ** **        | ** ** | **of Consolidated** | ** ** | **Interest in** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                        | ** ** | ** **                                              | ** ** | **Par**          | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**          | ** ** | **Investment** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                        | ** ** | **Shares**                                              | ** ** | **Value**        | ** ** | **Capital** | ** ** | **Loss**          | ** ** | **Deficit**              | ** ** | **Products** | ** ** | **Entity** | ** ** | **Total** | ** ** | **Loss** | ** ** |
| ** **                                                                                                        | ** ** | **(In  thousands)**                                     | ** ** |
| **Balance - January 1, 2010**                                                                                |       | 6,455                                                   |       | $                | 6          |        | $          | 866,557           |       | $                        | (87        | ) | $ | (877,155 | ) | $ | — |   | $ | 17,539 |   | $ | 6,860 |   |   |   |
| Cumulative  effect adjustment from the adoption of the amendments to ASC Topic 810                                |       |                                                    |       |             |       |        |       |              |       |                     |       | 244,865 |   |   |   | 244,865 |   |   |   |
| Net  income (loss)                                                                                                |       |                                                    |       |             |       |        |       |              |       | 9,701                    |       | (18,253 | ) | 622 |   | $ | (7,930 | ) | $ | (7,930 | ) |
| Adoption  of the amendments to ASC Topic 810 for the Consolidated Investment Products  acquired during the period |       |                                                    |       |             |       |        |       |              |       |                     |       | 186,007 |   |   |   | 186,007 |   |   |   |
| Distributions  to investors in Consolidated Investment Products                                                   |       |                                                    |       |             |       |        |       |              |       |                     |       | (31,805 | ) |   |   | (31,805 | ) |   |   |
| Distributions  to DPLC noncontrolling interest                                                                    |       |                                                    |       |             |       |        |       |              |       |                     |       |   |   | (12,970 | ) | (12,970 | ) |   |   |
| Issaunce  of common stock, net of issuance costs                                                                  |       | 4,545                                                   |       | 5                |       | 19,395      |       |              |       |                     |       |   |   |   |   | 19,400 |   |   |   |
| Previously  designated derivatives - amortization of net loss                                                     |       |                                                    |       |             |       |        |       | 31                |       |                     |       |   |   |   |   | 31 |   | 31 |   |
| Foreign  currency translation gain                                                                                |       |                                                    |       |             |       |        |       | 3                 |       |                     |       |   |   |   |   | 3 |   | 3 |   |
| Issuance  of stock warrants                                                                                       |       |                                                    |       |             |       | 529         |       |              |       |                     |       |   |   |   |   | 529 |   |   |   |
| Share-based  compensation                                                                                         |       |                                                    |       |             |       | 409         |       |              |       |                     |       |   |   |   |   | 409 |   |   |   |
| **Balance - September 30, 2010**                                                                             |       | 11,000                                                  |       | $                | 11         |        | $          | 886,890           |       | $                        | (53        | ) | $ | (867,454 | ) | $ | 380,814 |   | $ | 5,191 |   | $ | 405,399 |   | $ | (7,896 | ) |

 

See notes to condensedconsolidated financial statements.

 

7

----

Table of Contents

 

**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

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

 
| ** **                                                                                                                                   | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2010**                                                | ** ** | **2009** | ** ** |
| ** **                                                                                                                                   | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| ** **                                                                                                                                   | ** ** | **(In thousands)**                                 | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                                                                                   | ** ** | ** **                                              |       |   |   |
| Net income (loss)                                                                                                                            |       | $                                                       | (7,930     | ) | $ | 63,369 |   |
| **Adjustments to reconcile net  income (loss) attributable to common stockholders to net cash provided by  (used in) operating activities:** |       |                                                    |       |   |   |
| Net premium and discount amortization on  investments, loans and debt issuance costs                                                         |       | 2,629                                                   |       | (1,189 | ) |
| Share-based compensation                                                                                                                     |       | 409                                                     |       | 309 |   |
| Issuance of stock warrants                                                                                                                   |       | 529                                                     |       | — |   |
| Net purchases of investments at fair value                                                                                                   |       | (25,047                                                 | )          | (99,606 | ) |
| Net gain on investments at fair value                                                                                                        |       | (100,470                                                | )          | (9,294 | ) |
| Net loss on liabilties at fair value                                                                                                         |       | 173,706                                                 |       | — |   |
| Net gain on the deconsolidation of Market Square  CLO                                                                                        |       | —                                                  |       | (29,551 | ) |
| Other-than-temporary impairment on  available-for-sale securities                                                                            |       | —                                                  |       | 31 |   |
| Net other (gains) losses                                                                                                                     |       | (36                                                     | )          | 550 |   |
| Net sales of loans held for sale                                                                                                             |       | —                                                  |       | (866 | ) |
| Net gain on loans                                                                                                                            |       | (7,423                                                  | )          | (31,230 | ) |
| Provision for loan losses                                                                                                                    |       | 7,582                                                   |       | 15,452 |   |
| Net gain on the discharge of the Senior Notes                                                                                                |       | (17,418                                                 | )          | — |   |
| Net changes in undesignated derivatives                                                                                                      |       | 2,711                                                   |       | (12,901 | ) |
| Amortization of net loss on previously designated  derivatives                                                                               |       | 31                                                      |       | 136 |   |
| Depreciation and amortization                                                                                                                |       | 10,694                                                  |       | 4,894 |   |
| Impairment of intangible assets                                                                                                              |       | 2,566                                                   |       | 126 |   |
| Non-cash rental expense                                                                                                                      |       | (398                                                    | )          | 109 |   |
| **Changes in operating assets and  liabilities:**                                                                                            |       |                                                    |       |   |   |
| Due from broker                                                                                                                              |       | (130                                                    | )          | 13,769 |   |
| Receivables                                                                                                                                  |       | (15,278                                                 | )          | 3,306 |   |
| Prepaid and other assets                                                                                                                     |       | (370                                                    | )          | (303 | ) |
| Accrued interest on repurchase agreements                                                                                                    |       | (15                                                     | )          | (333 | ) |
| Due to broker                                                                                                                                |       | 66,831                                                  |       | 1,723 |   |
| Interest payable                                                                                                                             |       | 3,437                                                   |       | (4,352 | ) |
| Accrued and other liabilities                                                                                                                |       | 1,872                                                   |       | (10,641 | ) |
| **Net cash provided (used in) by  operating activities**                                                                                     |       | 98,482                                                  |       | (96,492 | ) |
|                                                                                                                                         |       |                                                    |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                                                                                   |       |                                                    |       |   |   |
| Change in restricted cash and cash equivalents                                                                                               |       | (39,551                                                 | )          | 49,410 |   |
| Proceeds from the sale of investments at fair  value previously classified as available-for-sale                                             |       | 145,432                                                 |       | 73,863 |   |
| Principal receipts on investments at fair value  previously classified as available-for-sale                                                 |       | 23,779                                                  |       | 46,922 |   |
| Origination and purchase of loans held for  investment                                                                                       |       | (121,370                                                | )          | (81,665 | ) |
| Principal receipts on loans held for investment                                                                                              |       | 70,772                                                  |       | 22,412 |   |
| Proceeds from sale of loans held for investment                                                                                              |       | 54,794                                                  |       | 12,882 |   |
| Principal receipts on loans held for sale  previously classified as held for investment                                                      |       | 23                                                      |       | — |   |
| Proceeds from sale of loans held for sale  previously classified as held for investment                                                      |       | 6,874                                                   |       | 11,960 |   |
| Proceeds from sale of other investments                                                                                                      |       | 2                                                       |       | — |   |
| Net cash aquired from the CNCIM Acquisition                                                                                                  |       | 2,470                                                   |       | — |   |
| (Purchases) sales of equipment and improvements                                                                                              |       | (1,559                                                  | )          | 6 |   |
| **Net cash provided by investing  activities**                                                                                               |       | 141,666                                                 |       | 135,790 |   |
|                                                                                                                                         |       |                                                    |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                                                                                   |       |                                                    |       |   |   |
| Net payments under repurchase agreements                                                                                                     |       | (50,103                                                 | )          | (19,475 | ) |
| Proceeds from issuance of long-term debt                                                                                                     |       | 25,000                                                  |       | — |   |
| Payments made on Wachovia Facility                                                                                                           |       |                                                    |       | (13,932 | ) |
| Payments made on long-term debt                                                                                                              |       | (179,817                                                | )          | (11,110 | ) |
| Payment of stock and debt issuance costs                                                                                                     |       | (1,170                                                  | )          | (142 | ) |
| Contributions from noncontrolling interest                                                                                                   |       | —                                                  |       | 20,133 |   |
| Distributions to noncontrolling interest and  investors in Consolidated Investment Products                                                  |       | (44,775                                                 | )          | — |   |
| **Net cash used in financing  activities**                                                                                                   |       | (250,865                                                | )          | (24,526 | ) |
|                                                                                                                                         |       |                                                    |       |   |   |
| Foreign currency translation                                                                                                                 |       | (13                                                     | )          | (21 | ) |
| Net increase (decrease) in cash and cash  equivalents                                                                                        |       | (10,730                                                 | )          | 14,751 |   |
| Cash and cash equivalents at beginning of period                                                                                             |       | 48,711                                                  |       | 32,791 |   |
| **Cash and cash equivalents at end  of period**                                                                                              |       | $                                                       | 37,981     |   | $ | 47,542 |   |
|                                                                                                                                         |       |                                                    |       |   |   |
| **SUPPLEMENTAL DISCLOSURE:**                                                                                                                 |       |                                                    |       |   |   |
| Cash paid for interest                                                                                                                       |       | $                                                       | 24,260     |   | $ | 19,243 |   |
| Cash paid for income taxes                                                                                                                   |       | 1,416                                                   |       | 87 |   |

 

See notes to condensedconsolidated financial statements.

 

8

----

Table of Contents

 

**DEERFIELD CAPITAL CORP. AND ITS SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.ORGANIZATION**

 

Deerfield Capital Corp., is a Maryland corporation (“DFR” and, togetherwith its subsidiaries, “us,” “we” or “our”), with an Investment Managementsegment that manages client assets, including bank loans and other corporatedebt, residential mortgage-backed securities (“RMBS”), government securitiesand asset-backed securities (“ABS”). Certain of these client assets, which weare required to consolidate, constitute our Consolidated Investment Productssegment. In addition, through our Principal Investing segment, we manage ourown assets, which are comprised primarily of fixed income investments,including bank loans and other corporate debt and Agency RMBS (as definedbelow).

 

***Business Segments***

 

We have three business segments:

 

*Investment Management*— Our Investment Managementsegment is operated through one of our wholly-owned subsidiaries, DeerfieldCapital Management LLC (“DCM”), and its wholly-owned subsidiary, Columbus NovaCredit Investments Management, LLC (“CNCIM”). Unless otherwise noted or thecontext otherwise requires, references to DCM’s investment managementactivities include the activities of CNCIM. Through our Investment Managementsegment, we manage investment accounts for various types of clients, includingcollateralized debt obligations (“CDOs”) and other investment vehicles.  These clients are collective investmentvehicles that pool the capital contributions of multiple investors, which aretypically institutional investors. We specialize in managing fixed incomeinvestments, including corporate debt, RMBS, government securities and ABS. Ourprimary source of revenue from our Investment Management segment is theinvestment advisory fees paid by the accounts we manage. These fees typicallyconsist of management fees based on the account’s assets and, in some cases,performance fees based on the profits we generate for the account.

 

*Principal Investing*— Our Principal Investingsegment manages our own assets, which are comprised primarily of fixed incomeinvestments, including bank loans and other corporate debt, and Agency RMBS. “AgencyRMBS” are RMBS backed by mortgage loans and guaranteed as to principal andinterest by either federally chartered entities or the U.S. government. Incomefrom our Principal Investing segment is influenced by four factors:(i) the difference between the interest income we earn on our investmentportfolio and the cost of our borrowings net of hedges, if any, (ii) thenet recognized gains and losses, if any, on our investment portfolio, (iii) provisionfor loan losses, if any, and (iv) the volume or aggregate amount of suchinvestments.

 

*ConsolidatedInvestment Products—*Our ConsolidatedInvestment Products segment consists of certain CDOs managed by our InvestmentManagement segment which we are required to consolidate as VariableInterest Entities (“VIEs”) in accordance with consolidation guidance in theFinancial Accounting Standards Board (“FASB”) Accounting Standards Codification(“Codification”) Topic 810—*Consolidation*(“ASC Topic 810”), as amended by Accounting Standards Update (“ASU”) 2009-17 (“ASU2009-17”). Effective January 1, 2010, we created our ConsolidatedInvestment Products segment and consolidated seven CDOs within this newsegment. In conjunction with the acquisition of CNCIM, effective June 9,2010, we consolidated four additional CDOs into this segment (which, togetherwith the seven CDOs we previously consolidated, we refer to as the “CIP CDOs”).See Note 3 for further information on the acquisition of CNCIM.

 

9

----

Table ofContents

 

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

 

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

 

*Principles of Consolidation*—The condensedconsolidated financial statements include the financial statements of DFR and(i) our wholly-owned subsidiaries, (ii) subsidiaries in which we havea controlling interest and (iii) VIEs with respect to which we are theprimary beneficiary.

 

Weconsolidate DFR Middle Market CLO Ltd. (“DFR MM CLO”) into our PrincipalInvesting segment because we own all of its preference shares. See Note 4 foradditional discussion concerning the consolidation of DFR MM CLO. We alsopreviously owned all of the preference shares of Market Square CLO Ltd. (“MarketSquare CLO”) and consolidated it into our Principal Investing segment throughJune 30, 2009, when we sold all of our preference shares 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 any future distributions on thepreference shares.  As a result of the sale, we deconsolidated MarketSquare CLO as of June 30, 2009.  We are, however, deemed to retain abeneficial interest in the preference shares of Market Square CLO as a resultof the delayed purchase price, and as of January 1, 2010, the amendmentsto ASC Topic 810 required us to again consolidate Market Square CLO as a partof our Consolidated Investment Products segment.

 

For the three and nine months ended September 30, 2010 and 2009,we consolidated Deerfield Pegasus Loan Capital LP (“DPLC”) into our PrincipalInvesting segment as a result of our control of DPLC General Partner LLC (“DPLCGP”), the general partner of DPLC. Effective March 31, 2010, wewithdrew the entire portion of our capital account attributable to ourinvestment in DPLC GP.  See Notes 3and 14 for details related to the warrants we issued in connection withthe formation of DPLC and in connection with the restructuring of DPLC. The netincome (loss) attributable to DFR in our condensed consolidated statements ofoperations excludes the net loss attributable to the noncontrolling interest inDPLC.

 

*Variable Interest Entities*—ASC Topic 810generally requires the consolidation of the assets, liabilities and results ofoperations of a VIE into the financial statements of the enterprise that has acontrolling financial interest in the VIE. ASC Topic 810 provides a frameworkfor determining whether an entity should be considered a VIE and evaluated forconsolidation. Pursuant to this framework, we consider all parties to determinewhether the entity is a VIE and, if so, whether our involvement with the entityresults in a variable interest in the entity. If we determine that we do have avariable interest in the entity, we perform an analysis to determine whether weare the primary beneficiary. If we determine that we are the primarybeneficiary, we consolidate the VIE into our consolidated financial statements.A company is the primary beneficiary of a VIE if it has a controlling financialinterest in the VIE.  A company is deemedto have a controlling financial interest in a VIE if it has both (i) thepower to direct the activities of the VIE that most significantly impact theVIE’s economic performance and (ii) the obligation to absorb the losses ofthe VIE that could potentially be significant to the VIE or the right toreceive benefits from the VIE that could potentially be significant to the VIE.

 

Other than DFR MM CLO, in which we own all the preference shares, wehave a variable interest in each of the CDOs we manage due to the provisions ofthe management agreements relating to those 

 

10

----

Table of Contents

 

CDOs.As of September 30, 2010, we had direct investments in certain of thoseCDOs, which represent a small portion of the total debt and equity issued bythe CDOs. Where we have a direct investment, it is typically only in theunrated, junior subordinated tranches of the CDOs. These unrated, juniorsubordinated tranches, referred to herein as “preference shares,” take the formof either subordinated notes or preference shares.

 

For CDOs, if we are deemed to have the power to direct the activitiesof the CDO that most significantly impact the CDO’s economic performance, andthe obligation to absorb losses or the right to receive benefits from the CDOthat could potentially be significant to the CDO, then we are deemed to be theCDO’s primary beneficiary and are required to consolidate the CDO.  Beginning January 1, 2010, weconsolidated the CIP CDOs into our Consolidated Investment Productssegment.  See Note 4 for additionaldiscussion of our Consolidated Investment Products segment.

 

As of September 30, 2010, we have a variable interest in 19additional CDOs that are not consolidated as part of our ConsolidatedInvestment Products segment as we have determined we are not the primarybeneficiary of these VIEs. Our maximum exposure to loss associated withnonconsolidated CDOs is limited to any future management fees. As ofSeptember 30, 2010, we have recorded management fee receivables totaling$0.8 million from the unconsolidated CDOs.

 

*Goodwill and Other Intangible Assets***— Goodwillrepresents the excess cost of a business acquisition over the fair value of thenet assets acquired. Intangible assets are comprised of finite-lived andindefinite-lived assets. In accordance with ASC Topic 350—*Intangibles—Goodwill and Other* (“ASC Topic350”), indefinite-lived assets and goodwill are not amortized. Finite-livedintangibles are amortized over their expected useful lives. These assets aretested for impairment annually or more frequently if events or changes incircumstances indicate that the asset might be impaired. An impairmentcharge is recorded if the carrying amount of an intangible asset is notrecoverable and its carrying amount exceeds its fair value.

 

Goodwill has been recognized and allocated to our Principal Investingand Investment Management segments as a result of the acquisition ofCNCIM. ASC Topic 350 requires, on a reporting unit level, a comparison ofthe book value of net assets to their estimated fair value. If the fair valueis determined to be less than book value, a second step is performed to computethe amount of the impairment. In this process, an implied fair value ofgoodwill is estimated in the same manner as the amount of goodwill recognizedin a business combination. If the carrying amount of the reporting unit exceedsthe implied fair value of that goodwill, an impairment loss will be recognizedin an amount equal to the excess. The loss recognized cannot exceed thecarrying amount of the goodwill.

 

Intangible assets associated with investment management contracts identifiedin the acquisition of a business are capitalized separately from goodwill ifthe fair value can be measured reliably on initial recognition. If they arefinite-lived, they are amortized over their useful lives, either on a straightline basis (intangible assets associated with the acquisition of Deerfield) orbased on a ratio of expected discounted cash flows from the contracts(intangible assets associated with the acquisition of CNCIM). We consider ourown assumptions about renewal or extension of the term of the arrangement,consistent with the expected use of the asset. A change in the useful life ofthe asset could have a significant impact on our amortization expense.

 

The evaluation of goodwill and intangible assets for impairmentrequires management to make estimates and exercise significant judgment. As ofSeptember 30, 2010, there were no events or changes in circumstances thatwould indicate that the current carrying amount of goodwill or other intangibleassets might be impaired; accordingly, we did not perform interim testingprocedures.

 

*Reclassifications* — Certain amounts in thecondensed consolidated statements of operations for the three and nine monthsended September 30, 2009 have been reclassified to conform to thepresentation for the three and nine months ended September 30, 2010.  Net loss on available-for-sale securities,net gain (loss) on investments at fair value, net gain (loss) on liabilities atfair value, net gain on loans and net gain (loss) on derivatives are presentedas a combined net gain (loss) on investments, loans, derivatives and 

 

11

----

Table of Contents

 

liabilitiesline item in the current quarter condensed consolidated statements ofoperations. In addition, strategic transactions expenses include $1.5 millionof legal fees and other professional fees, which were originally included inprofessional services during the three months ended March 31, 2010.

 

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

 

***Recent Accounting Updates***

 

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

 

In January 2010, the FASB issued ASU No. 2010-06, *Fair Value Measurements and Disclosure—ImprovingDisclosures about Fair Value Measurements* (“ASU 2010-06”). ASU2010-06 amends ASC Topic 820—*Fair ValueMeasurements and Disclosures* (“ASC Topic 820”) to add newrequirements for disclosures about transfers into and out of Levels 1 and2 and separate disclosures about purchases, sales, issuances and settlementsrelating to Level 3 measurements. ASU 2010-06 also clarifies existing fairvalue disclosures about the level of disaggregation and about inputs andvaluation techniques used to measure fair value. We adopted ASU 2010-06 andhave included the required disclosures in Note 5, with the exception ofthe requirement to provide disclosure of the Level 3 activity ofpurchases, sales, issuances and settlements on a gross basis, which will beeffective for our interim and annual reporting periods beginning afterDecember 15, 2010.

 

InJuly 2010, the FASB issued ASU No. 2010-20, *Receivables—Disclosures about the Credit Quality ofFinancing Receivables and the Allowance for Credit Losses*(“ASU2010-20”).  ASU 2010-20 amends ASC Topic310 to add enhanced disclosure requirements related to financing receivables,on a disaggregated basis.  ASU 2010-20 requiresspecific additional disclosures that will assist the financial statement users’evaluation of the nature of credit risk inherent in the entity’s financingreceivable portfolio, how the entity analyzes and assesses that risk whenarriving at their allowance for credit losses and the changes and reasons forthose changes in the entity’s allowance for credit losses.  For disclosures as of the end of a reportingperiod, ASU 2010-20 is effective for interim and annual reporting periodsending on or after December 15, 2010. For disclosures about activity that occurs during a reporting period,ASU 2010-20 is effective for interim and annual reporting periods beginning onor after December 15, 2010. Management is currently evaluating the impacts of adopting ASU 2010-20on the disclosures included in our condensed consolidated financial statements.

 

**3.STRATEGIC TRANSACTIONS**

 

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

 

OnMarch 22, 2010, we entered into an acquisitionand investment agreement (the “Acquisition Agreement”) with BountyInvestments, LLC (“Bounty”) and CNCIM, pursuant to which we agreed to acquireall of the outstanding equity interests of CNCIM from Bounty (the “CNCIMAcquisition”). CNCIM is an investment manager specializing in bank loans thatcurrently manages four collateralized 

 

12

----

Table of Contents

 

loanobligations (the “CNCIM CLOs”).  Wecompleted the CNCIM Acquisition on June 9, 2010 (the “Closing Date”) fortotal purchase consideration of $24.8 million consisting of (i) theissuance of 4,545,455 shares (at a Closing Date price of $4.50 per share)of our common stock, par value$0.001 per share (the “AcquisitionShares”), (ii) deferred payments totaling $7.5 million in cashpayable in five equal annual installments beginning on December 9, 2010(with a Closing Date fair value of $6.0 million) and (iii) an adjustmentrelated to the issuance of the Convertible Notes (as defined below).Calculation of the purchase consideration in accordance with ASC Topic 805 — *Business Combinations* (“ASC Topic 805”) is as follows:

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

 

----

(1)           Represents the closing price of ourcommon stock on the Closing Date.

 

(2)                                Represents a reduction ofthe purchase consideration because the par value of the Convertible Notes (asdefined below) of $25.0 million exceeded the fair value of the ConvertibleNotes of $23.4 million as of the Closing Date. As the CNCIM Acquisition and the issuance of the Convertible Notes areconsidered linked transactions, the Convertible Notes are initially recorded attheir Closing Date fair value with the difference between fair value and parallocated to the purchase consideration.

 

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

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

 

Thefair values of the assets acquired and liabilities assumed were estimated bymanagement with the assistance of an independent valuation firm. Theidentifiable intangible assets acquired by asset class are as follows:

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

 

13

----

Table of Contents

 

Thefair value of the intangible assets related to the CNCIM CLO investmentmanagement contracts was determined utilizing an excess earnings approach basedon the expected cash flows from the CLOs. The intangible assets related to themanagement contracts will be amortized based on a ratio of expected discountedcash flows from the contracts over the expected remaining term of thecontracts. The fair value of the intangible assets associated with thenon-compete agreements was determined using a lost cash flows analysis and willbe amortized straight-line over the term of the agreements. Amortizationexpense for the three and nine months ended September 30, 2010 related tothe intangible assets acquired was $0.6 million and $0.8 million, respectively.

 

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

 
| ** ** | ** ** | **(In thousands)** | ** ** |
|------------|------------|-------------------------|------------|
|       |       |                    |       |
| 2010       |       | $                       | 586        |   |
| 2011       |       | 2,300                   |       |
| 2012       |       | 2,230                   |       |
| 2013       |       | 2,021                   |       |
| 2014       |       | 1,366                   |       |
| Thereafter |       | 1,803                   |       |
|       |       | $                       | 10,306     |   |

 

Goodwillof $10.4 million is the excess of the total purchase consideration over theidentifiable tangible and intangible assets acquired in the CNCIM Acquisition.Goodwill relates to (i) the additional strategic opportunities that webelieve will be available to us as a result of the recapitalization of our debtand our increased assets under management, (ii) improvements in our capitalstructure resulting from the Trust Preferred Exchange and the Senior NotesDischarge (each as defined below) and (iii) the expected synergies fromthe CNCIM Acquisition. Goodwill of $8.7 million was allocated to our InvestmentManagement segment and goodwill of $1.7 million was allocated to the PrincipalInvesting segment. We considered the benefits to the individual segments in ourallocation of goodwill.  For taxpurposes, goodwill recognized was $16.5 million and will be amortized over 15years.

 

Wehave expensed CNCIM Acquisition-related expenses (other than those related tostock issuance and debt issuance) as incurred. For the nine months ended September 30, 2010, we recorded expensesrelated to the CNCIM Acquisition and associated transactions of $4.0 millionwithin strategic transactions expenses in the condensed consolidated statementsof operations.  Stock issuance costs of$1.1 million were recorded as a reduction to additional paid-in capital*.*

 

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

 

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

 

14

----

Table of Contents

 

Weevaluated the terms and conditions of the conversion feature contained in theConvertible Notes, and certain of the antidilution provisions of the conversionfeature cause it to be deemed an embedded derivative instrument (the “EmbeddedDerivative”). These antidilution provisions prevent the conversion feature fromqualifying as being indexed to our common stock. The Convertible Notes arerecorded as two components: (i) the Embedded Derivative initially recordedon the Closing Date as a $6.9 million derivative liability and,(ii) long-term debt initially recorded on the Closing Date at $16.5million. At each subsequent balance sheet date, the Embedded Derivative ismarked to fair value, and the change in fair value is recorded in the condensedconsolidated statements of operations within net gain (loss) on investments,loans, derivatives and liabilities. As of September 30, 2010, the EmbeddedDerivative was valued at $13.9 million, resulting in losses of $3.7 million and$7.0 million recorded in the condensed consolidated statements of operations asnet gain (loss) on investments, loans, derivatives and liabilities, during thethree and nine months ended September 30, 2010, respectively. The totalClosing Date fair value of the two components was $23.4 million. The $1.6million difference between the $25.0 million principal amount of theConvertible Notes and the $23.4 million Closing Date total fair value associatedwith the Convertible Notes was treated as a reduction of purchase considerationin conjunction with the CNCIM Acquisition. We did not elect the fair valueoption for the long-term debt component of the Convertible Notes. Thedifference between the $16.5 million Closing Date fair value of the componentof the Convertible Notes recorded as long-term debt and the $25.0 millionprincipal amount of the Convertible Notes will be accreted to earnings usingthe effective yield method of recognizing interest expense. Debt issuance costsof $0.5 million were recorded within prepaid and other assets and will beamortized into expense over the term of the Convertible Notes.

 

***The Senior Notes Discharge***

 

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

 

***The DPLC Restructuring***

 

OnMarch 21, 2010, we entered into a Termination Agreement (the “Termination Agreement”) with PegasusDeerfield (AIV), LLC (“PegasusDeerfield”), PGS Management, LLC (“PM”, and together with Pegasus Deerfield, the “Pegasus Parties”), DPLC, DCM, DPLC GP, Deerfield LoanManager LLC (“DLM” andtogether with DFR, DCM and DLM, the “DeerfieldParties”) and Jonathan Trutter, pursuant to which (i) the PegasusParties waived certain rights with respect to the stock issuances associatedwith the CNCIM Acquisition and (ii) the Deerfield Parties and the PegasusParties terminated or amended certain provisions of agreements related to DPLCand cancelled warrants to purchase three million shares of our common stock,which comprises all of the warrants previously issued to the Pegasus Parties(the “DPLC Restructuring”).Pursuant to the Termination Agreement, we granted Pegasus Deerfield and certainof its associates warrants to purchase an aggregate of 250,000 shares ofour common stock at an exercise price of $4.25 per share (the “DPLCRestructuring Warrants”). See Note 14 for further discussion of the DPLC RestructuringWarrants.  Pursuant to the TerminationAgreement, DPLC GP and DPLC released all partners of DPLC from theirunfunded capital commitments to DPLC as of the date of the TerminationAgreement. Effective as of March 31, 2010, DPLC made distributions of$9.0 million to Pegasus Deerfield 

 

15

----

Table of Contents

 

andan amount equal to his entire capital account balance to Jonathan Trutter.DPLC GP also withdrew an amount equal to the entire portion of its capitalaccount attributable to DLM’s investment in DPLC GP and distributed suchamount to DLM, our wholly-owned subsidiary. During the three months endedJune 30, 2010, DPLC made additional distributions to Pegasus Deerfield of$3.8 million. Pegasus Deerfield notified us that they intend to withdraw theirentire remaining capital account balance, which was $5.2 million as of September 30,2010.

 

***Unaudited Pro Forma Financial Information***

 

Duringthe three and nine months ended September 30, 2010, we recognized netrevenues of $1.7 million and $1.9 million, respectively, which are eliminatedupon consolidation, and net income attributable to DFR of $1.3 million and $1.0million, respectively, related to CNCIM. In addition, for the three and ninemonths ended September 30, 2010, we recorded a net loss of $6.5 millionand $7.3 million, respectively, related to the consolidation of the four CNCIMCLOs.  For the three months ended September 30,2010, the net loss of $6.5 million was comprised of net revenues of $12.4million, expenses of $1.9 million and net losses of $17.0 million in net otherincome (expense) and gain (loss). For the nine months ended September 30,2010, the net loss of $7.3 million was comprised of net revenues of $15.1million, expenses of $2.2 million and net losses of $20.2 million in net otherincome (expense) and gain (loss). The following unaudited pro forma condensedcombined financial information gives effect to the following transactions as ifthey had been completed as of the beginning of the periods presented:(1) the CNCIM Acquisition and issuance of the Acquisition Shares;(2) the issuance of the Convertible Notes; (3) the Senior Notes Discharge;(4) the Trust Preferred Exchange (as defined in Note 13); and (5) theDPLC Restructuring. This unaudited pro forma combined financial information ispresented for illustrative purposes only and is not necessarily indicative ofthe operating results that would have occurred if the CNCIM Acquisition hadbeen consummated during the period or as of the dates for which the pro formadata is presented, nor is it necessarily indicative of future operating resultsof DFR. The pro forma combined financial information for the three and ninemonths ended September 30, 2010 does not give effect to the application ofASC Topic 810 for the period prior to the CNCIM Acquisition as it relates tothe four CNCIM CLOs.

 
| ** **                                                                     | ** ** | **Three months ended September 30,**                    | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2010**                                                                    | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                     | ** ** | ** **                                                                  | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                     | ** ** | **(In thousands, except for per share data)** | ** ** |
| Total net revenue                                                              |       | $                                                                           | 35,690     |                                                    | $          | 9,896 |   | $ | 95,177 |   | $ | 29,237 |   |
| Net income (loss)                                                              |       | $                                                                           | (12,516    | )                                                       | $          | 3,694 |   | $ | (16,425 | ) | $ | 71,776 |   |
| Net income (loss) attributable to Deerfield Capital  Corp.                     |       | $                                                                           | (8,421     | )                                                       | $          | 3,694 |   | $ | 1,827 |   | $ | 71,776 |   |
| Net income (loss) attributable to Deerfield  Capital Corp. per share - basic   |       | $                                                                           | (0.74      | )                                                       | $          | 0.33 |   | $ | 0.16 |   | $ | 6.36 |   |
| Net income (loss) attributable to Deerfield  Capital Corp. per share - diluted |       | $                                                                           | (0.74      | )                                                       | $          | 0.27 |   | $ | 0.16 |   | $ | 4.75 |   |

 

**4. DFR MMCLO AND THE CONSOLIDATED INVESTMENT PRODUCTS SEGMENT**

 

***DFR MM CLO***

 

Althoughwe consolidate 100% of the assets and liabilities of DFR MM CLO into ourPrincipal Investing segment, our maximum exposure to loss on our investment inthis entity is limited to our initial investment of $69.0 million ($50.0million of preference shares and $19.0 million of debt). The economic impact ofour investment in DFR MM CLO is determined by the cash distributed to us on ourinvestment therein which, from the date of our initial investment through September 30,2010, have totaled $31.5 million on our preference shares investment and $3.7million in interest on our debt investment. DFR MM CLO’s debt holders haverecourse only to the assets of the DFR MM CLO and not to our general assets.Our preference shares investment is subject to diversion of cash flows inaccordance with the DFR MM CLO indenture.

 

Forthe three and nine months ended September 30, 2010, the net income of $1.3million and $11.9 million, respectively, recorded in our condensed consolidatedstatements of operations for DFR MM CLO was not indicative of the cashdistributions of $0.2 million and $8.1 million for the three and nine 

 

16

----

Table of Contents

 

monthsended September 30, 2010, respectively. These cash distributions included$7.5 million related to our investment in the preference shares for the ninemonths ended September 30, 2010, and $0.2 million and $0.6 million ininterest on our investment in debt for the three and nine months endedSeptember 30, 2010, respectively. We did not receive a cash distributionrelated to our investment in the preference shares in the third quarter.  However, we received a cash distribution of$7.5 million from DFR MM CLO in the fourth quarter, including a $7.3 milliondistribution related to our investment in the preference shares and $0.2million in interest on our investment in debt. While we expect to receivefuture cash distributions on our investment in the preference shares, it isvery difficult to predict the timing and amount of such future cashdistributions. We consolidated assets of $286.8 million and liabilities of$217.9 million related to DFR MM CLO as of September 30, 2010.

 

***The Consolidated Investment ProductsSegment***

 

Beginning January 1, 2010, as a result of the adoption of theamendments to ASC Topic 810, we created our Consolidated Investment Productssegment. As a result, we have consolidated the 11 CIP CDOs with non-recourseassets of $4.1 billion and non-recourse liabilities of $3.7 billion into ourcondensed consolidated financial statements as of September 30, 2010.There have been no changes to the terms of our management contracts with theCIP CDOs, the revenues we are contractually entitled to receive from the CIPCDOs or our exposure to liability with respect to the CIP CDOs. Although weconsolidate 100% of the assets, liabilities and equity of the CIP CDOs, ourmaximum exposure to loss related to the CIP CDOs is limited to our investmentsand beneficial interests in the CIP CDOs of $8.3 million and management feereceivables of $1.4 million as of September, 30, 2010, which are eliminatedupon consolidation, and future management fees.

 

The assets of each of the CIP CDOs are held solely as collateral tosatisfy the obligations of the respective CIP CDO. We have no right to thebenefits from, nor do we bear the risks associated with, the assets held by theCIP CDOs beyond our minimal direct investments and beneficial interests in, andmanagement fees generated from, the CIP CDOs. If DFR were to liquidate, theassets of the CIP CDOs would not be available to the general creditors of DFR,and as a result, we do not consider them to be our assets. Additionally, theinvestors in the CIP CDOs have no recourse to our general assets for the debtissued by the CIP CDOs. Therefore, this debt is not our obligation.

 

We have elected the fairvalue option for all assets and liabilities of the CIP CDOs. We have determinedthat, although the junior tranches of the CIP CDOs have certain characteristicsof equity, they should be recorded as debt on our balance sheet, as thesubordinated notes have a stated maturity indicating a date on which they aremandatorily redeemable. The preference shares of the CIP CDOs are alsoclassified as debt on our balance sheet, since redemption is required only uponliquidation or termination of the CDO and not upon liquidation or terminationof DFR or DCM.

 

For the three and nine months ended September 30, 2010, the netloss of $4.1 million and $18.3 million, respectively, recorded in our condensedconsolidated financial statements related to the CIP CDOs was not indicative ofthe cash flow distributions received from the CIP CDOs of $5.1 million and$12.4 million for the three and nine months ended September 30, 2010,respectively. For the three months ended September 30, 2010, the $5.1million received from the CIP CDOs consisted of management fees of $4.5million, equity distributions of $0.5 million and interest on our debtinvestments of $0.1 million. For the nine months ended September 30, 2010,the $12.4 million received from the CIP CDOs consisted of management fees of$11.5 million, equity distributions of $0.7 million and interest on our debtinvestments of $0.2 million. We consolidated assets of $4.1 billion,liabilities of $3.7 billion and equity of $0.4 billion related to the CIP CDOsas of September 30, 2010 despite the fact that the assets of the CIP CDOsare not available to us, nor are we obligated under the debt issued by the CIPCDOs. Upon consolidation, we eliminated management fee receivables of $1.4million as of September 30, 2010 and management fee revenue of $4.4 millionand $11.3 million related to the CIP CDOs for the three and nine months endedSeptember 30, 2010, respectively.

 

17

----

Table of Contents

 

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

 

**5. FAIRVALUE OF FINANCIAL INSTRUMENTS**

 

We have categorized our financial instruments carried at fair value,based on 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 assets included in Level 1 generally are equitysecurities or derivatives listed on an active exchange. We held no Level 1securities as of September 30, 2010.

 

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

 

Our assets and liabilities that are generally included in this categoryare Agency RMBS, loans classified as either investments at fair value or loansheld for sale where asset valuations are provided by independent pricingservices, corporate bonds, long-term debt and interest rate derivatives.

 

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

 

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

 

Our full valuation methodology and accounting policy are discussed inthe notes to the Consolidated Financial Statements included in our 200910-K.  There were no significant changesin our valuation methodologies during the three and nine months endedSeptember 30, 2010.

 

Wehave recorded all assets and liabilities in our Consolidated InvestmentProducts segment at fair value. We have not elected the fair value option forDFR MM CLO, which is included in our Principal Investing Segment. Theamendments to ASC Topic 810 indicate that assets and liabilities ofconsolidated VIEs should be recorded at their carrying value as of the datethat we became the primary beneficiary of the VIEs, provided such applicationis practicable. We have determined it is not practicable to initially recordthe CIP CDOs at their carrying value as they have never previously beenrequired to satisfy GAAP or other reporting requirements.  In connection with the adoption of theamendments to ASC Topic 810, we have elected and applied the fair value optionto measure, on an entity-by-entity basis, all of the eligible assets andliabilities of the CIP CDOs at fair value subsequent to the date of initialadoption of the amendments to ASC Topic 810, as we have also determined thatmeasurement of the notes issued by the CIP CDOs at fair value better correlateswith the fair value of the assets held by the CIP CDOs, which are held toprovide the cash flows for the note obligations of the CIP CDOs.

 

The following is a description of the valuation methodologies used forinstruments measured at fair value, including the general classification ofsuch instruments pursuant to the valuation hierarchy described below based ontheir classification in the condensed consolidated balance sheet. Management,from time to time, may make adjustments to the valuation methodologies describedbelow under certain 

 

18

----

Table of Contents

 

marketconditions. Management maintains a consistent policy and process for identifyingwhen and how such adjustments should be made. To the extent that a significantfair value adjustment is made by management, the valuation classification wouldgenerally be considered Level 3 within the fair value hierarchy.

 

***Investments at Fair Value***

 

Investments at fair value include RMBS, loans and other investmentsheld in DPLC and our Consolidated Investment Products segment, corporate bondsheld in DFR MM CLO, beneficial interests in CDOs and contingent liabilitiesrelated to CDOs. The fair value for RMBS generally represents a modeledvaluation, which includes spreads and prepayment rates which are observable inthe market. Agency RMBS are classified as Level 2 within the fair valuehierarchy. Loans and other investments held in DPLC and our ConsolidatedInvestment Products segment and corporate bonds held in DFR MM CLO aregenerally priced at a composite of the mid-point in the bid-ask spread ofdealer quotes or based on the composite price of a different tranche of thesame security if dealer quotes are unavailable for the specific tranche we own.Loans and other investments held in DPLC and our Consolidated InvestmentProducts segment and corporate bonds held in DFR MM CLO priced in this mannerare classified as Level 2 within the fair value hierarchy. Where no suchquotes are available, the price may be based on an internally developed modelusing composite or other comparable market data which could includeunobservable market inputs. Loans and other investments held in DPLC and ourConsolidated Investment Products segment priced in this manner are classifiedas Level 3 within the fair value hierarchy. Beneficial interests in CDOsand contingent liabilities related to CDOs are valued by management viainternal models which could include unobservable market inputs and as such arealso classified as Level 3 within the fair value hierarchy.

 

***Derivative assets and liabilities***

 

The derivatives held by us generally represent instruments traded inthe over-the-counter market and are valued using internally developedmarket-standard models. The inputs to the valuation models for the interestrate swaps and caps represent observable market data available at commonlyquoted intervals for the full terms of the contracts. All interest ratederivatives are classified as Level 2 within the fair value hierarchy. Thevaluation models for warrants may contain a significant level of unobservableinputs and are classified as Level 3 within the fair value hierarchy. TheEmbedded Derivative is valued by valuing the Convertible Notes and subsequentlyvaluing the Convertible Notes eliminating the conversion right.  The difference represents the value of theEmbedded Derivative.  The valuation ofthe Embedded Derivative is determined using a binomial tree model which maycontain a significant level of unobservable inputs and is classified as Level 3within the fair value hierarchy.

 

***Loans held for sale***

 

Loans held for sale are carried at the lower of cost or fair value. Ifthe fair value of a loan is less than its cost basis, a valuation adjustment isrecognized in the condensed consolidated statements of operations, and the loan’scarrying value is adjusted accordingly. The valuation adjustment may berecovered if the fair value increases, which is also recognized in the condensedconsolidated financial statements. Loans held for sale are generally priced ata composite of the mid-point in the bid-ask spread of dealer quotes or based onthe composite price of a different tranche of the same security if dealerquotes are unavailable for the specific tranche we own. As ofSeptember 30, 2010, we classify loans held for sale priced in this manneras Level 2 within the fair value hierarchy. Where no such quotes areavailable, the price may be based on an internally developed model usingcomposite or other comparable market data which could include unobservablemarket inputs. Loans held for sale priced in this manner are classified asLevel 3 within the fair value hierarchy.

 

19

----

Table ofContents

 

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

 

Long-term debt held in our Consolidated Investment Products segmentincludes the noncontrolling interest portion of the debt, includingsubordinated notes and preference shares of the CIP CDOs.  The fair value for long-term debt held in ourConsolidated Investment Products segment generally represents a modeled valuationthat utilizes inputs that are both observable and unobservable in the market.Long-term debt held in our Consolidated Investment Products segment priced inthis manner is classified as Level 2 within the fair value hierarchy.  The preferred shares of CDOs within thelong-term debt held in our Consolidated Investment Products segment are valuedby management by considering, among other things, available broker quotes. If abroker quote is unavailable, the preferred shares of CDOs are valued usinginternally developed models that utilize composite or other comparable marketdata management believes would be used by market participants, which couldinclude unobservable market inputs. Long-term debt held in our ConsolidatedInvestment Products segment priced in this manner is classified as Level 3within the fair value hierarchy.

 

***Assets and liabilities measured at fair value on a recurring basis***

 

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

 
| ** **                                             | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **(In thousands)** | ** ** |
| Investments and derivative assets at fair value        |       |                    |       |             |       |             |       |                    |       |
| RMBS                                                   |       | $                       | —     |             | $          | 254,538          |       | $                       | —     |   | $ | 254,538 |   |
| Loans                                                  |       | —                  |       | 2,990            |       | 303              |       | 3,293                   |       |
| Other                                                  |       | —                  |       | 9,313            |       | —           |       | 9,313                   |       |
| Derivative assets                                      |       | —                  |       | —           |       | 9                |       | 9                       |       |
| Total investments and derivative assets at fair  value |       | $                       | —     |             | $          | 266,841          |       | $                       | 312        |   | $ | 267,153 |   |
|                                                   |       |                    |       |             |       |             |       |                    |       |
| Derivative liabilities                                 |       | $                       | —     |             | $          | —           |       | $                       | 13,899     |   | $ | 13,899 |   |

 

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

 
| ** **                                             | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **(In thousands)** | ** ** |
| Investments and derivative assets at fair value        |       |                    |       |             |       |             |       |                    |       |
| Loans                                                  |       | $                       | —     |             | $          | 3,611,374        |       | $                       | 15,183     |   | $ | 3,626,557 |   |
| Corporate bonds                                        |       | —                  |       | 177,337          |       | 12,906           |       | 190,243                 |       |
| Other                                                  |       | —                  |       | 7,496            |       | 11,593           |       | 19,089                  |       |
| Derivative assets                                      |       |                    |       | —           |       | 30               |       | 30                      |       |
| Total investments and derivative assets at fair  value |       | $                       | —     |             | $          | 3,796,207        |       | $                       | 39,712     |   | $ | 3,835,919 |   |
|                                                   |       |                    |       |             |       |             |       |                    |       |
| Derivative liabilities                                 |       | $                       | —     |             | $          | 5,942            |       | $                       | —     |   | $ | 5,942 |   |
| Long-term debt                                         |       | —                  |       | 3,417,656        |       | 156,442          |       | 3,574,098               |       |
| Total financial instrument liabilities                 |       | $                       | —     |             | $          | 3,423,598        |       | $                       | 156,442    |   | $ | 3,580,040 |   |

 

20

----

 

Table of Contents

 

***Changes in Level 3 recurringfair value measurements***

 

The table below includes a rollforward of the balance sheet amounts forthe three months ended September 30, 2010 (including the change in fairvalue) for financial instruments classified within Level 3 of thevaluation hierarchy for our Principal Investing and Investment Managementsegments:

 
| ** **                                             | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **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, 2010**                                                                      | ** ** | **Gains (Losses) (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
| ** **                                             | ** ** | **(In thousands)**                                                                         | ** ** |
| Investments  and derivative assets at fair value       |       |                                                                                            |       |                             |       |                         |       |                     |       |                             |       |                                              |       |
| RMBS                                                   |       | $                                                                                               | 1,635      |                             | $          | (464                         | )          | $                        | (1,171     | )                                | $          | —                                            |       | $ | — |   | $ | — |   |
| Loans                                                  |       | 634                                                                                             |       | 15                               |       | (346                         | )          | —                   |       | 303                              |       | 15                                                |       |
| Other                                                  |       | 4,388                                                                                           |       | (2,001                           | )          | (2,387                       | )          | —                   |       | —                           |       | —                                            |       |
| Derivative  assets                                     |       | 29                                                                                              |       | (20                              | )          | —                       |       | —                   |       | 9                                |       | (20                                               | )          |
| Total  investments and derivative assets at fair value |       | $                                                                                               | 6,686      |                             | $          | (2,470                       | )          | $                        | (3,904     | )                                | $          | —                                            |       | $ | 312 |   | $ | (5 | ) |

 
| ** **                              | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **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, 2010**                                                                      | ** ** | **(Gains) Losses (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
| ** **                              | ** ** | **(In thousands)**                                                                         | ** ** |
| Financial  instrument liabilities       | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | ** **                                        | ** ** |
| Derivative  liabilities                 |       | $                                                                                               | 10,156     |                             | $          | 3,743                        |       | $                        | —     |                             | $          | —                                            |       | $ | 13,899 |   | $ | 3,743 |   |
| Accrued  and other liabilities          |       | 260                                                                                             |       | (20                              | )          | (240                         | )          | —                   |       | —                           |       | —                                            |       |
| Total  financial instrument liabilities |       | $                                                                                               | 10,416     |                             | $          | 3,723                        |       | $                        | (240       | )                                | $          | —                                            |       | $ | 13,899 |   | $ | 3,743 |   |

 

----

(1)                                  Net realizedand unrealized gains (losses) are reported within net gain (loss) oninvestments, loans, derivatives and liabilities in the condensed consolidatedstatement of operations.

 

The table below includes a rollforward of the balance sheet amounts forthe nine months ended September 30, 2010 (including the change in fairvalue) for financial instruments classified within Level 3 of thevaluation hierarchy for our Principal Investing and Investment Managementsegments:

 
| ** **                                             | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **Changes in Unrealized**               | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|--------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains (Losses)**          | ** ** |
| ** **                                             | ** ** | **Estimated**                                                                                   | ** ** | **Net Realized/**           | ** ** | **Purchases, (Sales),** | ** ** | **Net Transfers**   | ** ** | **Estimated**                    | ** ** | **Related to Financial**                | ** ** |
| ** **                                             | ** ** | **Fair Value**                                                                             | ** ** | **Unrealized**                   | ** ** | **Issuances and**       | ** ** | **In (Out)**        | ** ** | **Fair Value**              | ** ** | **Instruments Held**                         | ** ** |
| ** **                                             | ** ** | **January 1, 2010**                                                                   | ** ** | **Gains (Losses) (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
|                                                   | ** ** | **(In  thousands)**                                                                             |       |
| Investments  and derivative assets at fair value       |       |                                                                                            |       |                             |       |                         |       |                     |       |                             |       |                                              |       |
| RMBS                                                   |       | $                                                                                               | 2,631      |                             | $          | (551                         | )          | $                        | (2,080     | )                                | $          | —                                            |       | $ | — |   | $ | — |   |
| Loans                                                  |       | 990                                                                                             |       | 5                                |       | (692                         | )          | —                   |       | 303                              |       | 5                                                 |       |
| Other                                                  |       | 2,597                                                                                           |       | (210                             | )          | (2,387                       | )          | —                   |       | —                           |       | (210                                              | )          |
| Derivative  assets                                     |       | 74                                                                                              |       | (65                              | )          | —                       |       | —                   |       | 9                                |       | (65                                               | )          |
| Total  investments and derivative assets at fair value |       | $                                                                                               | 6,292      |                             | $          | (821                         | )          | $                        | (5,159     | )                                | $          | —                                            |       | $ | 312 |   | $ | (270 | ) |

 
| ** **                              | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **Changes in Unrealized**               | ** ** |
|-----------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|--------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|
| ** **                              | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs** | ** ** | **(Gains) Losses**          | ** ** |
| ** **                              | ** ** | **Estimated**                                                                                   | ** ** | **Net Realized/**           | ** ** | **Purchases, (Sales),** | ** ** | **Net Transfers**   | ** ** | **Estimated**                    | ** ** | **Related to Financial**                | ** ** |
| ** **                              | ** ** | **Fair Value**                                                                             | ** ** | **Unrealized**                   | ** ** | **Issuances and**       | ** ** | **In (Out)**        | ** ** | **Fair Value**              | ** ** | **Instruments Held**                         | ** ** |
| ** **                              | ** ** | **January 1, 2010**                                                                   | ** ** | **(Gains) Losses (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
| ** **                              | ** ** | **(In thousands)**                                                                         | ** ** |
| Financial  instrument liabilities       | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | ** **                                        | ** ** |
| Derivative  liabilities                 |       | $                                                                                               | —     |                             | $          | 7,010                        |       | $                        | 6,889      |                             | $          | —                                            |       | $ | 13,899 |   | $ | 7,010 |   |
| Accrued  and other liabilities          |       | 364                                                                                             |       | (10                              | )          | (354                         | )          | —                   |       | —                           |       | —                                            |       |
| Total  financial instrument liabilities |       | $                                                                                               | 364        |                             | $          | 7,000                        |       | $                        | 6,535      |                             | $          | —                                            |       | $ | 13,899 |   | $ | 7,010 |   |

 

----

(1)                                  Net realizedand unrealized gains (losses) are reported within net gain (loss) oninvestments, loans, derivatives and liabilities in the condensed consolidatedstatement of operations.

 

21

----

Table of Contents

 

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

 
| ** **                                             | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **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, 2010**                                                                      | ** ** | **Gains (Losses) (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
| ** **                                             | ** ** | **(In thousands)**                                                                         | ** ** |
| Investments  and derivative assets at fair value       |       |                                                                                            |       |                             |       |                         |       |                     |       |                             |       |                                              |       |
| Loans                                                  |       | $                                                                                               | 18,873     |                             | $          | (404                         | )          | $                        | (489       | )                                | $          | (2,797                                            | )(2)       | $ | 15,183 |   | $ | (754 | ) |
| Corporate  bonds                                       |       | 13,293                                                                                          |       | 1,114                            |       | (960                         | )          | (541                     | )(3)       | 12,906                           |       | 239                                               |       |
| Other                                                  |       | 11,862                                                                                          |       | (269                             | )          | —                       |       | —                   |       | 11,593                           |       | (269                                              | )          |
| Derivative  assets                                     |       | 27                                                                                              |       | 3                                |       | —                       |       | —                   |       | 30                               |       | 3                                                 |       |
| Total  investments and derivative assets at fair value |       | $                                                                                               | 44,055     |                             | $          | 444                          |       | $                        | (1,449     | )                                | $          | (3,338                                            | )          | $ | 39,712 |   | $ | (781 | ) |

 
| ** **      | ** ** | ** **                                                                                      | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **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, 2010**                                                                      | ** ** | **(Gains) Losses (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
| ** **      | ** ** | **(In thousands)**                                                                         | ** ** |
|            |       |                                                                                            |       |                             |       |                         |       |                     |       |                             |       |                                              |       |
| Long-term  debt |       | $                                                                                               | 128,683    |                             | $          | 30,146                       |       | $                        | (2,387     | )                                | $          | —                                            |       | $ | 156,442 |   | $ | 30,146 |   |
|                 |            |                                                                                                 |            |                                  |            |                              |            |                          |            |                                  |            |                                                   |            |  |  |  |  |  |  |

 

----

(1)                                  Net realized andunrealized gains (losses) are reported within net gain (loss) on investments,loans, derivatives and liabilities in the condensed consolidated statement ofoperations.

 

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

 

(3)                                  The nettransfers out of Level 3 include certain bonds which were valued via a singledealer quote as of June 30, 2010 and priced at a composite of themid-point in the bid-ask spread of dealer quotes as of September 30, 2010.

 

The table below includes arollforward of the balance sheet amounts for the nine months endedSeptember 30, 2010 (including the change in fair value) for financialinstruments classified within Level 3 of the valuation hierarchy for ourConsolidated Investment Products segment:

 
| ** **                                             | ** ** | ** **                                                                                      | ** ** | ** **                                     | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **Changes in Unrealized**               | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|--------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs** | ** ** | **Gains (Losses)**                        | ** ** |
| ** **                                             | ** ** | **Estimated**                                                                                   | ** ** | **Fair Value of CIP CDOs** | ** ** | **Net Realized/**           | ** ** | **Purchases, (Sales),** | ** ** | **Net Transfers**   | ** ** | **Estimated**                    | ** ** | **Related to Financial**                | ** ** |
| ** **                                             | ** ** | **Fair Value**                                                                             | ** ** | **Consolidated as of**               | ** ** | **Unrealized**                   | ** ** | **Issuances and**       | ** ** | **In (Out)**        | ** ** | **Fair Value**              | ** ** | **Instruments Held**                         | ** ** |
| ** **                                             | ** ** | **January 1, 2010**                                                                   | ** ** | **June 9, 2010**                     | ** ** | **Gains (Losses) (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010 (1)** | ** ** |
| ** **                                             | ** ** | **(In thousands)**                                                                         | ** ** |
| Investments  and derivative assets at fair value       |       |                                                                                            |       |                                           |       |                             |       |                         |       |                     |       |                             |       |                                              |       |
| Loans                                                  |       | $                                                                                               | 19,080     |                                           | $          | 1,497                            |       | $                            | 19         |                     | $          | 5,049                            |       | $                                                 | (10,462    | )(2) | $ | 15,183 |   | $ | (784 | ) |
| Corporate  bonds                                       |       | 12,890                                                                                          |       | 3,390                                          |       | 2,153                            |       | (4,986                       | )          | (541                     | )(3)       | 12,906                           |       | (493                                              | )          |
| Other                                                  |       | 477                                                                                             |       | 11,641                                         |       | (149                             | )          | —                       |       | (376                     | )(4)       | 11,593                           |       | (137                                              | )          |
| Derivative  assets                                     |       | 15                                                                                              |       | 10                                             |       | 5                                |       | —                       |       | —                   |       | 30                               |       | 5                                                 |       |
| Total  investments and derivative assets at fair value |       | $                                                                                               | 32,462     |                                           | $          | 16,538                           |       | $                            | 2,028      |                     | $          | 63                               |       | $                                                 | (11,379    | ) | $ | 39,712 |   | $ | (1,409 | ) |

 
| ** **      | ** ** | ** **                                                                                      | ** ** | ** **                                     | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | **Changes in Unrealized**                     | ** ** |
|-----------------|------------|-------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|--------------------------|------------|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **      | ** ** | **Fair Value Measurements Using Significant Unobservable Inputs** | ** ** | **(Gains) Losses**                        | ** ** |
| ** **      | ** ** | **Estimated**                                                                                   | ** ** | **Fair Value of CIP CDOs** | ** ** | **Net Realized/**           | ** ** | **Purchases, (Sales),** | ** ** | **Net Transfers**   | ** ** | **Estimated**                    | ** ** | **Related to Financial**                      | ** ** |
| ** **      | ** ** | **Fair Value**                                                                             | ** ** | **Consolidated as of**               | ** ** | **Unrealized**                   | ** ** | **Issuances and**       | ** ** | **In (Out)**        | ** ** | **Fair Value**              | ** ** | **Instruments Held**                               | ** ** |
| ** **      | ** ** | **January 1, 2010**                                                                   | ** ** | **June 9, 2010**                     | ** ** | **(Gains) Losses (1)** | ** ** | **(Settlements), Net**  | ** ** | **of Level 3** | ** ** | **September 30, 2010** | ** ** | **at September 30, 2010  (1)** | ** ** |
| ** **      | ** ** | **(In thousands)**                                                                         | ** ** |
| ** **      | ** ** | ** **                                                                                      | ** ** | ** **                                     | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **                       | ** ** | ** **                                              | ** ** |
| Long-term  debt |       | $                                                                                               | 45,414     |                                           | $          | 62,622                           |       | $                            | 50,793     |                     | $          | (2,387                           | )          | $                                                       | —     |   | $ | 156,442 |   | $ | 50,793 |   |
|                 |            |                                                                                                 |            |                                                |            |                                  |            |                              |            |                          |            |                                  |            |                                                         |            |  |  |  |  |  |  |  |

 

----

(1)                                  Net realizedand unrealized gains (losses) are reported within net gain (loss) oninvestments, loans, derivatives and liabilities in the condensed consolidatedstatement of operations.

 

(2)                                  The nettransfers out of Level 3 include certain loans which were valued via internallydeveloped models or a single dealer quote as of January 1, 2010 and pricedat a composite of the mid-point in the bid-ask spread of dealer quotes as of September 30,2010.

 

(3)                                  The nettransfers out of Level 3 include certain bonds which were valued via a singledealer quote as of January 1, 2010 and priced at a composite of the mid-pointin the bid-ask spread of dealer quotes as of September 30, 2010.

 

22

----

Table of Contents

 

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

 

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

 

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

 
| ** **                                                   | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying  Value** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **(In thousands)** | ** ** |
| Loans held for sale                                          |       | $                       | —     |             | $          | —           |       | $                   | 72         |   | $ | 72 |   |
| Loans held for investment, net of allowance for  loan losses |       | —                  |       | —           |       | 5,912            |       | 5,912               |       |
| Total assets at fair value on a nonrecurring basis           |       | $                       | —     |             | $          | —           |       | $                   | 5,984      |   | $ | 5,984 |   |

 

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

 

Thefollowing table presents the total change in value of financial assets includedin the table above for which a fair value adjustment was included in thecondensed consolidated financial statements during the three and nine monthsended September 30, 2010 for our Principal Investing and InvestmentManagement segments:

 
| ** **                           | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|--------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **September 30, 2010** | ** ** | **September 30, 2010** | ** ** |
| ** **                           | ** ** | **(In thousands)**          | ** ** |
| Loans held for sale (1)              |       | $                                | (38        | )                                | $          | (58 | ) |
| Loans held for investment (2)        |       | (3,105                           | )          | (3,257                           | )          |
| Total nonrecurring fair value losses |       | $                                | (3,143     | )                                | $          | (3,315 | ) |

 

----

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

 

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

 

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

 

23

----

Table of Contents

 

The carrying amounts and estimated fair values of our financialinstruments as of September 30, 2010 for our Principal Investing andInvestment Management segments, for which the disclosure of fair values isrequired, were as follows:

 
| ** **                                            | ** ** | **As of September 30, 2010** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                            | ** ** | ** **                                       | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **Carrying**                                     | ** ** | **Fair** | ** ** |
| ** **                                            | ** ** | **Value**                                        | ** ** | **Value** | ** ** |
| ** **                                            | ** ** | **(In thousands)**                          | ** ** |
| Financial assets:                                     |       |                                             |       |   |   |
| Cash and cash equivalents (1)                         |       | $                                                | 37,981     |   | $ | 37,981 |   |
| Restricted cash and cash equivalents (1)              |       | 18,593                                           |       | 18,593 |   |
| Investments and derivative assets at fair value  (2)  |       | 267,153                                          |       | 267,153 |   |
| Other investments (3)                                 |       | 1,412                                            |       | 1,412 |   |
| Loans, net of allowance for loan losses  (2) (3) |       | 259,201                                          |       | 242,122 |   |
|                                                  |       |                                             |       |   |   |
| Financial liabilities:                                |       |                                             |       |   |   |
| Repurchase agreements (1)                             |       | 241,346                                          |       | 241,346 |   |
| Derivative liabilities (2)                            |       | 13,899                                           |       | 13,899 |   |
| Long-term debt:                                       |       |                                             |       |   |   |
| Convertible notes (4)                                 |       | 16,660                                           |       | 17,556 |   |
| Subordinated notes and securities (4) (5)        |       | 120,775                                          |       | 33,434 |   |
| DFR MM CLO (4)                                        |       | 217,296                                          |       | 197,817 |   |
|                                                       |            |                                                  |            |  |  |  |  |

 

----

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

 

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

 

(3)                                  It was notpracticable to estimate the fair value of certain loans and other investmentsbecause they are not traded in an active market; therefore, the carrying valuehas been used as an approximation of fair value for loans with a carrying valueof $34.9 million and other investments with a carrying value of$1.4 million as of September 30, 2010. If an independent pricingservice cannot provide fair value estimates for a given loan, we may determineestimated fair value based on some or all of the following: (a) currentfinancial information of the borrowing company and performance against itsoperating plan; (b) changes in the fair value of collateral supporting theloan; (c) changes to the market for the borrowing company’s service orproduct and (d) present value of projected future cash flows.

 

(4)                                  The estimatedfair values of the long-term debt were calculated utilizing comparable marketdata and internal and external models.

 

(5)                                  Subordinatednotes and securities include both our trust preferred securities and our March JuniorSubordinated Notes (as defined in Note 13).

 

24

----

Table of Contents

 

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

 
| ** **                                           | ** ** | **As of September 30, 2010** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | ** **                                       | ** ** | **Estimated** | ** ** |
| ** **                                           | ** ** | **Carrying**                                     | ** ** | **Fair** | ** ** |
| ** **                                           | ** ** | **Value**                                        | ** ** | **Value** | ** ** |
| ** **                                           | ** ** | **(In thousands)**                          | ** ** |
| Financial assets:                                    |       |                                             |       |   |   |
| Restricted cash and cash equivalents (1)             |       | $                                                | 212,390    |   | $ | 212,390 |   |
| Investments and derivative assets at fair value  (2) |       | 3,835,919                                        |       | 3,835,919 |   |
|                                                 |       |                                             |       |   |   |
| Financial liabilities:                               |       |                                             |       |   |   |
| Derivative liabilities (2)                           |       | 5,942                                            |       | 5,942 |   |
| Long-term debt (2)                                   |       | 3,574,098                                        |       | 3,574,098 |   |
|                                                      |            |                                                  |            |  |  |  |  |

 

----

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

 

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

 

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

 
| ** **                | ** ** | **For the three months ended September 30** | ** ** | **For the nine months ended September 30,** | ** ** |
|---------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                | ** ** | **2010**                                                                  | ** ** | **2009**                                                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                | ** ** | **(In thousands)**                                                   | ** ** | **(In thousands)**                                                   | ** ** |
| Realized gains (losses)   |       | $                                                                         | (631       | )                                                                         | $          | 2,378 |   | $ | 14,148 |   | $ | 2,030 |   |
| Unrealized gains (losses) |       | 71,820                                                                    |       | 605                                                                       |       | 86,322 |   | 7,264 |   |
| Total gains (losses)      |       | $                                                                         | 71,189     |                                                                      | $          | 2,983 |   | $ | 100,470 |   | $ | 9,294 |   |

 

**6.OTHER INVESTMENTS**

 

As of September 30, 2010, we held certain other investmentscarried at cost less any adjustments for other-than-temporary impairment of$1.4 million. These investments consist of equity securities in theentities established in connection with the issuance of our trust preferredsecurities of $0.8 million and other common and preferred equitysecurities that are not traded in an active market with an original cost andcarrying value of $0.6 million as of September 30, 2010. We previouslyheld $3.7 million of equity securities in the entities established inconnection with the issuance of the trust preferred securities; however, onMarch 4, 2010, $2.9 million of equity securities were cancelled inconnection with the Trust Preferred Exchange as described in Note 13. Theremaining $0.8 million of equity in securities established in connection withthe issuance of the trust preferred securities were cancelled on October 20,2010 in connection with the Trust Preferred Redemption-in-Kind as described inNote 20.

 

25

----

Table of Contents

 

**7. LOANS**

 

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

 
| ** **                       | ** ** | **Carrying Value**    | ** ** |
|----------------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **Loans Held**        | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Type of Loan**       | ** ** | **for Sale (1)** | ** ** | **for Investment** | ** ** | **Total** | ** ** |
| ** **                       | ** ** | **(In thousands)**    | ** ** |
| Corporate leveraged loans:       |       |                       |       |   |   |   |   |
| Loans held in DFR MM CLO (2)     |       | $                          | —     |   | $ | 267,881 |   | $ | 267,881 |   |
| Other corporate leveraged loans  |       | 72                         |       | — |   | 72 |   |
| Commercial real estate loans (3) |       | —                     |       | 350 |   | 350 |   |
|                             |       | $                          | 72         |   | 268,231 |   | 268,303 |   |
| Allowance for loan losses        |       |                       |       | (9,102 | ) | (9,102 | ) |
|                             |       |                       |       | $ | 259,129 |   | $ | 259,201 |   |

 

----

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

 

(2)                                  Loans held inDFR MM CLO are reported gross of $8.8 million of allowance for loan losses asof September 30, 2010.

 

(3)                                  Commercial realestate loans are reported gross of $0.3 million of allowance for loanlosses as of September 30, 2010.

 

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

 
| ** **                   | ** ** | **Number**        | ** ** | **Par**                 | ** ** | **Allowance**                 | ** ** |
|------------------------------|------------|-------------------|------------|-------------------------|------------|-------------------------------|------------|
| **Type of Loan**   | ** ** | **of Loans** | ** ** | **Value**               | ** ** | **for Loan Losses** | ** ** |
| ** **                   | ** ** | ** **        | ** ** | **(In thousands)** | ** ** |
| Loans held in DFR MM CLO     |       | 5                 |       | $                       | 18,798     |                          | $          | (8,752 | ) |
| Commercial real estate loans |       | 1                 |       | 1,000                   |       | (350                          | )          |
| Total                        |       | 6                 |       | $                       | 19,798     |                          | $          | (9,102 | ) |

 

As of September 30, 2010, our loans held for sale and loans heldfor investment totaled $259.2 million, net of allowance for loan losses.Loans classified as held for sale and carried at the lower of cost or estimatedfair value totaled $0.1 million, net of a valuation allowance of$0.6 million, as of September 30, 2010. Loans classified as held forinvestment were carried at amortized cost of $268.2 million, less anallowance for loan losses of $9.1 million, as of September 30, 2010.For the three and nine months ended September 30, 2010, the average netcarrying value of impaired loans was $7.0 million and $5.6 million,respectively.

 

As of September 30, 2010, we held certain loans that allow theborrower to satisfy interest accruals by increasing the outstanding principalbalance of the loan. For the three and nine months ended September 30,2010, interest receivables were satisfied through increases to the loans’outstanding principal balances in the amount of $0.3 million and $1.0million, respectively.

 

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

 

26

----

Table of Contents

 

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

 
| ** **                                     | ** ** | **Allowance for Loan Losses** | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                     | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
| ** **                                     | ** ** | **(In thousands)**                      | ** ** |
| Allowance for loan losses at January 1    |       | $                                            | 15,889     |   | $ | 19,979 |   |
| Provision for loan losses                      |       | 7,590                                        |       | 15,452 |   |
| Charge-offs                                    |       | (14,369                                      | )          | (11,300 | ) |
| Recoveries                                     |       | (8                                           | )          | — |   |
| Allowance for loan losses at September 30 |       | $                                            | 9,102      |   | $ | 24,131 |   |

 

We did not recognize $0.9 million and $2.7 million of interest incomeearned, but not yet received, on loans held for investment for the three monthsand nine months ended September 30, 2010, respectively, as a result of theplacement of these loans on non-accrual status. In addition, we did notrecognize $0.5 million and $1.5 million of interest income earned, but notyet received, on loans held for sale for the three and nine months endedSeptember 30, 2009, respectively, as a result of the placement of theseloans on non-accrual status. Our loans held for investment, loans held for saleand loans classified as investments at fair value are diversified over manyindustries, and, as such, we do not believe we have any significantconcentration risk associated with the composition of the loan portfolio.

 

**8.DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES**

 

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

 
| ** **          | ** ** | **Number of** | ** ** | **Notional**            | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|---------------------|------------|--------------------|------------|-------------------------|------------|------------|------------|-----------------|------------|------------------------|------------|
| ** **          | ** ** | **Contracts**      | ** ** | **Amount**              | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **          | ** ** | ** **         | ** ** | **(In thousands)** | ** ** |
| Warrants            |       | 3                  |       | n/a                     |       | $          | 9          |            | $          | —                 |       | $ | 9 |   |
| Embedded Derivative |       | 1                  |       | n/a                     |       | —     |       | (13,899         | )          | (13,899                | )          |
|                |       | 4                  |       | $                       | —     |       | $          | 9               |       | $                      | (13,899    | ) | $ | (13,890 | ) |
|                     |            |                    |            |                         |            |            |            |                 |            |                        |            |  |  |  |  |

 

----

n/a—notapplicable

 

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

 
| ** **         | ** ** | **Number of** | ** ** | **Notional**            | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|--------------------|------------|--------------------|------------|-------------------------|------------|------------|------------|-----------------|------------|------------------------|------------|
| ** **         | ** ** | **Contracts**      | ** ** | **Amount**              | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **         | ** ** | ** **         | ** ** | **(In thousands)** | ** ** |
| Interest rate swap |       | 1                  |       | 123,000                 |       | $          | —     |            | $          | (5,942                 | )          | $ | (5,942 | ) |
| Warrants           |       | 9                  |       | n/a                     |       | 30         |       | —          |       | 30                     |       |
|               |       | 10                 |       | $                       | 123,000    |       | $          | 30              |       | $                      | (5,942     | ) | $ | (5,912 | ) |
|                    |            |                    |            |                         |            |            |            |                 |            |                        |            |  |  |  |  |

 

----

n/a—notapplicable

 

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

 

27

----

Table of Contents

 
| ** **                     | ** ** | **For the three months ended September 30** | ** ** | **For the nine months ended September 30,** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2010**                                                                  | ** ** | **2009**                                                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                     | ** ** | **(In thousands)**                                                   | ** ** | **(In thousands)**                                                   | ** ** |
| Interest rate swaps            |       | $                                                                         | (233       | )                                                                         | $          | (71 | ) | $ | (802 | ) | $ | 2,696 |   |
| Credit default swaps           |       | —                                                                    |       | —                                                                    |       | — |   | (119 | ) |
| Interest rate cap              |       | —                                                                    |       | 1                                                                         |       | — |   | 1 |   |
| Warrants                       |       | (17                                                                       | )          | 13                                                                        |       | (60 | ) | (58 | ) |
| Embedded Derivative            |       | (3,743                                                                    | )          | —                                                                    |       | (7,010 | ) | — |   |
| Net gain (loss) on derivatives |       | $                                                                         | (3,993     | )                                                                         | $          | (57 | ) | $ | (7,872 | ) | $ | 2,520 |   |

 

***Interest Rate Swaps***

 

Historically, in certain circumstances, when a fixed-rate or hybridadjustable-rate RMBS was funded by a short-term borrowing, our PrincipalInvesting segment entered into interest rate swap agreements that effectivelyfixed a portion of the borrowing costs for a period close to the anticipatedweighted-average life of the fixed-rate portion of the related RMBS. This strategywas designed to protect a portion of our portfolio from increased funding costsdue to rising interest rates because the borrowing costs were not fixed for theduration of the fixed-rate period of the related RMBS. We held no interest rateswaps in our Principal Investing Segment as of September 30, 2010, as ourremaining interest rate swap matured during the three months ended September 30,2010.

 

With respect to our Consolidated Investment Products segment, interestrate swaps may be entered into by a CDO to protect it from a mismatch betweenany fixed interest rates on its assets and the floating interest rates on itsdebt. No interest rate swaps held in the Consolidated Investment Productssegment were initiated, terminated or matured during the three or nine monthsended September 30, 2010. The weighted average fixed rate payable on theinterest rate swap in our Consolidated Investment Products segments as ofSeptember 30, 2010 was 5.96%.

 

***Interest Rate Cap***

 

Our interest rate cap was structured such that we received paymentsbased on the spread in rates if the three-month London Interbank Offered Rate (“LIBOR”)rate increased above a certain contractual rate, and we made payments based ona nominal fixed interest rate. This interest rate cap was entered into tomanage interest rate exposure in DFR MM CLO and matured during the three monthsended September 30, 2010.

 

***Embedded Derivative***

 

Our Convertible Notes contain a conversion feature with certainantidilution provisions that cause the conversion feature to be deemed anembedded derivative instrument. See Note 3 for additional discussion concerningthe Convertible Notes and the Embedded Derivative.

 

***Warrants***

 

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

 

28

----

Table of Contents

 

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

 

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

 
| ** **                                                          | ** ** | **For the three months ended September 30** | ** ** | **For the nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **2010**                                                                  | ** ** | **2009**                                                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                          | ** ** | **(In thousands)**                                                   | ** ** |
| ** **                                                          | ** ** | ** **                                                                | ** ** | ** **                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss on available-for-sale securities                           |       | $                                                                         | —     |                                                                      | $          | — |   | $ | — |   | $ | (31 | ) |
| Net gain on investments at fair value                               |       | 71,189                                                                    |       | 2,983                                                                     |       | 100,470 |   | 9,294 |   |
| Net loss on liabilities at fair value                               |       | (100,652                                                                  | )          | —                                                                    |       | (173,706 | ) | — |   |
| Net gain on loans                                                   |       | 432                                                                       |       | 539                                                                       |       | 7,423 |   | 31,230 |   |
| Net gain (loss) on derivatives                                      |       | (3,993                                                                    | )          | (57                                                                       | )          | (7,872 | ) | 2,520 |   |
| Net gain (loss) on investments, loans, derivatives  and liabilities |       | $                                                                         | (33,024    | )                                                                         | $          | 3,465 |   | $ | (73,685 | ) | $ | 43,013 |   |

 

**10.EQUIPMENT AND IMPROVEMENTS**

 

On November 27, 2009, we entered into an amendment to our originaloffice lease agreement dated July 11, 2005. Pursuant to the amendment, on April 30,2010, we relocated to new office space in the same building. The new term ofthe lease will expire on February 28, 2021. As a result of our relocation,our annual rent expense under the lease will be reduced by approximately$1.3 million. In addition, the letter of credit constituting our securitydeposit under the lease was reduced from approximately $1.3 million as of December 31,2009 to approximately $0.5 million as of September 30, 2010.

 

In connection with the amendment, we recognized a non-cash accelerationof depreciation and amortization expense related to certain leaseholdimprovements and equipment on the original premises as a result of a shorterestimated life for the use of those assets. The total impact of the accelerationof the depreciation and amortization expense was approximately$6.9 million, which we expensed ratably from the date the amendment wassigned (November 27, 2009) to the date on which we vacated the originalpremises (April 30, 2010). The impact of the accelerated depreciation forthe nine months ended September 30, 2010 was approximately $5.5 million.During the three and nine months ended September 30, 2010, we alsoinvested $0.5 million and $1.8 million, respectively, in additions to leaseholdimprovements, equipment, and furniture and fixtures related to the newpremises.

 

**11.REPURCHASE AGREEMENTS**

 

Repurchase agreements are short-term borrowings from financialinstitutions that bear interest at rates that have historically moved in closerelationship with one-month, two-month or three-month LIBOR. As ofSeptember 30, 2010, we had repurchase agreements outstanding with fourcounterparties in the amount of $241.3 million with a weighted-averageborrowing rate of 0.32% and remaining weighted average maturity of 19 days.During the nine months ended September 30, 2010, repurchase agreementliabilities decreased by $50.1 million, primarily as a result of net RMBSsales and paydowns, which resulted in associated repurchase agreementreductions. As of September 30, 2010, the fair value of securities pledgedminus repurchase agreement liabilities and related accrued interest payable was$14.1 million. At September 30, 2010, 68.4% of our repurchase agreementliabilities were concentrated with one counterparty. See Note 12 foradditional discussion concerning securities received and pledged as collateral.

 

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

 

To the extent that we receive securities as collateral in connectionwith derivative and repurchase agreement transactions, we are generallypermitted to sell or repledge these securities. As of September 30, 2010,we did not have any such securities held as collateral. We also pledge our ownassets to collateralize our repurchase agreements and derivative transactions.These owned and pledged securities, where the counterparty has the right bycontract or custom to sell or repledge the financial instruments, wereapproximately $255.4 million as of September 30, 2010 and consistedof securities pledged as initial collateral on repurchase agreements.

 

29

----

Table of Contents

 

**13.LONG-TERM DEBT**

 

The following table summarizes our long-term debt as ofSeptember 30, 2010:

 
| ** **                           | ** ** | ** **              | ** ** | **Current**               | ** ** | ** **                  | ** ** |
|--------------------------------------|------------|-------------------------|------------|---------------------------|------------|-----------------------------|------------|
| ** **                           | ** ** | **Carrying**            | ** ** | **Weighted Average** | ** ** | **Weighted Average**   | ** ** |
| ** **                           | ** ** | **Value**               | ** ** | **Borrowing Rate**   | ** ** | **Remaining Maturity** | ** ** |
| ** **                           | ** ** | **(In thousands)** | ** ** | ** **                | ** ** | **(In years)**         | ** ** |
| **Recourse:**                        |       |                    |       |                      |       |                        |       |
| Trust Preferred Securities           |       | $                       | 25,775     |                      | 3.98       | %                           | 25.1       |   |
| March Junior Subordinated Notes |       | 95,000                  |       | 1.00                      | %          | 25.1                        |       |
| Convertible Notes (1)                |       | 16,660                  |       | 8.00                      | %          | 7.2                         |       |
| Total Recourse                       |       | 137,435                 |       | 2.41                      | %          | 22.9                        |       |
| **Non-Recourse:**                    |       |                    |       |                      |       |                        |       |
| DFR MM CLO (2)                       |       | 217,296                 |       | 1.24                      | %          | 8.8                         |       |
| Consolidated Investment Products (3) |       | 3,574,098               |       | 1.03                      | %          | 8.7                         |       |
| Total Non-Recourse                   |       | 3,791,394               |       | 1.04                      | %          | 8.7                         |       |
| Total long-term debt                 |       | $                       | 3,928,829  |                      | 1.09       | %                           | 9.2        |   |

 

----

(1)         The Convertible Notesprincipal outstanding of $25.0 million is presented net of an $8.3 milliondiscount. The Convertible Notes currently pay interest at the 8.00% statedrate; however, including the discount, the effective rate of interest is18.14%.

 

(2)         Excludes $19.0 millionof DFR MM CLO debt that is owned by us and eliminated upon consolidation. Hadthis debt been included, the weighted-average borrowing rate would have been1.50% as of September 30, 2010.

 

(3)         Long-term debt of the CIPCDOs is recorded at fair value.  Thisincludes the fair value of the preference shares issued by the CIP CDOs in thecarrying value.  However, the preferenceshares do not have a stated interest rate and are therefore excluded from thecalculation of the weighted average borrowing rate. The par value of the CIPCDOs long-term debt (including preference shares) was $4.2 billion.

 

*Recourse Debt*

 

Recourse debt refers to debt where the lenders have recourse to ourunencumbered assets to satisfy our obligations under such debt.

 

*Junior Subordinated Notes and Trust Preferred Securities*

 

OnMarch 4, 2010, we entered into an exchangeagreement with the holders of our trust preferred securities to exchange$95.0 million of the $120.0 million aggregate outstanding principalamount of trust preferred securities previously issued by our threewholly-owned indirect subsidiaries, Deerfield Capital Trust I, DeerfieldCapital Trust II and Deerfield Capital Trust III, for$95.0 million aggregate principal amount of junior subordinated notes (the“March Junior Subordinated Notes”)issued by us (the “Trust PreferredExchange”). The Trust Preferred Exchange was completed on March 4,2010. In connection with the Trust Preferred Exchange, $2.9 million of equitysecurities in the entities established in connection with the issuance of theexchanged trust preferred securities and previously included in long-term debtwere cancelled.  On October 20,2010, the remaining $25.0 million in principal amount of trust preferredsecurities issued by Deerfield Capital Trust I was redeemed-in-

 

30

----

Table of Contents

 

kindfor $25.0 million in principal amount of junior subordinated notes (“October JuniorSubordinated Notes”) in the Trust Preferred Redemption-in-Kind described inNote 20. Following the redemption-in-kind, we no longer have any trustpreferred securities outstanding.

 

TheMarch Junior Subordinated Notes are governed by a junior subordinatedindenture (the “March NoteIndenture”), dated March 4, 2010, between us and The Bank of NewYork Mellon Trust Company, National Association, as trustee. Pursuant to the March NoteIndenture, the March Junior Subordinated Notes bear interest at a fixedrate of 1.00% per annum from the date of issuance through April 30, 2015as a result of the CNCIM Acquisition and the related strategic transactions, whichcollectively qualified as a Credit Enhancing Transaction (as defined in the March NoteIndenture). Thereafter, the March Junior Subordinated Notes will besubject to a variable interest rate equal to LIBOR plus 2.58% per annum, untilmaturity on October 30, 2035. The covenants contained in the March NoteIndenture are substantially less restrictive than the covenants contained inthe indentures governing the trust preferred securities.

 

The March Note Indenture contains certain restrictive covenants including(i) a covenant that requires all asset management activities to beconducted by DFR and its subsidiaries, and which permits us to sell equity andmaterial assets of DCM only if all asset management fees and proceeds fromequity and asset sales are subject to the limits on restricted payments setforth in the March Note Indenture, (ii) a debt covenant that permitsDFR and DCM to incur indebtedness only if the proceeds of such indebtedness aresubject to the limits on restricted payments set forth in the March NoteIndenture and (iii) a restricted payments covenant that restricts ourability to pay dividends or make distributions in respect of our equitysecurities, subject to a number of exceptions and conditions.

 

*Convertible Notes*

 

Seethe “The ConvertibleNotes Agreement and Issuance of the Conversion Shares” discussion in Note 3 fora description of the Convertible Notes.

 

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

 

TheConvertible Notes Agreement contains customary covenants including(i) that we will not, and will not permit any of our subsidiaries to,incur any indebtedness that is contractually subordinated in right of paymentto other indebtedness of ours unless such indebtedness is also contractuallysubordinated in right of payment to the Convertible Notes on substantiallysimilar terms; (ii) that we will not consolidate or merge with or intoanother person or sell, transfer or otherwise dispose of all or substantiallyall of our assets to another person unless certain conditions are satisfied;(iii) that, upon a change of control, we will offer to repurchase all orany part of the Convertible Notes of each holder of Convertible Notes at apurchase price in cash equal to 100% of the aggregate principal amount of theConvertible Notes repurchased, plus accrued and unpaid interest; and(iv) that we will use commercially reasonable efforts to keep theConversion Shares listed on the NASDAQ Stock Market or another securitiesexchange on which our common stock is listed or quoted.

 

*Senior Notes*

 

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

 

31

----

Table of Contents

 

*Non-Recourse Debt*

 

Non-recoursedebt refers to debt where the lenders have recourse only to specific assetspledged as collateral to the lenders, such as the debt issued by the CIP CDOsand DFR MM CLO. The lenders of non-recourse debt have no recourse to ourgeneral assets. None of our non-recourse debt is subject to potential margincalls for additional pledges of cash or assets.

 

*DFR MMCLO*

 

Thecarrying value of the assets held in DFR MM CLO, which are the only assets towhich DFR MM CLO’s debt holders have recourse for repayment, was $286.8 millionas of September 30, 2010.

 

*ConsolidatedInvestment Products*

 

During the three and nine months endedSeptember 30, 2010, the CIP CDOs paid down $18.7 million and $124.3million, respectively, of their outstanding debt. The carrying value of theassets held in the CIP CDOs, which are the only assets to which the CIP CDOdebt holders have recourse for repayment, was $4.1 billion as ofSeptember 30, 2010.

 

**14. STOCKHOLDERS’ EQUITY**

 

***Common Stock***

 

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

 

***Performance Shares***

 

Duringthe nine months ended September 30, 2010, we granted 11,111 restrictedstock units (the “Performance Shares”) to each of the eight non-employeedirectors of our Board as a component of their compensation. We recorded$0.4 million in expense within other general and administrative expense on thecondensed consolidated statement of operations during the nine months endedSeptember 30, 2010 related to these grants.  Each of the PerformanceShares represents the right to receive one share of our common stock onJune 16, 2013, subject to forfeiture and acceleration upon the occurrenceof certain specified events. The number of Performance Shares granted to eachnon-employee director is subject to adjustment for dividends or otherdistributions paid between June 16, 2010 and June 16, 2013 and mayalso be adjusted, as determined by the Board, in connection with any stockdividends, stock splits, subdivisions or consolidations of shares (includingreverse stock splits) or similar changes in our capitalization.

 

Thefollowing table summarizes our Performance Shares activity for the nine monthsended September 30, 2010:

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

 

***Restricted Stock Grants***

 

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

 

32

----

Table of Contents

 

***Warrants***

 

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

 

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

 

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

 
| ** **                                                                                      | ** ** | **For the three months ended September 30** | ** ** | **For the nine months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2010**                                                                  | ** ** | **2009**                                                                  | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands, except per share data)**        | ** ** | **(In thousands, except per share data)**        | ** ** |
|                                                                                            |       |                                                                      |       |                                                                      |       |   |   |   |   |
| **Net income (loss)**                                                                           |       | $                                                                         | (12,016    | )                                                                         | $          | 1,924 |   | $ | (7,930 | ) | $ | 63,369 |   |
| Net (income) loss attributable to noncontrolling  interest and Consolidated investment Products |       | 3,997                                                                     |       | (108                                                                      | )          | 17,631 |   | 2,852 |   |
| **Net income (loss) attributable to  Deerfield Capital Corp.**                                  |       | $                                                                         | (8,019     | )                                                                         | $          | 1,816 |   | $ | 9,701 |   | $ | 66,221 |   |
|                                                                                            |       |                                                                      |       |                                                                      |       |   |   |   |   |
| Weighted average shares used in basic calculation                                               |       | 11,398                                                                    |       | 6,763                                                                     |       | 8,699 |   | 6,732 |   |
| Diluive effect of:                                                                              |       |                                                                      |       |                                                                      |       |   |   |   |   |
| Warrants                                                                                        |       | —                                                                    |       | —                                                                    |       | 41 |   | — |   |
| Weighted average shares used in diluted  calculation                                            |       | 11,398                                                                    |       | 6,763                                                                     |       | 8,740 |   | 6,732 |   |
|                                                                                            |       |                                                                      |       |                                                                      |       |   |   |   |   |
| **Net income attributable to  Deerfield Capital Corp. per share - basic**                       |       | $                                                                         | (0.70      | )                                                                         | $          | 0.27 |   | $ | 1.12 |   | $ | 9.84 |   |
|                                                                                            |       |                                                                      |       |                                                                      |       |   |   |   |   |
| **Net income attributable to  Deerfield Capital Corp. per share - diluted**                     |       | $                                                                         | (0.70      | )                                                                         | $          | 0.27 |   | $ | 1.11 |   | $ | 9.84 |   |

 

For the three and nine months ended September 30, 2010, the4,132,231 Conversion Shares related to the Convertible Notes were excluded fromthe calculation of diluted net income (loss) per share because their effect wasanti-dilutive under the if-converted method. For the three months endedSeptember 30, 2010, the 250,000 DPLC Restructuring Warrants issued andvested on March 22, 2010 in connection with the Termination Agreement wereexcluded from the calculation of diluted net income (loss) per share becausetheir effect was anti-dilutive under the treasury stock method.  For the nine months ended September 30,2010, the 250,000 DPLC Restructuring Warrants were included in the calculationof diluted net income (loss) per share because there effect was dilutive underthe treasury stock method.

 

For the three and nine months ended September 30, 2010 and 2009,Performance Shares were included in the weighted average shares calculations.For the three and nine months ended September 30, 2009, restricted stockgrants for 433 shares of our common stock were not included in the calculationof diluted net income (loss) per share because their effect was anti-dilutiveunder the treasury stock method.

 

**16. INCOMETAXES**

 

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

 

33

----

Table of Contents

 

$77.5 million,a deferred tax liability of $8.0 million and a valuation allowance fordeferred tax assets in the amount of $69.5 million.

 

Under ASC Topic 740, we are required to identify and consider allavailable evidence, both positive and negative, in determining whether it ismore likely than not that all or some portion of the deferred tax assets willnot be realized. We will continue to reassess our ability to recognizeadditional deferred tax assets, and if management concludes, after evaluationof all positive and negative evidence, that realization of the deferred taxasset is more likely than not, then we will remove some or all of the valuationallowance and recognize a deferred tax asset at that time, which will impactour recorded income tax expense or benefit on the condensed consolidatedstatements of operations.

 

The issuance of the Acquisition Shares resultedin an ownership change as defined in Sections 382 and 383 of the InternalRevenue Code of 1986, as amended (the “Ownership Change”). As a result of theoccurrence of the Ownership Change, our ability to use our net operating losses(“NOLs”), net capital losses (“NCLs”) and certain recognized built-in losses toreduce our taxable income in future years is generally limited to an annualamount (the “Section 382 Limitation”) equal to the fair market value ofour common stock immediately prior to the Ownership Change, subject to certainadjustments, multiplied by the long-term tax-exempt interest rate, which forthe month of June was 4.01%.  NOLsand NCLs that exceed the Section 382 Limitation in any year will continueto be allowed as carryforwards for the remainder of the carryforward period;however, if the carryforward period for any NOL or NCL expires before that lossis fully utilized, the unused portion will provide no future benefit.

 

For periods prior to the Ownership Change, the utilization of NOLs andNCLs resulted in no provision for federal or state income taxes.  Because of the Ownership Change and Section 382Limitation, we no longer can offset all of our federal taxable income with ourNOLs and NCLs; therefore, we are required to pay current federal taxes on ournet taxable income.  As we continue torecord a full valuation allowance on our net deferred tax assets, the provisionfor income taxes of $1.7 million for the three and nine months ended September 30,2010 represents our current liability for federal income taxes. Our state NOLsand NCLs are not subject to the Section 382 Limitation, which means thatour state NOLs and NCLs are able to offset our state net taxable income, and,as such, we have recorded no state income tax expense for the three and ninemonths ended September 30, 2010.

 

**17. SEGMENT REPORTING**

 

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

 

34

----

Table of Contents

 

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

 
| ** **                                                     | ** ** | **For the three months ended September 30, 2010** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **DFR Operations**                                                              | ** ** | ** ** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Investment  Management (1)**                                                  | ** ** | **Principal  Investing (1)** | ** ** | **Total DFR  Operations** | ** ** | **Investment  Products** | ** ** | **Eliminations** | ** ** | **Consolidated DFR** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                              | ** ** |
| Interest  income                                               |       | $                                                                                    | (202       | ) | $ | 7,369 |   | $ | 7,167 |   | $ | 42,276 |   | $ | (117 | )(2) | $ | 49,326 |   |
| Interest  expense                                              |       | 91                                                                                   |       | 2,320 |   | 2,411 |   | 10,263 |   | 140 | (2) | 12,814 |   |
| Net  interest income (expense)                                 |       | (293                                                                                 | )          | 5,049 |   | 4,756 |   | 32,013 |   | (257 | ) | 36,512 |   |
| Provision  for loan losses                                     |       | —                                                                               |       | 3,105 |   | 3,105 |   | — |   | — |   | 3,105 |   |
| Net  interest income (expense) after provision for loan losses |       | (293                                                                                 | )          | 1,944 |   | 1,651 |   | 32,013 |   | (257 | ) | 33,407 |   |
| Investment  advisory fees                                      |       | 6,780                                                                                |       | — |   | 6,780 |   | — |   | (4,402 | )(3) | 2,378 |   |
| Total  net revenues                                            |       | $                                                                                    | 6,487      |   | $ | 1,944 |   | $ | 8,431 |   | $ | 32,013 |   | $ | (4,659 | ) | $ | 35,785 |   |
| Depreciation  and amortization                                 |       | $                                                                                    | 1,931      |   | $ | — |   | $ | 1,931 |   | $ | — |   | $ | — |   | $ | 1,931 |   |
| Income  tax expense                                            |       | $                                                                                    | —     |   | $ | 1,699 |   | $ | 1,699 |   | $ | — |   | $ | — |   | $ | 1,699 |   |
| Net  loss                                                      |       | $                                                                                    | (3,511     | ) | $ | (3,644 | ) | $ | (7,155 | ) | $ | (4,096 | ) | $ | (765 | )(4) | $ | (12,016 | ) |

 
| ** **                                                     | ** ** | **For the three months ended September 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **DFR Operations**                                                              | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Investment  Management (1)**                                                  | ** ** | **Principal  Investing (1)** | ** ** | **Consolidated DFR** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                              | ** ** |
| Interest income                                                |       | $                                                                                    | 10         |   | $ | 10,829 |   | $ | 10,839 |   |
| Interest expense                                               |       | 1,191                                                                                |       | 2,675 |   | 3,866 |   |
| Net interest income (expense)                                  |       | (1,181                                                                               | )          | 8,154 |   | 6,973 |   |
| Provision for loan losses                                      |       | —                                                                               |       | 4,226 |   | 4,226 |   |
| Net interest income (expense) after provision for  loan losses |       | (1,181                                                                               | )          | 3,928 |   | 2,747 |   |
| Investment advisory fees                                       |       | 3,949                                                                                |       | — |   | 3,949 |   |
| Total net revenues                                             |       | $                                                                                    | 2,768      |   | $ | 3,928 |   | $ | 6,696 |   |
| Depreciation and amortization                                  |       | $                                                                                    | 1,630      |   | $ | — |   | $ | 1,630 |   |
| Income tax expense                                             |       | $                                                                                    | —     |   | $ | 75 |   | $ | 75 |   |
| Net income (loss)                                              |       | $                                                                                    | (2,457     | ) | $ | 4,381 |   | $ | 1,924 |   |

 
| ** **                                                     | ** ** | **For the nine months ended September 30, 2010** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **DFR Operations**                                                             | ** ** | ** ** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Investment  Management (1)**                                                 | ** ** | **Principal  Investing (1)** | ** ** | **Total DFR  Operations** | ** ** | **Investment  Products** | ** ** | **Eliminations** | ** ** | **Consolidated DFR** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                             | ** ** |
| Interest  income                                               |       | $                                                                                   | 12         |   | $ | 23,455 |   | $ | 23,467 |   | $ | 94,985 |   | $ | (441) | (2) | $ | 118,011 |   |
| Interest  expense                                              |       | 2,329                                                                               |       | 5,700 |   | 8,029 |   | 20,935 |   | (184) | (2) | 28,780 |   |
| Net  interest income (expense)                                 |       | (2,317                                                                              | )          | 17,755 |   | 15,438 |   | 74,050 |   | (257 | ) | 89,231 |   |
| Provision  for loan losses                                     |       | —                                                                              |       | 7,582 |   | 7,582 |   | — |   | — |   | 7,582 |   |
| Net  interest income (expense) after provision for loan losses |       | (2,317                                                                              | )          | 10,173 |   | 7,856 |   | 74,050 |   | (257 | ) | 81,649 |   |
| Investment  advisory fees                                      |       | 20,327                                                                              |       | — |   | 20,327 |   | — |   | (11,271) | (3) | 9,056 |   |
| Total  net revenues                                            |       | $                                                                                   | 18,010     |   | $ | 10,173 |   | $ | 28,183 |   | $ | 74,050 |   | $ | (11,528 | ) | $ | 90,705 |   |
| Depreciation  and amortization                                 |       | $                                                                                   | 10,694     |   | $ | — |   | $ | 10,694 |   | $ | — |   | $ | — |   | $ | 10,694 |   |
| Income  tax expense                                            |       | $                                                                                   | 2          |   | $ | 1,699 |   | $ | 1,701 |   | $ | — |   | $ | — |   | $ | 1,701 |   |
| Net  income (loss)                                             |       | $                                                                                   | 7,665      |   | $ | 3,423 |   | $ | 11,088 |   | $ | (18,253 | ) | $ | (765) | (4) | $ | (7,930 | ) |

 
| ** **          | ** ** | **As of September 30, 2010** | ** ** |
|---------------------|------------|--------------------------------------------------|------------|
| ** **          | ** ** | **(In thousands)**                          | ** ** |
| Identifiable assets |       | $                                                | 54,608     |   | $ | 615,239 |   | $ | 669,847 |   | $ | 4,088,180 |   | $ | (9,738 | )(5) | $ | 4,748,289 |   |
|                     |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                     | ** ** | **For the nine months ended September 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **DFR Operations**                                                             | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Investment  Management (1)**                                                 | ** ** | **Principal  Investing (1)** | ** ** | **Consolidated DFR** | ** ** |
| ** **                                                     | ** ** | **(In thousands)**                                                             | ** ** |
| Interest income                                                |       | $                                                                                   | 72         |   | $ | 38,647 |   | $ | 38,719 |   |
| Interest expense                                               |       | 3,849                                                                               |       | 12,682 |   | 16,531 |   |
| Net interest income (expense)                                  |       | (3,777                                                                              | )          | 25,965 |   | 22,188 |   |
| Provision for loan losses                                      |       | —                                                                              |       | 15,452 |   | 15,452 |   |
| Net interest income (expense) after provision for  loan losses |       | (3,777                                                                              | )          | 10,513 |   | 6,736 |   |
| Investment advisory fees                                       |       | 12,695                                                                              |       | — |   | 12,695 |   |
| Total net revenues                                             |       | $                                                                                   | 8,918      |   | $ | 10,513 |   | $ | 19,431 |   |
| Depreciation and amortization                                  |       | $                                                                                   | 4,894      |   | $ | — |   | $ | 4,894 |   |
| Income tax expense                                             |       | $                                                                                   | 28         |   | $ | 225 |   | $ | 253 |   |
| Net income (loss)                                              |       | $                                                                                   | (9,245     | ) | $ | 72,614 |   | $ | 63,369 |   |

 
| ** **          | ** ** | **As of September 30, 2009** | ** ** |
|---------------------|------------|--------------------------------------------------|------------|
| ** **          | ** ** | **(In thousands)**                          | ** ** |
| Identifiable assets |       | $                                                | 47,652     |   | $ | 692,480 |   | $ | 740,132 |   |
|                     |            |                                                  |            |  |  |  |  |  |  |  |

 

35

----

Table of Contents

 

----

(1)                                 Excludesintercompany investment advisory fee revenues of our Investment Managementsegment and corresponding intercompany management fee expense of our PrincipalInvesting segment related to the management agreement between the two segmentsof $0.8 million and $2.1 million for the three and nine months endedSeptember 30, 2010, respectively, and $1.3 million and $4.2 million forthe three and nine months ended September 30, 2009, respectively.

 

(2)                                 Primarilyrepresents interest income earned by our Principal Investing segment on itsinvestments in our Consolidated Investment Products segment debt and thecorresponding interest expense recorded in our Consolidated Investment Productssegment.

 

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

 

(4)                                 Primarilyrepresents distributions received by our Principal Investing segment on itsinvestments in our Consolidated Investment Products preference shares.

 

(5)                                 Primarilyrepresents the elimination of Investment Management segment and PrincipalInvesting segment investments in CIP CDOs of $8.3 million and the receivablefor fees charged to our Consolidated Investment Products segment by ourInvestment Management segment of $1.4 million.

 

Our Principal Investing segment results of operations include thefinancial results of DFR MM CLO and DPLC for the three and ninemonths ended September 30, 2010 and 2009.

 

**18. SALE OF RPM**

 

On September 30, 2010, we sold the portfolio management productknown as Return Profile Management (“RPM”) and ceased management of ourseparately managed accounts related to the RPM strategy. As a result ofthe sale, during the three months ended September 30, 2010, we recognizeda loss in the form of an impairment charge of $2.4 million on the intangibleassets associated with the asset management contracts for the separatelymanaged accounts.

 

**19.COMMITMENTS AND CONTINGENCIES**

 

***Legal Proceedings***

 

Aspreviously reported, in connection with the investigation by the SEC of certainmortgage securities transactions effected by DCM on behalf of DFR in 2005 and2006, and the accounting for those transactions, DFR received a “Wells notice”from the staff of the SEC on June 7, 2010 stating that the staff willrecommend that the SEC bring an enforcement proceeding against DFR for possibleviolations of certain securities laws. On July 16, 2010, DFR submitted aresponse to the “Wells notice” presenting its position on the issues raised inthe “Wells notice” and requesting that the SEC reject the staff’srecommendation that it bring an enforcement proceeding against DFR. The SEC hasnot yet determined whether it will commence enforcement proceedings againstDFR.

 

Asa result of the SEC’s investigation, DFR determined that it was appropriate toestablish a reserve of $1.3 million as of June 30, 2010 which is includedin other, net in the condensed consolidated statements of operations, whichrepresents its current best estimate of the probable loss associated with DFR’sresolution of this matter with the SEC.  There can be, however, noassurance that the amount reserved will be sufficient, and DFR cannot predictwhen or how this matter will be resolved.

 

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

 

36

----

Table of Contents

 

**20. SUBSEQUENT EVENTS**

 

OnOctober 20, 2010, we redeemed-in-kind the $25.0 million of aggregateoutstanding principal amount of trust preferred securities issued in 2005 byDeerfield Capital Trust I for $25.0 million in aggregate principal of October JuniorSubordinated Notes (the “Trust Preferred Redemption-in-Kind”). Inconnection with the Trust Preferred Redemption-in-Kind, $0.8 million of equitysecurities in Deerfield Capital Trust I which are included in long-term debtwere cancelled. Following the Trust Preferred Redemption-in-Kind, we no longerhave any trust preferred securities outstanding.

 

TheOctober Junior Subordinated Notes we issued in connection with the TrustPreferred Redemption-in-Kind are governed by a junior subordinated indenture(the “October Note Indenture”), dated October 20, 2010, between usand The Bank of New York Mellon Trust Company, National Association, astrustee. Consistent with the terms of the trust preferred securities that wereredeemed, the October Junior Subordinated Notes bear interest at an annualrate of LIBOR plus 3.50% and mature on October 30, 2035. With theexception of the interest rate, the terms of the October JuniorSubordinated Notes are substantially similar to those of the March JuniorSubordinated Notes issued on March 4, 2010 as part of the Trust PreferredExchange. The covenants contained in both the March Note Indenture and theOctober Note Indenture are substantially less restrictive than thecovenants contained in the indentures governing the trust preferred securities.

 

Therehave been no other significant subsequent events since September 30, 2010that require adjustment to or additional disclosure in these financialstatements.

 

37

----

Table of Contents

 

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

 

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

 

**Overview**

 

We are a Maryland corporation with an Investment Management segmentthat manages approximately $9.6 billion of client assets as of October 1,2010, including bank loans and other corporate debt, residentialmortgage-backed securities (“RMBS”), government securities and asset-backedsecurities (“ABS”). Certain of these client assets, which we are required toconsolidate, constitute our Consolidated Investment Products segment. Inaddition, through our Principal Investing segment, we manage our own assets,which are comprised primarily of fixed income investments, including bank loansand other corporate debt and Agency RMBS (as defined below), and totaled $535.0million as of September 30, 2010.

 

***Our Business***

 

We have three businesssegments: Investment Management, Principal Investing and ConsolidatedInvestment Products. Our Investment Management segment earns investmentadvisory fees for managing investment accounts, including collateralized debtobligations (“CDOs”) and other investment vehicles. We are required toconsolidate 11 of the CDOs managed by our Investment Management segment becausewe are deemed to be the primary beneficiary of these variable interestentities. These 11 CDOs (the “CIP CDOs”) constitute our Consolidated InvestmentProducts segment. Our Principal Investing segment maintains an investmentportfolio comprised primarily of bank loans and other corporate debt and AgencyRMBS (as defined below).

 

*Investment Management Segment*

 

Our Investment Management segment is operated through DCM and itswholly-owned subsidiary, Columbus Nova Credit Investments Management LLC (“CNCIM”).Unless otherwise noted or the context otherwise requires, references to DCM’sinvestment management activities include the activities of CNCIM. Through ourInvestment Management segment, we manage investment accounts for various typesof clients, including CDOs and other investment vehicles. These clients arecollective investment vehicles that pool the capital contributions of multipleinvestors, which are typically institutional investors.  We specialize in managing fixed incomeinvestments, including corporate debt, RMBS, government securities and ABS.

 

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

 

*PrincipalInvesting Segment*

 

Our Principal Investing segment manages ourown assets, which are comprised primarily of fixed income investments,including bank loans and other corporate debt and Agency RMBS. We refer toour investments in senior secured loans (first lien and second lien term loans),senior subordinated debt facilities and other junior securities as “CorporateLoans.” “Agency RMBS” are RMBS backed by mortgage loans and guaranteed as toprincipal and interest by either federally chartered entities or the U.S.government.

 

38

----

Table of Contents

 

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

 

*ConsolidatedInvestment Products Segment*

 

OurConsolidated Investment Products segment consists of the CIP CDOs, which we arerequired to consolidate pursuant to the amendments to the consolidationguidance in the Financial Accounting Standards Board Accounting StandardsCodification Topic 810—Consolidation (“ASC Topic 810”), as amended byAccounting Standards Update 2009-17, which became effective January 1, 2010.The assets of the CIP CDOs are held solely as collateral to satisfy theobligations of the CIP CDOs. We have no right to the benefits from, nor do webear the risks associated with, the assets held by the CIP CDOs, beyond ourminimal direct investments and beneficial interests in, and management feesgenerated from, the CIP CDOs. If DFR were to liquidate, the assets of the CIPCDOs would not be available to our general creditors, and as a result, we donot consider them our assets. Additionally, the investors in the CIP CDOs haveno recourse to the general credit of DFR for the debt issued by the CIP CDOs.Therefore, this debt is not our obligation. See Notes 2, 4, 5, 8, 13 and 17 tothe condensed consolidated financial statements for disclosures related to ourConsolidated Investment Products segment.

 

***Market andEconomic Conditions***

 

Duringthe three and nine months ended September 30, 2010, the corporate creditmarkets, including the loan market, improved markedly as evidenced by continuedprice appreciation and decreasing default rates.  The weighted average bid price for loans inthe S&P/LSTA Loan Index rose from 87.4% at December 31, 2009 to 89.6%at June 30, 2010 and 91.6% at September 30, 2010.  The trailing 12-month loan default rate, asreported by JP Morgan, decreased from 9.6% at January 2010 to 3.9% at September 2010.A significant portion of our Investment Management segment revenues come frommanaging collateralized loan obligations (“CLOs”).  Increases in the prices of the loansunderlying those CLOs and decreased default rates have the effect of improvingthe CLOs’ compliance with their overcollateralization and other tests, whichincreases the likelihood that we will receive subordinated management fees on acurrent basis from those CLOs.

 

Throughour Principal Investing segment, we invest in Agency RMBS on a leveragedbasis.  Beginning in early 2009, theFederal Reserve implemented historic plans to purchase $1.25 trillion of AgencyRMBS during the year.  In addition, in February 2010,Fannie Mae and Freddie Mac announced plans to buyout substantially allsignificantly delinquent loans from the RMBS pools that they guarantee.  As a result of these buyouts, the Agency RMBSmarket experienced a sustained period of higher than normal prepayment ratesfrom March to July of 2010. Following the completion of the Federal Reserve purchase program on March 31,2010, there was a great deal of concern in the market as to whether there wouldbe sufficient private demand to maintain the prices realized during theimplementation of this repurchase program. However, despite subsequent events such as the Eurozone crisis, arumored government sponsored national refinance program and looming uncertaintyabout the future of the government sponsored enterprises, prices in the AgencyRMBS market have remained stable.

 

***Summary ofResults of Operations and Financial Condition***

 

Netloss attributable to DFR for the three months ended September 30, 2010totaled $8.0 million, or $0.70 loss per diluted common share, compared to netincome attributable to DFR of $1.8 million, or $0.27 per diluted common share,for the same period in 2009. The majority of the 2010 net loss was attributableto non-cash items, including, a $3.7 million unrealized loss on the conversionfeature of our senior subordinated convertible notes primarily resulting fromshare price appreciation during the quarter and a $2.4 million impairmentcharge on intangible assets associated with the sale of a non-core portfoliomanagement product. Additionally, we recorded $1.7 million of income taxexpense in the 2010 quarter.

 

39

----

Table ofContents

 

Whenwe analyze our financial results, we focus on the combined results of our InvestmentManagement and Principal Investing segments (“DFR Operations”). While we are required to include our ConsolidatedInvestment Products segment in our consolidated GAAP results, this segment doesnot have any economic impact on our operations beyond the investment advisoryfees we earn on the CIP CDOs and the gains (losses) on our minimal directinvestments in the CIP CDOs, which are eliminated upon consolidation.  See “*Results of Operations”*below for a reconciliation of DFR Operations results to our consolidated GAAPresults, as well as a detailed discussion of results of operations by segment.

 

*Results of DFR Operations*

 

Duringthe three months ended September 30, 2010, net revenues were $8.4 million,a net increase of $1.7 million, or 25.4 percent, as compared to the sameperiod in 2009. This significant improvement is the result of a $2.8 millionincrease in investment advisory fees and a $1.1 million decrease in theprovision for loan losses, partially offset by a $2.2 million decrease in netinterest income.

 

Investmentadvisory fees were $6.8 million for the three months ended September 30,2010, an increase of $2.8 million, or 70.0 percent, as compared to the sameperiod in 2009. The increase in investment advisory fees is primarilyattributable to an increase in subordinated management fees, as most of theCLOs that we manage have resumed current payment of subordinated managementfees and begun to pay previously deferred subordinated management fees.  Furthermore, on June 9, 2010, weacquired all of the outstanding equity interests of CNCIM (the “CNCIMAcquisition”), which contributed investment advisory fees of $1.6 millionduring the period.

 

Netinterest income was $4.8 million for the three months ended September 30,2010, a decline of $2.2 million, or 31.4 percent, as compared to the sameperiod in 2009.  This decline isprimarily the result of declines in net interest income on our RMBS portfolioand DFR Middle Market CLO Ltd. (“DFR MM CLO”), partially offset by interestexpense savings on our long-term debt.

 

Expenseswere $12.4 million for the three months ended September 30, 2010, anincrease of $4.7 million, or 61.0 percent, as compared to the same period in2009.  The increase was primarily drivenby $2.4 million of impairment charges on intangible assets associated with thesale of a non-core portfolio management product during the period and a $1.9million increase in compensation and benefits.

 

Netother income (expense) and gain (loss) was a net loss of $1.5 million for thethree months ended September 30, 2010, a decrease of $4.5 million, or150.0 percent, as compared to the same period in 2009.  This decrease is primarily related to $3.7million of unrealized losses on the quarterly valuation of the conversionfeature of the senior subordinated convertible notes (the “Convertible Notes”)that we issued in connection with the CNCIM Acquisition, which we determinedwas an embedded derivative instrument (the “Embedded Derivative”). These unrealizedlosses primarily resulted from share price appreciation during thequarter.  We record the unrealized losseson the Embedded Derivative within net other income (expense) and gain (loss).

 

*Assets Under Management*

 

Asof October 1, 2010, our assets under management (“AUM”) totaledapproximately $9.6 billion, primarily held in 31 CDOs.

 

*Principal Investing Portfolio*

 

ThePrincipal Investing segment’s total invested assets decreased by $58.6 million,or 9.9 percent, to $535.0 million as of September 30, 2010, as compared to$593.6 million as of December 31, 2009. The decrease was primarilyattributable to a reduction in our RMBS portfolio of $50.6 million as a resultof paydowns and opportunistic sales**.**

 

40

----

Table of Contents

 

***Our Strategy***

 

Our growth strategy centers on four areas:(i) the acquisition of existing CDO contracts from other managers,(ii) the internal development of new product offerings relying onexisting capabilities, (iii) the introduction of new productsresulting from acquisitions of and ventures with external managers and(iv) the creation of new CLOs as the market environment improves and theeconomics for new issuances become attractive to investors.

 

Consistent with our strategy, we acquired CNCIM, an investment managerwith four CLOs under management (the “CNCIM CLOs”) on June 9, 2010. Inaddition, in prior years, we acquired the management contracts for Robeco CDOII Limited and Mayfair Euro CDO I B.V. We are also focused on growing ourInvestment Management segment by launching new investment products that webelieve will diversify our revenue streams and take advantage of our corecompetencies of credit analysis and asset management. We intend to makeinvestments in certain of these new investment products. We believe that thegrowth of fee-based income through the management of alternative investmentproducts will provide the most attractive risk-adjusted return on capital.

 

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

 

***Strategic Transactions***

 

OnJune 9, 2010, we completed the CNCIM Acquisition and several otherstrategic transactions which provided a significant increase in our AUM and ourinvestment advisory fee income, eliminated our near-term debt maturities,reduced our total debt and removed a number of restrictive debt covenants towhich we were subject. We believe these transactions will result inopportunities for us to grow both organically and via acquisitions that may nothave otherwise been available to us. See Note 3 to the condensed consolidatedfinancial statements for a description of these strategic transactions.

 

***Recent Developments***

 

OnOctober 20, 2010, we redeemed-in-kind $25.0 million of aggregateoutstanding principal amount of trust preferred securities issued in 2005 byDeerfield Capital Trust I for $25.0 million in aggregate principal of juniorsubordinated notes.  The covenantscontained in the indentures governing the junior subordinated notes aresubstantially less restrictive than the covenants contained in the indenturesgoverning the trust preferred securities. See Note 20 to the condensedconsolidated financial statements for a detailed description of the in-kindredemption.

 

**Changes inFinancial Condition**

 

EffectiveJanuary 1, 2010, we consolidated seven CDOs into our condensedconsolidated financial statements and created our Consolidated InvestmentProducts segment. As a result of the CNCIM Acquisition, the four CNCIM CLOs arenow also consolidated into our condensed consolidated financial statements. Asof September 30, 2010 the Consolidated Investment Products segmentrepresents $4.1 billion of non-recourse assets and $3.7 billion of non-recourseliabilities. See Note 4 to our condensed consolidated financial statements fora description of the Consolidated Investment Products segment.

 

Duringthe nine months ended September 30, 2010, our financial condition improvedprimarily as a result of the CNCIM Acquisition and related strategictransactions. We issued 4.5 million shares of our common stock in connectionwith the CNCIM Acquisition.  Thisacquisition also requires us to make deferred payments to the seller of $7.5million, payable in five equal annual installments beginning on December 9,2010. Additionally, we issued $25.0 million in principal amount of ConvertibleNotes and used the proceeds, along with available cash, to extinguish $73.9million in principal amount of the Series A and B Senior Secured Notesissued by Deerfield (the “Senior Notes”) for $55.0 million (the “Senior 

 

41

----

Table of Contents

 

NotesDischarge”). Further, we exchanged $95.0 million in principal amount of ourvariable interest rate trust preferred securities for $95.0 million inprincipal amount of junior subordinated notes (the “March JuniorSubordinated Notes”) which bear interest at a fixed rate of 1% per annumthrough April 30, 2015 and thereafter will be subject to a variableinterest rate equal to LIBOR plus 2.58% per annum (the “Trust PreferredExchange”). In addition, we reduced our RMBS portfolio, through paydowns andopportunistic sales, by $50.6 million to $254.5 million as of September 30,2010.

 

**Results ofOperations**

 

Thefollowing tables present the consolidation of our Investment Management andPrincipal Investing segments into DFR Operations and the consolidation of DFROperations and our Consolidated Investment Products segment into our condensedconsolidated statements of operations. DFR Operations for the three and nine months ended September 30,2010 are comparable to our consolidated results for periods prior to January 1,2010.

 

**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**SEGMENTCONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                                                      | ** ** | **Three months ended September 30, 2010**                        | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **DFR Operations**                                                                   | ** ** | ** ** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                      | ** ** | **Investment**                                                                            | ** ** | **Principal** | ** ** | **Total** | ** ** | **Investment** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                      | ** ** | **Management**                                                                            | ** ** | **Investing** | ** ** | **DFR** | ** ** | **Products** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                                                      | ** ** | **Segment (1)**                                                                      | ** ** | **Segment (1) (2)** | ** ** | **Operations** | ** ** | **Segment** | ** ** | **Elimination** | ** ** | **DFR** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| **Revenues**                                                                                    | ** ** | ** **                                                                                | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest income                                                                                 |       | $                                                                                         | (202       | ) | $ | 7,369 |   | $ | 7,167 |   | $ | 42,276 |   | $ | (117 | ) | $ | 49,326 |   |
| Interest expense                                                                                |       | 91                                                                                        |       | 2,320 |   | 2,411 |   | 10,263 |   | 140 |   | 12,814 |   |
| Net interest income                                                                             |       | (293                                                                                      | )          | 5,049 |   | 4,756 |   | 32,013 |   | (257 | ) | 36,512 |   |
| Provision for loan losses                                                                       |       | —                                                                                    |       | 3,105 |   | 3,105 |   | — |   | — |   | 3,105 |   |
| Net interest income (expense) after provision for  loan losses                                  |       | (293                                                                                      | )          | 1,944 |   | 1,651 |   | 32,013 |   | (257 | ) | 33,407 |   |
| Investment advisory fees                                                                        |       | 6,780                                                                                     |       | — |   | 6,780 |   | — |   | (4,402 | ) | 2,378 |   |
| Total net revenues                                                                              |       | 6,487                                                                                     |       | 1,944 |   | 8,431 |   | 32,013 |   | (4,659 | ) | 35,785 |   |
|                                                                                            |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total expenses                                                                                  |       | 10,374                                                                                    |       | 2,048 |   | 12,422 |   | 5,222 |   | (4,402 | ) | 13,242 |   |
| Net other income (expense) and gain (loss)                                                      |       | 376                                                                                       |       | (1,841 | ) | (1,465 | ) | (30,887 | ) | (508 | ) | (32,860 | ) |
| Loss before income tax expense                                                                  |       | (3,511                                                                                    | )          | (1,945 | ) | (5,456 | ) | (4,096 | ) | (765 | ) | (10,317 | ) |
| Income tax expense                                                                              |       | —                                                                                    |       | 1,699 |   | 1,699 |   | — |   | — |   | 1,699 |   |
|                                                                                            |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| **Net loss**                                                                                    |       | (3,511                                                                                    | )          | (3,644 | ) | (7,155 | ) | (4,096 | ) | (765 | ) | (12,016 | ) |
| Net (income) loss attributable to noncontrolling  interest and Consolidated Investment Products |       | —                                                                                    |       | (99 | ) | (99 | ) | 4,096 |   | — |   | 3,997 |   |
| **Net loss attributable to  Deerfield Capital Corp.**                                           |       | $                                                                                         | (3,511     | ) | $ | (3,743 | ) | $ | (7,254 | ) | $ | — |   | $ | (765 | ) | $ | (8,019 | ) |

 
| ** **                                                     | ** ** | **Three months ended September 30, 2009**                        | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **DFR Operations**                                                                   | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Investment**                                                                            | ** ** | **Principal** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Management**                                                                            | ** ** | **Investing** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **Segment (1)**                                                                      | ** ** | **Segment (1) (2)** | ** ** | **DFR** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| **Revenues**                                                   | ** ** | ** **                                                                                | ** ** | ** ** | ** ** |   | ** ** |
| Interest income                                                |       | $                                                                                         | 10         |   | $ | 10,829 |   | $ | 10,839 |   |
| Interest expense                                               |       | 1,191                                                                                     |       | 2,675 |   | 3,866 |   |
| Net interest income                                            |       | (1,181                                                                                    | )          | 8,154 |   | 6,973 |   |
| Provision for loan losses                                      |       | —                                                                                    |       | 4,226 |   | 4,226 |   |
| Net interest income (expense) after provision for  loan losses |       | (1,181                                                                                    | )          | 3,928 |   | 2,747 |   |
| Investment advisory fees                                       |       | 3,949                                                                                     |       | — |   | 3,949 |   |
| Total net revenues                                             |       | 2,768                                                                                     |       | 3,928 |   | 6,696 |   |
|                                                           |       |                                                                                      |       |   |   |   |   |
| Total expenses                                                 |       | 5,706                                                                                     |       | 2,013 |   | 7,719 |   |
| Net other income (expense) and gain (loss)                     |       | 481                                                                                       |       | 2,541 |   | 3,022 |   |
| Income (loss) before income tax expense                        |       | (2,457                                                                                    | )          | 4,456 |   | 1,999 |   |
| Income tax expense                                             |       | —                                                                                    |       | 75 |   | 75 |   |
|                                                           |       |                                                                                      |       |   |   |   |   |
| **Net income (loss)**                                          |       | (2,457                                                                                    | )          | 4,381 |   | 1,924 |   |
| Net income attributable to noncontrolling interest             |       | —                                                                                    |       | (108 | ) | (108 | ) |
| **Net income (loss) attributable to  Deerfield Capital Corp.** |       | $                                                                                         | (2,457     | ) | $ | 4,273 |   | $ | 1,816 |   |

 

42

----

Table of Contents

 

**DEERFIELDCAPITAL CORP. AND ITS SUBSIDIARIES**

**SEGMENTCONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                                                      | ** ** | **Nine months ended September 30, 2010**                         | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **DFR Operations**                                                                   | ** ** | ** ** | ** ** | **Consolidated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                      | ** ** | **Investment**                                                                            | ** ** | **Principal** | ** ** | **Total** | ** ** | **Investment** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                      | ** ** | **Management**                                                                            | ** ** | **Investing** | ** ** | **DFR** | ** ** | **Products** | ** ** | ** ** | ** ** | **Consolidated** | ** ** |
| ** **                                                                                      | ** ** | **Segment (1)**                                                                      | ** ** | **Segment (1) (2)** | ** ** | **Operations** | ** ** | **Segment** | ** ** | **Elimination** | ** ** | **DFR** | ** ** |
| ** **                                                                                      | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| **Revenues**                                                                                    | ** ** | ** **                                                                                | ** ** | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |
| Interest income                                                                                 |       | $                                                                                         | 12         |   | $ | 23,455 |   | $ | 23,467 |   | $ | 94,985 |   | $ | (441 | ) | $ | 118,011 |   |
| Interest expense                                                                                |       | 2,329                                                                                     |       | 5,700 |   | 8,029 |   | 20,935 |   | (184 | ) | 28,780 |   |
| Net interest income                                                                             |       | (2,317                                                                                    | )          | 17,755 |   | 15,438 |   | 74,050 |   | (257 | ) | 89,231 |   |
| Provision for loan losses                                                                       |       | —                                                                                    |       | 7,582 |   | 7,582 |   | — |   | — |   | 7,582 |   |
| Net interest income (expense) after provision for  loan losses                                  |       | (2,317                                                                                    | )          | 10,173 |   | 7,856 |   | 74,050 |   | (257 | ) | 81,649 |   |
| Investment advisory fees                                                                        |       | 20,327                                                                                    |       | — |   | 20,327 |   | — |   | (11,271 | ) | 9,056 |   |
| Total net revenues                                                                              |       | 18,010                                                                                    |       | 10,173 |   | 28,183 |   | 74,050 |   | (11,528 | ) | 90,705 |   |
|                                                                                            |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total expenses                                                                                  |       | 27,493                                                                                    |       | 7,428 |   | 34,921 |   | 13,285 |   | (11,271 | ) | 36,935 |   |
| Net other income (expense) and gain (loss)                                                      |       | 17,150                                                                                    |       | 2,377 |   | 19,527 |   | (79,018 | ) | (508 | ) | (59,999 | ) |
| Income (loss) before income tax expense                                                         |       | 7,667                                                                                     |       | 5,122 |   | 12,789 |   | (18,253 | ) | (765 | ) | (6,229 | ) |
| Income tax expense                                                                              |       | 2                                                                                         |       | 1,699 |   | 1,701 |   | — |   | — |   | 1,701 |   |
|                                                                                            |       |                                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| **Net income (loss)**                                                                           |       | 7,665                                                                                     |       | 3,423 |   | 11,088 |   | (18,253 | ) | (765 | ) | (7,930 | ) |
| Net (income) loss attributable to noncontrolling  interest and Consolidated Investment Products |       | —                                                                                    |       | (622 | ) | (622 | ) | 18,253 |   | — |   | 17,631 |   |
| **Net income attributable to  Deerfield Capital Corp.**                                         |       | $                                                                                         | 7,665      |   | $ | 2,801 |   | $ | 10,466 |   | $ | — |   | $ | (765 | ) | $ | 9,701 |   |

 
| ** **                                                     | ** ** | **Nine months ended September 30, 2009**                         | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **DFR Operations**                                                                   | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Investment**                                                                            | ** ** | **Principal** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Management**                                                                            | ** ** | **Investing** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **Segment (1)**                                                                      | ** ** | **Segment (1) (2)** | ** ** | **DFR** | ** ** |
| ** **                                                     | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| **Revenues**                                                   | ** ** | ** **                                                                                | ** ** | ** ** | ** ** |   | ** ** |
| Interest income                                                |       | $                                                                                         | 72         |   | $ | 38,647 |   | $ | 38,719 |   |
| Interest expense                                               |       | 3,849                                                                                     |       | 12,682 |   | 16,531 |   |
| Net interest income                                            |       | (3,777                                                                                    | )          | 25,965 |   | 22,188 |   |
| Provision for loan losses                                      |       | —                                                                                    |       | 15,452 |   | 15,452 |   |
| Net interest income (expense) after provision for  loan losses |       | (3,777                                                                                    | )          | 10,513 |   | 6,736 |   |
| Investment advisory fees                                       |       | 12,695                                                                                    |       | — |   | 12,695 |   |
| Total net revenues                                             |       | 8,918                                                                                     |       | 10,513 |   | 19,431 |   |
|                                                           |       |                                                                                      |       |   |   |   |   |
| Total expenses                                                 |       | 18,395                                                                                    |       | 9,638 |   | 28,033 |   |
| Net other income (expense) and gain (loss)                     |       | 260                                                                                       |       | 71,964 |   | 72,224 |   |
| Income (loss) before income tax expense                        |       | (9,217                                                                                    | )          | 72,839 |   | 63,622 |   |
| Income tax expense                                             |       | 28                                                                                        |       | 225 |   | 253 |   |
|                                                           |       |                                                                                      |       |   |   |   |   |
| **Net income (loss)**                                          |       | (9,245                                                                                    | )          | 72,614 |   | 63,369 |   |
| Net loss attributable to noncontrolling interest               |       | —                                                                                    |       | 2,852 |   | 2,852 |   |
| **Net income (loss) attributable to  Deerfield Capital Corp.** |       | $                                                                                         | (9,245     | ) | $ | 75,466 |   | $ | 66,221 |   |

 

----

(1)          Excludes intercompanyinvestment advisory fee revenues of our Investment Management segment andcorresponding intercompany management fee expense of our Principal Investingsegment related to the management agreement between the two segments of $0.8million and $2.1 million for the three and nine months ended September 30,2010, respectively, and $1.3 million and $4.2 million for the three and ninemonths ended September 30, 2009, respectively.

 

(2)          Our Principal Investingsegment results of operations include the financial results of DFR MM CLO andDeerfield Pegasus Loan Capital LP (“DPLC”) for the three and nine months endedSeptember 30, 2010 and September 30, 2009. Our Principal Investingsegment results of operations also include the financial results of MarketSquare CLO Ltd. (“Market Square CLO”) through June 30, 2009, when we soldall of our preference shares in Market Square CLO to an unrelated third partyin exchange for an upfront payment and a delayed purchase price in the form ofa right to receive a portion of the future distributions on the preferenceshares. As a result of the sale, we deconsolidated 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, and as of January 1, 2010, the amendments toASC Topic 810 required us to again consolidate Market Square CLO as a part ofour Consolidated Investment Products segment.

 

43

----

Table of Contents

 

On a consolidated basis, DFR recorded net loss attributable to DFR of$8.0 million and net income attributable to DFR of $9.7 million, during thethree and nine months ended September 30, 2010, respectively, as comparedto net income attributable to DFR of $1.8 million and $66.2 million forthe same periods in 2009, respectively. On a consolidated basis, DFR dilutednet loss of $0.70 per share and diluted net income of $1.11 per share for thethree and nine months ended September 30, 2010, respectively, as comparedto diluted net income per share of $0.27 and $9.84 for the same periods in2009, respectively.

 

During the three months ended September 30, 2010, DFR Operationsexperienced an increase in net revenues of $1.7 million as compared to the sameperiod in 2009.  This increase was primarilythe result of a $2.8 million increase in investment advisory fees and a $1.1million reduction in provision for loan losses, partially offset by a $2.2million decrease in net interest income. During the nine months endedSeptember 30, 2010, DFR Operations experienced an increase in net revenuesof $8.8 million as compared to the same period in 2009.  This increase was primarily the result of a$7.6 million increase in investment advisory fees and a $7.9 million reductionin provision for loan losses, partially offset by a $6.7 million decrease innet interest income.

 

The increases in DFR Operations investment advisory fee income for thethree and nine months ended September 30, 2010 are primarily the result ofincreases in CLO investment advisory fees as most of the CLOs we manage haveresumed current payment of subordinated management fees and have begun to paydeferred subordinated management fees during the periods and the addition ofinvestment advisory fees related to the CNCIM CLOs. The decreases in netinterest income were primarily driven by the deconsolidation of Market SquareCLO Ltd. (“Market Square CLO”) as of June 30, 2009 and decreases in netinterest income on our RMBS portfolio and DFR MM CLO, partially offset byinterest expense savings on our long-term debt.

 

During the three months ended September 30, 2010, DFR Operationstotal expenses increased by $4.7 million as compared to the same period in2009.  The increase was primarily theresult of a $2.4 million of impairment charges on intangible assets associatedwith a non-core portfoliomanagement product sold during the period and a $1.9 million increase incompensation and benefits.

 

During the nine months ended September 30, 2010, DFR Operationstotal expenses increased by $6.9 million as compared to the same period in2009.  This increase is primarily theresult of a $5.8 million increase in depreciation and amortization, a $2.4million increase in impairment of intangible assets, a $1.5 million increase inprofessional services expenses and $1.4 million increase in compensation andbenefits, partially offset by declines in other general and administrativeexpenses of $2.7 million and occupancy costs of $0.5 million. The increase indepreciation and amortization is primarily the result of accelerateddepreciation and amortization in connection with abandoning the equipment andleasehold improvements associated with our old lease. The impairment charges onintangible assets are associated with a portfolio management product sold duringthe period.  The increase in professionalservices expenses is primarily a result of increased legal fees related to ourpreviously disclosed Securities and Exchange Commission (“SEC”) investigation.The decrease in other general and administrative expenses is primarily theresult of $3.3 million in one-time Deerfield Pegasus Loan Capital LP (“DPLC”)structuring and organizational expenses incurred during the nine months endedSeptember 30, 2009, partially offset by $0.5 million increase in expensewe incurred during the nine months ended September 30, 2010 to grantwarrants to purchase an aggregate of 250,000 shares of our common stock at anexercise price of $4.25 per share as part of the termination agreementassociated with DPLC (the “DPLC Restructuring Warrants”). The decline inoccupancy costs is the result of our office lease amendment.

 

During the three and ninemonths ended September 30, 2010, DFR Operations net other income (expense)and gain (loss) declined by $4.5 million and $52.7 million, respectively.  The decline during the three months ended September 30,2010, as compared to the same period in 2009, is primarily the result ofunrealized losses on the Embedded Derivative related to the Convertible Notesof $3.7 million. The decline during the nine months ended September 30,2010, as compared to the same period in 2009, was primarily driven by effectsof the deconsolidation of Market Square CLO on June 30, 2009.  During the nine months endedSeptember 30, 2009, we recorded a net gain on the deconsolidation ofMarket Square CLO of $29.6 million and net gains on our loan portfolio(primarily attributable to net gains on loans held in Market 

 

44

----

Table of Contents

 

Square CLO) of $31.2 million.  During the nine months ended September 30,2010, we recorded unrealized losses of $7.0 million on the Embedded Derivativerelated to the Convertible Notes and incurred strategic transactions expensesof $4.0 million. Strategic transactions expenses were primarily comprised oflegal fees, investment banking fees and compensation. These declines werepartially offset by a $17.4 million gain on the Senior Notes Discharge duringthe nine months ended September 30, 2010.

 

During the three and ninemonths ended September 30, 2010, DFR Operations recorded income taxexpense of $1.7 million. For the period from January 1, 2008 through June 9, 2010, we did not paysignificant corporate income taxes as a result of net operating losses and netcapital losses incurred primarily in 2008. As a result of the CNCIMAcquisition, our ability to use these net operating losses and net capitallosses to offset our federal taxable income has been significantly reduced. Aswe continue to record a full valuation allowance on our net deferred taxassets, the provision for income taxes represents our current liability forfederal income taxes.

 

***Core Earnings***

 

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

 

The table below provides a reconciliation between net income (loss) andcore earnings:

 
| ** **                                                                      | ** ** | **Three months ended September 30,**                                  | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2010**                                                                                  | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                                      | ** ** | **(In thousands, except share and per share amounts)** | ** ** |
| ** **                                                                      | ** ** | ** **                                                                                | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                               |       | $                                                                                         | (12,016    | )                                                       | $          | 1,924 |   | $ | (7,930 | ) | $ | 63,369 |   |
| Adjusting items:                                                                | ** ** | ** **                                                                                |       |                                                    | ** ** | ** ** |   |   |   |
| Provision for loan losses                                                       |       | 3,105                                                                                     |       | 4,226                                                   |       | 7,582 |   | 15,452 |   |
| Depreciation and amortization                                                   |       | 1,931                                                                                     |       | 1,630                                                   |       | 10,694 |   | 4,894 |   |
| Impairment of intangible assets                                                 |       | 2,398                                                                                     |       | —                                                  |       | 2,566 |   | 126 |   |
| Net other income (expense) and gain (loss) (1)                                  |       | 33,826                                                                                    |       | (3,022                                                  | )          | 60,965 |   | (72,224 | ) |
| Income tax expense                                                              |       | 1,699                                                                                     |       | 75                                                      |       | 1,701 |   | 253 |   |
| Noncontrolling interest and Consolidated  Investment Products core earnings (2) |       | (26,860                                                                                   | )          | 379                                                     |       | (61,164 | ) | 3,676 |   |
| Consolidated Investment Products net interest  income elimination (3)           |       | 257                                                                                       |       | —                                                  |       | 257 |   | — |   |
| Warrant expense                                                                 |       | —                                                                                    |       | —                                                  |       | 529 |   | — |   |
| Cost savings initiatives                                                        |       | —                                                                                    |       | 11                                                      |       | — |   | 236 |   |
| Core earnings                                                                   |       | $                                                                                         | 4,340      |                                                    | $          | 5,223 |   | $ | 15,200 |   | $ | 15,782 |   |
|                                                                            |       |                                                                                      |       |                                                    |       |   |   |   |   |
| Core earnings per share - diluted                                               |       | $                                                                                         | 0.33       |                                                    | $          | 0.77 |   | $ | 1.53 |   | $ | 2.34 |   |
| Weighted-average number of shares outstanding -  diluted (4)                    |       | 15,587,264                                                                                |       | 6,763,088                                               |       | 10,465,791 |   | 6,732,272 |   |

 

----

(1)                                  Core earningsfor the three and nine months ended September 30, 2010, includes net otherincome (expense) and gain (loss) related to certain short-term corporate debttrading strategies, but excludes all other components of net other income(expense) and gain (loss), which includes gains (losses) related to all otherinvesting strategies.

 

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

 

45

----

Table of Contents

 

(3)                                  Primarilyrepresents interest income earned by our Principal Investing segment on itsinvestments in our Consolidated Investment Products segment debt partiallyoffset by the corresponding interest expense recorded in our ConsolidatedInvestment Products segment.

 

(4)                                  For the threeand nine months ended September 30, 2010, we utilized the fully-dilutedshare number of 15,587,264 and 10,465,791, respectively, in the computation ofthe diluted core earnings per share, which includes the dilutive impact of theDPLC Restructuring Warrants and the Convertible Notes. In addition,tax-effected interest expense on the Convertible Notes of $0.8 million wasadded back to core earnings for the three and nine months endedSeptember 30, 2010 to calculate diluted earnings per share under theif-converted method.

 

***Results ofOperations by Segment***

 

*InvestmentManagement Segment*

 

AUM

 

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

 

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

 
| ** **                   | ** ** | **As of October 1, 2010** | ** ** |
|------------------------------|------------|-----------------------------------------------|------------|
| ** **                   | ** ** | **Number of**                            | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **Accounts**                                  | ** ** | **AUM** | ** ** |
| ** **                   | ** ** | ** **                                    | ** ** | **(In thousands)** | ** ** |
| CDOs (1):                    |       |                                          |       |   |   |
| CLOs                         |       | 16                                            |       | $ | 5,546,053 |   |
| Asset-backed securities      |       | 11                                            |       | 3,462,755 |   |
| Corporate bonds              |       | 4                                             |       | 549,360 |   |
| Total CDOs                   |       | 31                                            |       | 9,558,168 |   |
| Other investment vehicle (2) |       | 1                                             |       | 5,986 |   |
| Total AUM (3)                |       |                                          |       | $ | 9,564,154 |   |

 

----

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

 

(2)                                  Otherinvestment vehicle AUM represents the AUM of DPLC.

 

(3)                                  Included inTotal AUM for October 1, 2010 is $273.6 million related to DFR MMCLO. DCM manages DFR MM CLO but is not contractually entitled to receive anymanagement fees therefrom for so long as all of the preference shares issued byDFR MM CLO are held by Deerfield Capital LLC (“DC LLC”) or an affiliatethereof.

 

46

----

Table of Contents

 

Net Revenues

 

*InvestmentAdvisory Fees*

 

For the three months ended September 30, 2010 and 2009, investmentadvisory fees were $6.8 million and $3.9 million, respectively, on asegment basis, and $2.4 million and $3.9 million, respectively, on aconsolidated basis due to the $4.4 million of fees earned by our InvestmentManagement segment from our Consolidated Investment Products segment for thethree months ended September 30, 2010, which were eliminated uponconsolidation. For the nine months ended September 30, 2010 and 2009,investment advisory fees were $20.3 million and $12.7 million,respectively, on a segment basis, and $9.1 million and $12.7 million,respectively, on a consolidated basis due to the $11.2 million of fees earnedby our Investment Management segment from our Consolidated Investment Productssegment for the nine months ended September 30, 2010, which wereeliminated upon consolidation. Our investment advisory fee revenue during theperiods presented was generated by our management of CDOs and separatelymanaged accounts. The following discussion further analyzes and explainschanges in our CDO investment advisory fees.

 

*CDO Investment Advisory Fees*

 

The following table summarizes the investment advisory fee revenuesfrom the CDOs we manage:

 
| ** **                            | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                            | ** ** | **2010**                                                 | ** ** | **2009**     | ** ** | **2010 vs. 2009**                             | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                            | ** ** | **(In thousands)**                                  | ** ** |
| **Senior Management Fees:**           | ** ** | ** **                                               | ** ** | ** **   |       |                                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | $                                                        | 2,541      |         | $          | 1,900                                                   |       | $            | 641        |   | $ | 6,037 |   | $ | 4,953 |   | $ | 1,084 |   |
| ABS                                   |       | 590                                                      |       | 782          |       | (192                                                    | )          | 2,003        |       | 2,594 |   | (591 | ) |
| Corporate Bonds                       |       | 351                                                      |       | 412          |       | (61                                                     | )          | 1,089        |       | 1,377 |   | (288 | ) |
| **Total Senior Mangement Fees**       |       | 3,482                                                    |       | 3,094        |       | 388                                                     |       | 9,129        |       | 8,924 |   | 205 |   |
|                                  |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| **Subordinated Management Fees:**     | ** ** | ** **                                               | ** ** | ** **   |       |                                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | 2,594                                                    |       | 441          |       | 2,153                                                   |       | 6,066        |       | 1,945 |   | 4,121 |   |
| ABS                                   |       | —                                                   |       | —       |       | —                                                  |       | 27           |       | 152 |   | (125 | ) |
| Corporate Bonds                       |       | —                                                   |       | —       |       | —                                                  |       | 255          |       | 272 |   | (17 | ) |
| **Total Subordinated Mangement Fees** |       | 2,594                                                    |       | 441          |       | 2,153                                                   |       | 6,348        |       | 2,369 |   | 3,979 |   |
|                                  |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| **Performance Fees (1):**             | ** ** | ** **                                               | ** ** | ** **   |       |                                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | 450                                                      | (2)        | 67           | (2)        | 383                                                     |       | 4,205        | (2)        | 239 | (2) | 3,966 |   |
| ABS                                   |       | —                                                   |       | —       |       | —                                                  |       | —       |       | — |   | — |   |
| Corporate Bonds                       |       | 60                                                       | (3)        | —       |       | 60                                                      |       | 60           | (3)        | 225 | (3) | (165 | ) |
| **Total Performance Fees**            |       | 510                                                      |       | 67           |       | 443                                                     |       | 4,265        |       | 464 |   | 3,801 |   |
|                                  |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| **Total CDO Advisory Fees:**          | ** ** | ** **                                               | ** ** | ** **   |       |                                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | 5,585                                                    |       | 2,408        |       | 3,177                                                   |       | 16,308       |       | 7,137 |   | 9,171 |   |
| ABS                                   |       | 590                                                      |       | 782          |       | (192                                                    | )          | 2,030        |       | 2,746 |   | (716 | ) |
| Corporate Bonds                       |       | 411                                                      |       | 412          |       | (1                                                      | )          | 1,404        |       | 1,874 |   | (470 | ) |
| **Total CDO Advisory Fees**           |       | $                                                        | 6,586      |         | $          | 3,602                                                   |       | $            | 2,984      |   | $ | 19,742 |   | $ | 11,757 |   | $ | 7,985 |   |

 

----

(1)                                 Performancefees are generally earned after certain investors’ returns exceed a specifiedinternal rate of return. For purposes of this 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)                                 Performancefees on CLOs for the three and nine months ended September 30, 2010 and2009 represent previously deferred subordinated management fees.

 

(3)                                 Performancefees on corporate bond CDOs primarily represent fees related to a previouslyliquidated corporate bond CDO.

 

CLO investment advisory fee revenue increased by $3.2 million and$9.2 million for the three and nine months ended September 30, 2010, respectively,as compared to the same periods in 2009. The increase in CLO investmentadvisory fee revenue for the three and nine months ended September 30,2010, compared to the same periods in 2009, is primarily based on increases insubordinated management fees of $2.2 million and $4.1 million, respectively, ascertain of the CLOs we manage have resumed current

 

47

----

Table of Contents

 

paymentof subordinated management fees, and an increase in the receipt of deferredsubordinated management fees of $0.4 million and $4.0 million, respectively. Inaddition, the CNCIM CLOs contributed $0.9 million and $1.1 million to seniormanagement fees during the three and nine months ended September 30, 2010,respectively, and $0.7 million to subordinated management fees during the threeand nine months ended September 30, 2010.

 

Subordinated management fees may be deferred if, among other things, overcollateralizationtests and other structural provisions built into the CDOs divert cash flows tothe prepayment of the debt securities issued by the CDOs. We expect a portionof subordinated management fees for the CLOs we manage to continue to be deferredin the near term. As a result of improvement in market conditions and effectiveportfolio management, most of the CLOs we manage have returned to compliancewith their overcollateralization tests, and we have begun to recoup some of ourdeferred subordinated management fees from those CLOs and expect those CLOs topay future subordinated management fees on a current basis. With continuedimprovement in market conditions and ongoing effective portfolio management, weexpect most of our other CLOs to return to compliance with theirovercollateralization tests, and, subject to the satisfaction of certain otherconditions, we would expect to recoup substantially all of our deferredsubordinated management fees from those CLOs and to receive future subordinatedmanagement fees on a current basis. As of September 30, 2010, unrecognizeddeferred subordinated management fees related to the CLOs we manage totaledapproximately $6.9 million.

 

ABS CDO revenue decreased by $0.2 million and $0.7 million,respectively, for the three and nine months ended September 30, 2010, ascompared to the same periods in 2009. This decrease is primarily based ondeclines in senior management fees of $0.2 million and $0.6 million forthe three and nine months ended September 30, 2010, respectively,resulting from declines in AUM in our ABS CDOs. We expect our ABS CDO AUM andmanagement fees to continue to decline as a result of both the diversion ofcash flows to repay the debt securities issued by those CDOs based on continuednoncompliance with overcollateralization tests and other structural provisionsand additional defaults and ratings downgrades with respect to the underlyingcollateral in those CDOs.

 

Corporate Bond CDO revenue remained flat for the three months ended September 30,2010, and declined by $0.5 million for the nine months endedSeptember 30, 2010, as compared to the same periods in 2009, primarilybased on declines in senior management fees of $0.1 million and $0.3million, respectively. The decline in senior fees is primarily due to a declinein AUM on our Corporate Bond CDOs as a result of paydowns or maturities of theunderlying collateral in those CDOs.

 

*Interest Expense*

 

Primarily as aresult of the Senior Notes Discharge, our Investment Management segment interestexpense declined by $1.1 million and $1.5 million for the three and nine monthsended September 30, 2010, as compared to the same periods in 2009,respectively.

 

48

----

Table of Contents

 

Expenses

 

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

 
| ** **                                   | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2010**                                                 | ** ** | **2009**     | ** ** | **2010 vs. 2009**                             | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                                  | ** ** |
| ** **                                   | ** ** | ** **                                               | ** ** | ** **   | ** ** | ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Compensation and benefits                    |       | $                                                        | 4,490      |         | $          | 2,637                                                   |       | $            | 1,853      |   | $ | 10,408 |   | $ | 9,020 |   | $ | 1,388 |   |
| Professional services                        |       | 618                                                      |       | 272          |       | 346                                                     |       | 926          |       | 508 |   | 418 |   |
| Insurance expense                            |       | 85                                                       |       | 97           |       | (12                                                     | )          | 269          |       | 291 |   | (22 | ) |
| Other general and administrative expenses    |       | 434                                                      |       | 449          |       | (15                                                     | )          | 1,336        |       | 1,502 |   | (166 | ) |
| Depreciation and amortization                |       | 1,931                                                    |       | 1,630        |       | 301                                                     |       | 10,694       |       | 4,894 |   | 5,800 |   |
| Occupancy                                    |       | 418                                                      |       | 610          |       | (192                                                    | )          | 1,294        |       | 1,818 |   | (524 | ) |
| Cost savings initiatives                     |       | —                                                   |       | 11           |       | (11                                                     | )          | —       |       | 236 |   | (236 | ) |
| Impairment of intangible assets              |       | 2,398                                                    |       | —       |       | 2,398                                                   |       | 2,566        |       | 126 |   | 2,440 |   |
| Total Investment Management segment expenses |       | $                                                        | 10,374     |         | $          | 5,706                                                   |       | $            | 4,668      |   | $ | 27,493 |   | $ | 18,395 |   | $ | 9,098 |   |

 

The increase in expenses of $4.7 million for the three months endedSeptember 30, 2010, as compared to the same period in 2009, was primarilyattributable to a $2.4 million increase in impairment of intangible assets anda $1.9 million increase in compensation and benefits.

 

The increase in expenses of $9.1 million for the nine months endedSeptember 30, 2010, as compared to the same period in 2009, was primarilyattributable to a $5.8 million increase in depreciation and amortization, a$2.4 million increase in impairment of intangible assets, a $1.4 million increasein compensation and benefits and a $0.4 million increase in professionalservices, partially offset by a $0.5 million decrease in occupancy costs.

 

On November 27, 2009, we entered into an amendment to our originaloffice lease agreement dated July 11, 2005. Pursuant to the amendment, on April 30,2010, we relocated to a new space in the same building. The new term of thelease will expire on February 28, 2021. As a result of our relocation, ourannual rent expense under the lease will be reduced by approximately$1.3 million. During the three and nine months ended September 30,2010, occupancy costs were reduced by $0.2 million and $0.5 million,respectively, as compared to the same periods in 2009, primarily as a result ofthe amendment.

 

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

 

On September 30, 2010, we sold the non-core portfolio managementproduct known as Return Profile Management (“RPM”) and ceased management of ourseparately managed accounts related to the RPM strategy. As a result of thesale, during the three months ended September 30, 2010, we recognized aloss in the form of an impairment charge of $2.4 million on the intangibleassets associated with the asset management contracts for the separatelymanaged accounts. In addition, during the nine months endedSeptember 30, 2010, we recorded $0.2 million of impairment charges onthe intangible assets associated with the management contract for Oceanview CBOI, Ltd., as DCM is no longer the manager of this CDO.

 

Other Income (Expense) and Gain (Loss)

 

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

 

49

----

Table of Contents

 

*PrincipalInvesting Segment*

 

Principal Investing Portfolio

 

Income from our Principal Investing segment is primarily composed ofinterest income and net recognized gains and losses on our investmentportfolio.

 

The following table is a summary of our Principal Investing segmentinvestment portfolio by asset class:

 
| ** **                         | ** ** | **Investments at** | ** ** | **Other**       | ** ** | **Loans Held**        | ** ** | **Loans Held**     | ** ** | ** ** | ** ** |
|------------------------------------|------------|-------------------------|------------|-----------------|------------|----------------------------|------------|-------------------------|------------|------------|------------|
| **Security Description**      | ** ** | **Fair Value**     | ** ** | **Investments** | ** ** | **For Sale (1)** | ** ** | **For Investment** | ** ** | **Total**  | ** ** |
| ** **                         | ** ** | **(In thousands)** | ** ** |
| RMBS                               |       | $                       | 254,538    |            | $          | —                     |       | $                       | —     |       | $          | — |   | $ | 254,538 |   |
| Corporate loans:                   |       |                    |       |            |       |                       |       |                    |       |       |       |
| Loans held in DFR MM CLO (2)       |       | —                  |       | —          |       | —                     |       | 267,881                 |       | 267,881    |       |
| Other corporate leveraged loans    |       | —                  |       | —          |       | 72                         |       | —                  |       | 72         |       |
| Loans held in DPLC                 |       | 3,292                   |       | —          |       | —                     |       | —                  |       | 3,292      |       |
| Commercial real estate loans (3)   |       | —                  |       | —          |       | —                     |       | 350                     |       | 350        |       |
| Corporate bonds held in DFR MM CLO |       | 6,003                   |       | —          |       | —                     |       | —                  |       | 6,003      |       |
| Equity securities                  |       | —                  |       | 1,412           |       | —                     |       | —                  |       | 1,412      |       |
| Other investments (4)              |       | 10,539                  |       | —          |       | —                     |       | —                  |       | 10,539     |       |
| Total invested assets              |       | $                       | 274,372    |            | $          | 1,412                      |       | $                       | 72         |       | 268,231    |   | 544,087 |   |
|                               |       |                    |       |            |       |                       |       |                    |       |       |       |
| Allowance for loan losses          |       |                    |       |            |       |                       |       | (9,102                  | )          | (9,102     | )          |
|                               |       |                    |       |            |       |                       |       |                    |       |       |       |
|                               |       |                    |       |            |       |                       |       | $                       | 259,129    |       | $          | 534,985 |   |

 

----

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

 

(2)         Loans held inDFR MM CLO are reported gross of $8.8 million of allowance for loan losses asof September 30, 2010

 

(3)         Commercial realestate loans are reported gross of $0.3 million of allowance for loanlosses as of September 30, 2010.

 

(4)         Otherinvestments include $7.2 million of investments and beneficial interests in theCIP CDOs, which are eliminated upon consolidation.

 

Net Revenues

 

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

 

50

----

Table of Contents

 

The following table summarizes our Principal Investing segment interestincome:

 
| ** **                                   | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2010**                                                 | ** ** | **2009**     | ** ** | **2010 vs. 2009**                             | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
|                                         |       | **(In thousands)**                                  |       |
|                                         |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| RMBS                                         |       | $                                                        | 2,145      |         | $          | 3,848                                                   |       | $            | (1,703     | ) | $ | 6,172 |   | $ | 12,568 |   | $ | (6,396 | ) |
| Corporate  Loans:                            |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Loans  held in DFR MM CLO                    |       | 4,753                                                    |       | 5,950        |       | (1,197                                                  | )          | 16,034       |       | 17,996 |   | (1,962 | ) |
| Loans  held in the Wachovia Facility         |       | —                                                   |       | 40           |       | (40                                                     | )          | —       |       | 1,236 |   | (1,236 | ) |
| Other  corporate leveraged loans             |       | 103                                                      |       | 272          |       | (169                                                    | )          | 181          |       | 255 |   | (74 | ) |
| Corporate  bonds held in DFR MM CLO          |       | 136                                                      |       | —       |       | 136                                                     |       | 216          |       | — |   | 216 |   |
| Assets  held in Market Square CLO            |       | —                                                   |       | —       |       | —                                                  |       | —       |       | 6,073 |   | (6,073 | ) |
| Assets  held in DPLC                         |       | 96                                                       |       | 162          |       | (66                                                     | )          | 449          |       | 197 |   | 252 |   |
| Commercial  real estate loans and securities |       | 5                                                        |       | —       |       | 5                                                       |       | 74           |       | (88 | ) | 162 |   |
| Other  investments                           |       | 131                                                      |       | 557          |       | (426                                                    | )          | 329          |       | 410 |   | (81 | ) |
| **Total interest income**                    |       | $                                                        | 7,369      |         | $          | 10,829                                                  |       | $            | (3,460     | ) | $ | 23,455 |   | $ | 38,647 |   | $ | (15,192 | ) |

 

Interest income decreased by $3.5 million for the three months endedSeptember 30, 2010, as compared to the same period in 2009. This decreasewas primarily comprised of a $1.7 million reduction in interest income earnedon our RMBS portfolio and a $1.4 million reduction of interest earned onCorporate Loans. Interest income decreased by $15.2 million for the nine monthsended September 30, 2010, as compared to the same period in 2009. Thisdecrease was primarily comprised of a $6.4 million reduction in interest incomeearned on our RMBS portfolio, a $6.1 million reduction in interest on assetsheld in Market Square CLO and a $3.3 million reduction in interest earned onCorporate Loans.

 

The $1.7 million and $6.4 million decrease in interest earned on ourRMBS portfolio during the three and nine months ended September 30, 2010,as compared to the same periods in 2009, respectively, is primarily the resultof increased premium amortization and the acceleration of premium amortizationas a result of paydowns, which provided declines in interest income of $1.5million and $4.8 million during the three and nine months endedSeptember 30, 2010, respectively. In addition, the reduction in theaverage size of our RMBS portfolio contributed $0.2 million and $1.6 million tothe decline in interest income during the three and nine months endedSeptember 30, 2010, as compared to the same periods in 2009, respectively.

 

The$1.4 million and $3.3 million decrease in interest income on Corporate Loansfor the three and nine months ended September 30, 2010, as compared to thesame periods in 2009, respectively, was primarily the result of a reduction inthe average size of the DFR MM CLO loan portfolio and the lower interest rateenvironment, which contributed to declines in interest income of $1.2 millionand $2.0 million during the periods, respectively. In addition, the sale ofloans previously held in our since dissolved revolving warehouse fundingfacility with Wachovia Capital Markets, LLC (the “Wachovia Facility”),contributed to a decline in interest income of $1.2 million for the nine monthsended September 30, 2010, as compared to the same period in 2009.

 

The $6.1 million decrease in interest income earned on assets held inMarket Square CLO for the nine months ended September 30, 2010, ascompared to the same period in 2009, was directly attributable to thedeconsolidation of Market Square CLO as of June 30, 2009.

 

51

----

Table of Contents

 

The following table summarizes our Principal Investing segment interestexpense:

 
| ** **                             | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                             | ** ** | **2010**                                                 | ** ** | **2009**     | ** ** | **2010 vs. 2009**                             | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
|                                   | ** ** | **(In thousands)**                                  | ** ** |
| Short-term  debt:                      | ** ** | ** **                                               | ** ** | ** **   | ** ** | ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Repurchase  agreements                 |       | $                                                        | 241        |         | $          | 519                                                     |       | $            | (278       | ) | $ | 695 |   | $ | 1,713 |   | $ | (1,018 | ) |
| Hedging  activity                      |       | —                                                   |       | 41           |       | (41                                                     | )          | 31           |       | 136 |   | (105 | ) |
| Total  short term debt                 |       | 241                                                      |       | 560          |       | (319                                                    | )          | 726          |       | 1,849 |   | (1,123 | ) |
| Long-term  debt:                       |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Recourse:                              |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Subordinated  notes and securities (1) |       | 569                                                      |       | 1,268        |       | (699                                                    | )          | 2,037        |       | 4,274 |   | (2,237 | ) |
| Convertible  notes                     |       | 769                                                      |       | —       |       | 769                                                     |       | 957          |       | — |   | 957 |   |
| Non-Recourse:                          |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| DFR  MM CLO                            |       | 741                                                      |       | 846          |       | (105                                                    | )          | 1,980        |       | 3,522 |   | (1,542 | ) |
| Market  Square CLO                     |       | —                                                   |       | —       |       | —                                                  |       | —       |       | 2,910 |   | (2,910 | ) |
| Wachovia  Facility                     |       | —                                                   |       | 1            |       | (1                                                      | )          | —       |       | 127 |   | (127 | ) |
| Total  long-term debt                  |       | 2,079                                                    |       | 2,115        |       | (36                                                     | )          | 4,974        |       | 10,833 |   | (5,859 | ) |
| Total  interest expense                |       | $                                                        | 2,320      |         | $          | 2,675                                                   |       | $            | (355       | ) | $ | 5,700 |   | $ | 12,682 |   | $ | (6,982 | ) |

 

----

(1)                                 Subordinatednotes and securities includes interest expense for both our trust preferredsecurities and our March Junior Subordinated Notes.

 

The decrease in interest expense of $0.4 million and $7.0 millionfor the three and nine months ended September 30, 2010, as compared to thesame periods in 2009, respectively, was primarily the result of reducedrepurchase agreement and long-term debt balances and, to a lesser extent, lowerinterest rates on our repurchase agreements and our long-term debt. Thedecrease in both the average outstanding repurchase agreement balance and theweighted average borrowing rate for the three and nine months endedSeptember 30, 2010, as compared to the same periods in 2009, contributedto reductions of $0.3 million and $1.0 million, respectively, in interestexpense on repurchase agreements.

 

Theinterest expense related to long-term debt remained flat and decreased by $5.9million for the three and nine months ended September 30, 2010, ascompared to the same periods in 2009, respectively. Subordinated notes andsecurities provided a $0.7 million and $2.2 million reduction in interestexpense for the three and nine months ended September 30, 2010, respectively,as compared to the same periods in 2009. The reduction in interest expenserelated to the subordinated notes and securities was primarily due to adecrease in the average borrowing rate for the periods.  Lower outstanding long-term debt balances andlower interest rates on DFR MM CLO provided a decrease in interest expense of$0.1 million and $1.5 million for the three and nine months endedSeptember 30, 2010, as compared to the same periods in 2009, respectively.In addition, the deconsolidation of Market Square CLO on June 30, 2009provided a decrease in interest expense of $2.9 million for the nine monthsended September 30, 2010, as compared to the same period in 2009. Theissuance of the Convertible Notes on June 9, 2010 provided an increase ininterest expense of $0.8 million and $1.0 million for the three and nine monthsended September 30, 2010, as compared to the same periods in 2009,respectively.

 

Intereston subordinated notes and securities will continue to decline as compared toprior periods primarily as a result of the Trust Preferred Exchange and therelated issuance of our March Junior Subordinated Notes, which accrueinterest at a fixed rate of 1.0% per annum through April 30, 2015.  See Note 13 to our condensed consolidatedfinancial statements for further information on the Trust Preferred Exchangeand the March Junior Subordinated Notes. Additionally, we expect a furthernet reduction in DFR Operations’ long-term debt interest expense as a result ofthe Senior Notes Discharge, which eliminated $73.9 million in aggregateprincipal amount of outstanding debt, although this reduction will be partiallyoffset by an increase in interest expense associated with the issuance of the$25.0 million in aggregate principal amount of Convertible Notes.  See Note 3 to our condensed consolidatedfinancial statements for further information on the Senior Notes Discharge andthe issuance of the Convertible Notes.

 

52

----

Table ofContents

 

Provision for Loan Losses

 

Thefollowing table summarizes our Principal Investing segment provision for loanlosses:

 
| ** **                      | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                                 | ** ** | **2009**                                                | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(In thousands)**                                  | ** ** |
| Loans held in DFR MM CLO        |       | $                                                        | 3,105      |                                                    | $          | 4,226 |   | $ | 7,582 |   | $ | 13,866 |   |
| Commercial real estate loans    |       | —                                                   |       | —                                                  |       | — |   | 1,586 |   |
| Total provision for loan losses |       | $                                                        | 3,105      |                                                    | $          | 4,226 |   | $ | 7,582 |   | $ | 15,452 |   |

 

Expenses

 

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

 
| ** **                                  | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                                  | ** ** | **2010**                                                 | ** ** | **2009**     | ** ** | **2010 vs. 2009**                             | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                                  | ** ** | **(In thousands)**                                  | ** ** |
| ** **                                  | ** ** | ** **                                               | ** ** | ** **   | ** ** | ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Professional services                       |       | $                                                        | 815        |         | $          | 516                                                     |       | $            | 299        |   | $ | 2,848 |   | $ | 1,798 |   | $ | 1,050 |   |
| Insurance expense                           |       | 681                                                      |       | 681          |       | —                                                  |       | 1,890        |       | 2,022 |   | (132 | ) |
| Other general and administrative expenses   |       | 552                                                      |       | 479          |       | 73                                                      |       | 2,690        |       | 5,186 |   | (2,496 | ) |
| Management fee expense to related party (1) |       | —                                                   |       | 337          |       | (337                                                    | )          | —       |       | 632 |   | (632 | ) |
| Total Principal Investing segment expenses  |       | $                                                        | 2,048      |         | $          | 2,013                                                   |       | $            | 35         |   | $ | 7,428 |   | $ | 9,638 |   | $ | (2,210 | ) |

 

----

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

 

Total Principal Investing segment expenses remained flat for the threemonths ended September 30, 2010, as compared to the same period in2009.  The increase of $0.3 million inprofessional services is primarily a result of increased legal fees for theperiod related to our previously disclosed SEC investigation. The $0.3 milliondecrease in management fee expense to related party is related to fees chargedto the noncontrolling interest investors in DPLC during the three months endedSeptember 30, 2009. Management fees charged to noncontrolling interestinvestors in DPLC were discontinued effective January 1, 2010.

 

The$2.2 million decrease in expenses for the nine months ended September 30,2010, as compared to the same periods in 2009, is primarily comprised of a $2.5million decrease in other general and administrative expenses and a $0.6million decrease in management fee expense to related party, partially offsetby a $1.1 million increase in professional services expenses. The $2.5 milliondecrease in other general and administrative expenses is primarily attributableto $3.3 million in one-time DPLC structuring and organizational expensesincurred during the nine months ended September 30, 2009, partially offsetby a $0.5 increase in expense related to the DPLC Restructuring Warrants and a$0.5 million increase in directors’ fees. See Note 3 to our condensedconsolidated financial statements for further information on the DPLCRestructuring Warrants. The $0.6 million decrease in management fee expense torelated party is related to fees charged to the noncontrolling interestinvestors in DPLC during the nine months ended September 30, 2009. Theincrease of $1.1 million in professional services is primarily a result ofincreased legal fees for the period related to our previously disclosed SECinvestigation.

 

53

----

Table of Contents

 

Other Income (Expense)and Gain (Loss)

 

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

 
| ** **                                                         | ** ** | **Three months ended September 30,** | ** ** | **Variance** | ** ** | **Nine months ended September 30,** | ** ** | **Variance** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------------------------|------------|--------------|------------|---------------------------------------------------------|------------|--------------|------------|
| ** **                                                         | ** ** | **2010**                                                 | ** ** | **2009**     | ** ** | **2010 vs. 2009**                             | ** ** | **2010**     | ** ** | **2009** | ** ** | **2010 vs. 2009** | ** ** |
| ** **                                                         | ** ** | **(In thousands)**                                  | ** ** |
| ** **                                                         | ** ** | ** **                                               | ** ** | ** **   | ** ** | ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other-than-temporary impairment on  available-for-sale securities  | ** ** | $                                                        | —     | ** **   | $          | —                                                  | ** ** | $            | —     | ** ** | $ | — | ** ** | $ | (31 | ) | $ | 31 | ** ** |
| Net loss on available-for-sale securities                          |       | —                                                   |       | —       |       | —                                                  |       | —       |       | (31 | ) | 31 |   |
| ** **                                                         | ** ** | ** **                                               | ** ** | ** **   | ** ** | ** **                                              | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net realized gain (loss) on investments at fair  value             |       | (11,288                                                  | )          | 2,378        |       | (13,666                                                 | )          | (10,828      | )          | 2,030 |   | (12,858 | ) |
| Net unrealized gain on investments at fair value                   |       | 12,327                                                   |       | 197          |       | 12,130                                                  |       | 16,537       |       | 7,016 |   | 9,521 |   |
| Net gain on investments at fair value                              |       | 1,039                                                    |       | 2,575        |       | (1,536                                                  | )          | 5,709        |       | 9,046 |   | (3,337 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Net realized gain (loss) on loans                                  |       | 59                                                       |       | 708          |       | (649                                                    | )          | 206          |       | (6,345 | ) | 6,551 |   |
| Net unrealized gain (loss) on loans                                |       | 374                                                      |       | (169         | )          | 543                                                     |       | 7,217        |       | 37,575 |   | (30,358 | ) |
| Net gain on loans                                                  |       | 433                                                      |       | 539          |       | (106                                                    | )          | 7,423        |       | 31,230 |   | (23,807 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Net realized loss on derivatives                                   |       | (227                                                     | )          | (405         | )          | 178                                                     |       | (458         | )          | (10,334 | ) | 9,876 |   |
| Net unrealized gain (loss) on derivatives                          |       | (3,538                                                   | )          | 348          |       | (3,886                                                  | )          | (6,625       | )          | 12,854 |   | (19,479 | ) |
| Net gain (loss) on derivatives                                     |       | (3,765                                                   | )          | (57          | )          | (3,708                                                  | )          | (7,083       | )          | 2,520 |   | (9,603 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Net gain (loss) on investments, loans, derivatives  and liabilties |       | (2,293                                                   | )          | 3,057        |       | (5,350                                                  | )          | 6,049        |       | 42,765 |   | (36,716 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Strategic transactions expenses                                    |       | —                                                   |       | —       |       | —                                                  |       | (3,167       | )          | — |   | (3,167 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Net gain on the deconsolidation of Market Square  CLO              |       | —                                                   |       | —       |       | —                                                  |       | —       |       | 29,551 |   | (29,551 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Other, net                                                         |       | 452                                                      |       | (516         | )          | 968                                                     |       | (505         | )          | (352 | ) | (153 | ) |
|                                                               |       |                                                     |       |         |       |                                                    |       |         |       |   |   |   |   |
| Net other income (expense) and gain (loss)                         |       | $                                                        | (1,841     | )            | $          | 2,541                                                   |       | $            | (4,382     | ) | $ | 2,377 |   | $ | 71,964 |   | $ | (69,587 | ) |

 

Net other income (expense) and gain (loss) declined by$4.4 million for the three months ended September 30, 2010, ascompared to the same period in 2009. This decline was primarily attributable toa $3.7 million increase in net losses on derivatives. Additionally, thedecrease is comprised of a $1.5 million decrease in gains on investments atfair value and a $0.1 million decrease in net gains on loans, partially offsetby a $1.0 million variance in other, net.

 

Net other income (expense) and gain (loss) declined by$69.6 million for the nine months ended September 30, 2010, ascompared to the same period in 2009. This decline was primarily attributable toa $29.6 million net gain on the deconsolidation of Market Square CLO as ofJune 30, 2009. Additionally, the decrease is comprised of a $23.8 milliondecrease in net gains on loans, a $9.6 million variance in net losses on derivatives,a $3.2 million increase in strategic transactions expenses, a $3.3 milliondecrease in gains on investments at fair value and a $0.2 million variance inother, net.

 

During the three months ended September 30, 2010, the net gains oninvestments at fair value was primarily the result of $1.1 million in net gainson other investments at fair value, partially offset by $0.1 million in netlosses on RMBS. During the nine months ended September 30, 2010, the netgains on investments at fair value was primarily the result of $2.0 million innet gains on RMBS and $2.2 million in net gains on investments and otherinterests in our CIP CDOs, which are eliminated upon consolidation. The netgains on RMBS were primarily driven by valuation increases on our RMBS portfolio.During the three and nine months ended September 30, 2009, the net gainson investments at fair value of $2.6 million and $9.0 million, respectively,were primarily driven by valuation increases on our RMBS portfolio.

 

During the nine months ended September 30, 2010, net gain on loansis primarily comprised of $5.6 million in gains on loans held in DFR MM CLO and$1.8 million in gains on other corporate leveraged loans. The decrease in netgains on loans during the nine months ended September 30, 2010, ascompared to the same period in 2009, is primarily attributable to thedeconsolidation of Market Square CLO as of June 30, 2009. Loans held inMarket Square CLO accounted for $43.1 million in gains on loans during the ninemonths ended September 30, 2009.

 

During the three and nine months ended September 30, 2010, the netloss on derivatives is primarily comprised of unrealized losses on the EmbeddedDerivative related to the Convertible Notes of $3.7 million and $7.0 million,respectively. See Note 3 to our condensed consolidated financial statements 

 

54

----

Table ofContents

 

forfurther information on the Embedded Derivative. For the nine months endedSeptember 30, 2009, the net gain on derivatives is primarily comprised ofnet gains on interest rate swaps of $2.7 million.

 

During the three months ended September 30, 2010, other, net isprimarily comprised of $0.4 million in income received related to ourbeneficial interest in Market Square CLO, which is eliminated uponconsolidation.  In addition, during thenine months ended September 30, 2010, other, net includes a $1.3 millionreserve representing our current best estimate of the probable loss associatedwith the resolution of the SEC investigation.

 

Income Tax Expense

 

For the three and nine months ended September 30, 2010, ourPrincipal Investing segment recorded federal income tax expense of $1.7million.  See our discussion of DFRresults of operations and Note 16 to our condensed consolidated financialstatements for further information concerning income taxes.

 

*ConsolidatedInvestment Products Segment*

 

Our Consolidated Investment Products Segmentwas established on January 1, 2010, and, therefore, there is no priorperiod comparable data.  The results ofoperations include the results for the seven CIP CDOs consolidatedJanuary 1, 2010 and the four CNCIM CLOs consolidated effectiveJune 9, 2010.

 

Net Revenues

 

Our Consolidated Investment Products segment revenues represent thedifference between the interest income earned on the assets held by the CIPCDOs and the cost of the borrowings of the CIP CDOs.

 

Net interest income for the three months ended September 30, 2010is primarily composed of $38.4 million of interest income on loans and $3.9million of interest income on corporate bonds, partially offset by $10.3million of interest expense on non-recourse long-term debt.  Net interest income for the nine months endedSeptember 30, 2010 is primarily composed of $83.1 million of interestincome on loans and $11.9 million of interest income on corporate bonds,partially offset by $20.9 million of interest expense on non-recourse long-termdebt.

 

OtherIncome (Expense) and Gain (Loss)

 

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

 
| ** **                                                  | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                  | ** ** | **2010**                                                 | ** ** | **2010**                                                | ** ** |
| ** **                                                  | ** ** | **(In thousands)**                                  | ** ** |
| ** **                                                  | ** ** | ** **                                               | ** ** | ** **                                              | ** ** |
| Net realized gain on investments at fair value              |       | $                                                        | 10,657     |                                                    | $          | 24,976 |   |
| Net unrealized gain on investments at fair value            |       | 61,570                                                   |       | 72,220                                                  |       |
| Net gain on investments investments at fair value           |       | 72,227                                                   |       | 97,196                                                  |       |
|                                                        |       |                                                     |       |                                                    |       |
| Net realized loss on liabilities                            |       | (931                                                     | )          | (5,633                                                  | )          |
| Net unrealized loss on liabilities                          |       | (102,114                                                 | )          | (171,041                                                | )          |
| Net loss on liabilities                                     |       | (103,045                                                 | )          | (176,674                                                | )          |
|                                                        |       |                                                     |       |                                                    |       |
| Net realized loss on derivatives                            |       | —                                                   |       | (4,710                                                  | )          |
| Net unrealized gain (loss) on derivatives                   |       | (230                                                     | )          | 3,919                                                   |       |
| Net loss on derivatives                                     |       | (230                                                     | )          | (791                                                    | )          |
|                                                        |       |                                                     |       |                                                    |       |
| Net loss on investments, loans, derivatives and  liabilties |       | (31,048                                                  | )          | (80,269                                                 | )          |
|                                                        |       |                                                     |       |                                                    |       |
| Other net gain                                              |       | 161                                                      |       | 1,251                                                   |       |
|                                                        |       |                                                     |       |                                                    |       |
| Net other income (expense) and gain (loss)                  |       | $                                                        | (30,887    | )                                                       | $          | (79,018 | ) |

 

55

----

Table ofContents

 

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

 

**Liquidity and Capital Resources**

 

***Cash Flows***

 

Our operating activities provided cash of $98.5 million for the ninemonths ended September 30, 2010, Net cash inflows and non-cash adjustmentsof $257.2 million included a net loss on liabilities at fair value of $173.7million, net change in operating assets and liabilities of $56.4 million anddepreciation and amortization of $10.7 million. Net cash outflows and non-cashadjustments of $158.7 million included net gain on investments at fair value of$100.5 million, net purchases of investments at fair value of $25.0 million anda net gain on the discharge of the Senior Notes of $17.4 million.

 

Our investing activities provided cash of $141.7 million for the ninemonths ended September 30, 2010, primarily from principal receipts andproceeds from the sale of investments at fair value previously classified asavailable-for-sale of $169.2 million and principal receipts and proceeds fromloans held for investment of $125.6 million, partially offset by theorigination and purchase of loans held for investment of $121.4 millionand changes in restricted cash and cash equivalents of $39.6 million.

 

Our financing activities used cash of $250.9 million for the ninemonths ended September 30, 2010, primarily for payments on long-term debtof $179.8 million, net payments on repurchase agreements of $50.1 millionand distributions to noncontrolling interest and investors in ConsolidatedInvestment Products of $44.8 million, partially offset by proceeds from theissuance of long-term debt of $25.0 million.

 

***Liquidity***

 

As of September 30, 2010, unrestricted cash and cash equivalentsand unencumbered RMBS totaled $38.1 million. We believe that our currentcash and cash equivalents, unencumbered RMBS and net equity in our financedRMBS portfolio, along with cash flows from operations, among other things, areadequate to meet our anticipated long-term liquidity requirements. Net equityin our financed RMBS portfolio, excluding the unencumbered RMBS, totaled$22.1 million at September 30, 2010. In total, we had unrestrictedcash and cash equivalents, unencumbered RMBS and net equity in the financedRMBS portfolio of $60.2 million as of September 30, 2010. As ofSeptember 30, 2010, the fair value of our Agency RMBS was$254.5 million. We attempt to maintain our leverage related to our RMBSportfolio at a level that we believe ensures that our cash and cash equivalentswill be sufficient to satisfy our liquidity requirements.

 

***Other Sourcesand Uses of Funds***

 

We may increase our capital resources by issuing securities, includingpreferred stock, common stock and various forms of debt. The ability to executethese strategies will depend on, among other things, market conditions forcapital raises and the investment of any proceeds.

 

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

 

*DFR MM CLO*

 

The economic impact of our investment in DFR MM CLO is determined bythe cash flows distributed to us on our investment in $50.0 million ofpreference shares and $19.0 million of debt issued by DFR MM CLO, subjectto diversion of cash flows away from our investments in accordance with itsindenture. From the date of our initial investment through September 30,2010, such distributions have 

 

56

----

Table ofContents

 

totaled$31.5 million on our preference shares investment and $3.7 million in intereston our debt investment. For the three and nine months ended September 30,2010, the net income of $1.3 million and $11.9 million, respectively, recordedin our condensed consolidated statements of operations for DFR MM CLO was notindicative of the cash distributions of $0.2 million and $8.1 million for thethree and nine months ended September 30, 2010, respectively. These cashdistributions included $7.5 million related to our investment in the preferenceshares for the nine months ended September 30, 2010, and $0.2 million and$0.6 million in interest on our investment in debt for the three and nine monthsended September 30, 2010, respectively. We did not receive a cashdistribution related to our investment in the preference shares in the thirdquarter.  However, we received a cashdistribution of $7.5 million from DFR MM CLO in the fourth quarter, including a$7.3 million cash distribution on our investment in the preference shares and$0.2 million in interest on our investment in debt. While we expect to receivefuture cash distributions on our investment in the preference shares, it isvery difficult to predict the timing and amount of such future cashdistributions.

 

*Letter of Credit*

 

Pursuant to the amendment to our lease, the amount of the cashcollateralized letter of credit constituting our security deposit under thelease was reduced from approximately $1.3 million to approximately $0.5 millionduring the nine months ended September 30, 2010.

 

*Deferred Purchase Payments*

 

Deferred purchase payments related to the CNCIM Acquisition thataggregate $7.5 million are payable by us in five equal annual payments of $1.5million beginning on December 9, 2010.

 

*Debt*

 

As of September 30, 2010, we had repurchase agreements outstandingwith four counterparties in the amount of $241.3 million with aweighted-average borrowing rate of 0.32% and remaining weighted averagematurity of 19 days.  AtSeptember 30, 2010, 68.4% of our repurchase agreement liabilities wereconcentrated with one counterparty.

 

The following table summarizes our long-term debt as ofSeptember 30, 2010:

 
| ** **                           | ** ** | ** **              | ** ** | **Current**               | ** ** | ** **                  | ** ** |
|--------------------------------------|------------|-------------------------|------------|---------------------------|------------|-----------------------------|------------|
| ** **                           | ** ** | **Carrying**            | ** ** | **Weighted Average** | ** ** | **Weighted Average**   | ** ** |
| ** **                           | ** ** | **Value**               | ** ** | **Borrowing Rate**   | ** ** | **Remaining Maturity** | ** ** |
| ** **                           | ** ** | **(In thousands)** | ** ** | ** **                | ** ** | **(In years)**         | ** ** |
| **Recourse:**                        | ** ** | ** **              | ** ** | ** **                |       |                        |       |
| Trust Preferred Securities           |       | $                       | 25,775     |                      | 3.98       | %                           | 25.1       |   |
| March Junior Subordinated Notes |       | 95,000                  |       | 1.00                      | %          | 25.1                        |       |
| Convertible Notes (1)                |       | 16,660                  |       | 8.00                      | %          | 7.2                         |       |
| Total Recourse                       |       | 137,435                 |       | 2.41                      | %          | 22.9                        |       |
| **Non-Recourse:**                    |       |                    |       |                      |       |                        |       |
| DFR MM CLO (2)                       |       | 217,296                 |       | 1.24                      | %          | 8.8                         |       |
| Consolidated Investment Products (3) |       | 3,574,098               |       | 1.03                      | %          | 8.7                         |       |
| Total Non-Recourse                   |       | 3,791,394               |       | 1.04                      | %          | 8.7                         |       |
| Total long-term debt                 |       | $                       | 3,928,829  |                      | 1.09       | %                           | 9.2        |   |

 

57

----

Table ofContents

 

----

(1)   The Convertible Notesprincipal outstanding of $25.0 million is presented net of an $8.3 milliondiscount. The Convertible Notes currently pay interest at the 8.00% statedrate; however, including the discount, the effective rate of interest is18.14%.

 

(2)   Excludes $19.0 millionof DFR MM CLO debt that is owned by us and eliminated upon consolidation. Hadthis debt been included, the weighted-average borrowing rate would have been1.50% as of September 30, 2010.

 

(3)   Long-term debt of the CIPCDOs is recorded at fair value.  Thisincludes the fair value of the preference shares issued by the CIP CDOs in thecarrying value. However, the preference shares do not have a stated interestrate and are therefore excluded from the calculation of the weighted averageborrowing rate. The par value of the CIP CDOs long-term debt (includingpreference shares) was $4.2 billion.

 

OnMarch 4, 2010, we entered into an exchangeagreement with the holders of our trust preferred securities to exchange$95.0 million of the $120.0 million aggregate outstanding principalamount of trust preferred securities previously issued by our threewholly-owned indirect subsidiaries, Deerfield Capital Trust I, DeerfieldCapital Trust II and Deerfield Capital Trust III, for$95.0 million aggregate principal amount of junior subordinated notesissued by us. The exchange was completed on March 4, 2010.   On October 20, 2010, weredeemed-in-kind $25.0 million of aggregate outstanding principal amount oftrust preferred securities issued in 2005 by Deerfield Capital Trust I for$25.0 million in aggregate principal of junior subordinated notes.  Following this redemption-in-kind, we nolonger have any trust preferred securities outstanding.  See Note 20 to the condensed consolidatedfinancial statements for a detailed description of the in-kind redemption. Thecovenants contained in the indentures governing the junior subordinated notesare substantially less restrictive than the covenants contained in theindentures governing the trust preferred securities.

 

See Notes 11 and 13 to our condensed consolidated financial statementsfor a discussion of our repurchase agreements and long-term debt (includingcovenants relating thereto), respectively.

 

**Critical Accounting Policies**

 

We believe that the critical accounting policies upon which ourfinancial condition and results of operations depend, and which involve themost complex subjective decisions or assessments, are included in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2009, asfiled with the SEC on March 23, 2010 (our “2009 10-K”). There have been nomaterial changes to the critical accounting policies disclosed in our 2009 10-Kexcept as indicated below. Our most critical accounting policies involvejudgments and estimates that could affect our reported assets and liabilities,as well as our reported revenues and expenses. We believe that all of thejudgments and estimates inherent in our financial statements were reasonable,based upon information available to us. We rely on management’s experience andanalysis of historical and current market data in order to arrive at what webelieve to be reasonable estimates. Under varying conditions, we could reportmaterially different amounts arising under these critical accounting policies.

 

***Variable Interest Entities*******

 

ASC Topic 810 generally requires the consolidation of the assets,liabilities and results of operations of a variable interest entity (“VIE”)into the financial statements of the enterprise that has a controllingfinancial interest in the VIE. ASC Topic 810 provides a framework fordetermining whether an entity should be considered a VIE and evaluated forconsolidation. Pursuant to this framework, we consider all parties to determinewhether the entity is a VIE and, if so, whether our involvement with the entityresults in a variable interest in the entity. If we determine that we do have avariable interest in the entity, we perform an analysis to determine whether weare the primary beneficiary. If we determine that we are the primarybeneficiary, we consolidate the VIE into our consolidated financial statements.A company is the primary beneficiary of a VIE if it has a controlling financialinterest in the VIE.  A company is deemedto have a controlling financial interest in a VIE if it has both (i) thepower to direct the activities of the VIE that most significantly impact theVIE’s economic performance and (ii) the 

 

58

----

Table ofContents

 

obligationto absorb the losses of the VIE that could potentially be significant to theVIE or the right to receive benefits from the VIE that could potentially besignificant to the VIE.

 

Other than DFR MM CLO, in which we own all the preference shares, wehave a variable interest in each of the CDOs we manage due to the provisions ofthe management agreements relating to those CDOs. As of September 30,2010, we had direct investments in certain of those CDOs, which represent asmall portion of the total debt and equity issued by the CDOs. Where we have adirect investment, it is typically only in the unrated, junior subordinatedtranches of the CDOs. These unrated, junior subordinated tranches, referred toherein as “preference shares,” take the form of either subordinated notes orpreference shares.

 

For CDOs, if we are deemed to have the power to direct the activitiesof the CDO that most significantly impact the CDO’s economic performance, andthe obligation to absorb losses or the right to receive benefits from the CDOthat could potentially be significant to the CDO, then we are deemed to be theCDO’s primary beneficiary and are required to consolidate the CDO.  Beginning January 1, 2010, weconsolidated the CIP CDOs into our Consolidated Investment Productssegment.  See Note 4 to our condensedconsolidated financial statements for additional discussion of our ConsolidatedInvestment Products segment.

 

As of September 30, 2010, we have a variable interest in 19additional CDOs that are not consolidated as part of our ConsolidatedInvestment Products segment as we have determined we are not the primarybeneficiary of these VIEs. Our maximum exposure to loss associated withnonconsolidated CDOs is limited to any future management fees. As ofSeptember 30, 2010, we have recorded management fee receivables totaling$0.8 million from the unconsolidated CDOs.

 

***Goodwill and Other Intangible Assets***

 

Goodwill represents the excess cost of a business acquisition over thefair value of the net assets acquired. Intangible assets are comprised offinite-lived and indefinite-lived assets. In accordance with ASC Topic 350—*Intangibles—Goodwill and Other* (“ASC Topic350”), indefinite-lived assets and goodwill are not amortized. Finite-livedintangibles are amortized over their expected useful lives. These assets aretested for impairment annually or more frequently if events or changes incircumstances indicate that the asset might be impaired. An impairmentcharge is recorded if the carrying amount of an intangible asset is notrecoverable and its carrying amount exceeds its fair value.

 

Goodwill has been recognized and allocated to our Principal Investingand Investment Management segments as a result of the CNCIMAcquisition. ASC Topic 350 requires, on a reporting unit level, acomparison of the book value of net assets to their estimated fair value. Ifthe fair value is determined to be less than book value, a second step isperformed to compute the amount of the impairment. In this process, an impliedfair value of goodwill is estimated in the same manner as the amount ofgoodwill recognized in a business combination. If the carrying amount of thereporting unit exceeds the implied fair value of that goodwill, an impairmentloss will be recognized in an amount equal to the excess. The loss recognizedcannot exceed the carrying amount of the goodwill.

 

Intangible assets associated with investment management contractsidentified in the acquisition of a business are capitalized separately fromgoodwill if the fair value can be measured reliably on initial recognition. Ifthey are finite-lived, they are amortized over their useful lives, either on astraight line basis (intangible assets associated with the acquisition ofDeerfield) or based on a ratio of expected discounted cash flows from thecontracts (intangible assets associated with the CNCIM Acquisition). Weconsider our own assumptions about renewal or extension of the term of thearrangement, consistent with the expected use of the asset. A change in theuseful life of the asset could have a significant impact on our amortizationexpense.

 

The evaluation of goodwill and intangible assets for impairmentrequires management to make estimates and exercise significant judgment. As ofSeptember 30, 2010, there were no events or changes in circumstances thatwould indicate that the current carrying amount of goodwill or other intangibleassets might be impaired; accordingly, we did not perform interim testingprocedures.

 

59

----

Table ofContents

 

***RecentAccounting Updates***

 

See Note 2 to our condensed consolidated financial statements for acomplete discussion of recent accounting updates.

 

**Off-BalanceSheet Arrangements**

 

Through our wholly-owned subsidiary, DC LLC, we owned all of thecommon shares of Deerfield Capital Trust I (“Trust I”). Trust I, a VIE, wasformed in September 2005 and issued, in the aggregate, $25.0 millionof preferred shares to unaffiliated investors. In connection with this issuance,DC LLC issued junior subordinated debt securities, which we refer to asthe trust preferred securities, to Trust I in the aggregate of$25.8 million which were guaranteed by us. The rights of the holders ofcommon shares of Trust I were subordinate to the rights of the holders ofpreferred shares only in the event of a default. Otherwise, the commonstockholders’ economic and voting rights rank pari passu with the preferredstockholders. We recorded the investment in the Trust I common shares as other investmentsat cost and record dividend income upon declaration by the Trust. The juniorsubordinated debt securities were recorded as long-term debt, and debt issuancecosts were deferred in prepaid and other assets in the consolidated balancesheet. Interest on the debt securities and amortization of debt issuance costswere recorded in the consolidated statements of operations as interest expense.

 

OnOctober 20, 2010, we redeemed-in-kind the $25.0 million of aggregateoutstanding principal amount of trust preferred securities issued in 2005 byTrust I for $25.0 million in aggregate principal amount of junior subordinatednotes. In connection with the in-kind redemption, $0.8 million of equitysecurities in Deerfield Capital Trust I which are included in long-term debtwere cancelled. Following the in-kind redemption, we no longer have any trustpreferred securities outstanding.  SeeNote 20 to our condensed consolidated financial statements for a completediscussion of the in-kind redemption.

 

As of September 30, 2010, we did not maintain any otherrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance, special purpose or VIEs,established for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. Further, as ofSeptember 30, 2010, we did not guarantee any obligations of unconsolidatedentities or entered into any commitment or intent to provide additional fundingto any such entities, other than Trust I.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

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

 

**Change inInternal Control Over Financial Reporting**

 

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

 

**InherentLimitations on Effectiveness of Controls**

 

There are inherent limitations in the effectiveness of any controlsystem, including the potential for human error and the circumvention oroverriding of the controls and procedures. Additionally, 

 

60

----

Table ofContents

 

judgmentsin decision-making can be faulty and breakdowns can occur because of simpleerror or mistake. An effective control system can provide only reasonable, notabsolute, assurance that the control objectives of the system are adequatelymet. Accordingly, our management, including our Chief Executive Officer and ourInterim Chief Financial Officer do not expect that our control system canprevent or detect all errors or fraud. Finally, projections of any evaluationor assessment of effectiveness of a control system to future periods aresubject to the risks that, over time, controls may become inadequate because ofchanges in an entity’s operating environment or deterioration in the degree ofcompliance with policies or procedures.

 

**PART II.OTHER INFORMATION**

 

**ITEM1A.  RISK FACTORS**

 

There have been nomaterial changes in our risk factors from those disclosed in “Part I —Item 1A. Risk Factors” of our 2009 10-K and “Part II —Item 1A. RiskFactors” of our Quarterly Report for the quarter ended June 30, 2010.

 

**ITEM6.  EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

 
| **Exhibit.   No.** | ** ** | **Description of Exhibit**                                                                                                                                                                        |
|-------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                        |
| 4.1                     |       | Junior  Subordinated Indenture dated October 20, 2010 between the Company and  The Bank of New York Mellon Trust Company, National Association, as trustee.  (1)                                       |
|                    |       |                                                                                                                                                                                                        |
| **10.1                  |       | Asset  Purchase Agreement by and between Deerfield Capital Management LLC and Luke  D. Knecht, dated September 30, 2010.*                                                                              |
|                    |       |                                                                                                                                                                                                        |
| 31.1                    |       | Certification  of Principal Executive Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.* |
|                    |       |                                                                                                                                                                                                        |
| 31.2                    |       | Certification  of Principal Financial Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.* |
|                    |       |                                                                                                                                                                                                        |
| 32.1                    |       | Certification  of Principal Executive Officer and Principal Financial Officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.*        |

 

----

*              Filed herewith

 

**           Compensatory plan orarrangement

 

(1)           Incorporated by reference to our Current Report on Form 8-Kfiled with the SEC on October 21, 2010.

 

61

----

Tableof Contents

 

**SIGNATURES**

 

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

 
|                          | DEERFIELD  CAPITAL CORP.                                   |
|-------------------------------|------------------------------------------------------------|
|                          | (Registrant)                                               |
|                          |                                                       |
|                          |                                                       |
| Date:  November 15, 2010 | By:                                                        | /s/  Jonathan W. Trutter |
|                          | Jonathan  W. Trutter, Chief Executive Officer and Director |
|                          | (Principal  Executive Officer)                             |
|                          |                                                       |
| Date:  November 15, 2010 | By:                                                        | /s/  Kenneth R. Posner |
|                          | Kenneth  R. Posner, Interim Chief Financial Officer   |
|                          | (Principal  Financial and Accounting Officer)              |

 

62

----