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**UNITEDSTATES**

**SECURITIESAND 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 June 30, 2009**

 

**OR**

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

 

**For the transition periodfrom             to**

 

**Commission file number: 1-32551**

 

**DEERFIELDCAPITAL CORP.**

(Exact name of registrant as specified in its charter)

 

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

 

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

**(773) 380-1600**

(Address, including zip code, and telephone number,

including area code, of registrant’s principalexecutive offices)

 

**n/a**

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

 

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

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).     Yes o No o

 

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

 

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

 

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

 

There were 6,454,924 shares of the registrant’s CommonStock outstanding as of August 7, 2009.

 

 

 

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**DEERFIELD CAPITAL CORP.**

**QUARTERLY REPORT ON FORM 10-Q**

**FOR THE QUARTER ENDED JUNE 30, 2009**

 

**INDEX**

 
| ** **                                                                                                           | **Page**   |
|----------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** |
| Part I.  Financial Information                                                                                  |       |
|                                                                                                                 |       |
| Item 1.  Condensed Consolidated Financial Statements and Notes (Unaudited)                                      | 6          |
|                                                                                                                 |       |
| Condensed  Consolidated Balance Sheets — June 30, 2009 and December 31, 2008                          | 6          |
|                                                                                                                 |       |
| Condensed  Consolidated Statements of Operations — Three and Six Months Ended  June 30, 2009 and 2008      | 7          |
|                                                                                                                 |       |
| Condensed  Consolidated Statement of Stockholders’ Equity (Deficit) — Six Months Ended  June 30, 2009 | 8          |
|                                                                                                                 |       |
| Condensed Consolidated Statements of Cash Flows — Six  Months Ended June 30, 2009 and 2008                 | 9          |
|                                                                                                                 |       |
| Notes to Condensed Consolidated Financial Statements                                                                 | 10         |
|                                                                                                                 |       |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations            | 31         |
|                                                                                                                 |       |
| Item 3. Quantitative and Qualitative Disclosures  About Market Risk                                             | 64         |
|                                                                                                                 |       |
| Item 4. Controls and Procedures                                                                                 | 67         |
|                                                                                                                 |       |
| Part II.  Other Information                                                                                     |       |
|                                                                                                                 |       |
| Item 1A.  Risk Factors                                                                                          | 67         |
|                                                                                                                 |       |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                         | 68         |
|                                                                                                                 |       |
| Item  5. Other Information                                                                                           | 69         |
|                                                                                                                 |       |
| Item 6. Exhibits                                                                                                | 69         |
|                                                                                                                 |       |
| Signatures                                                                                                           | 71         |

 

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**SPECIAL NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

 

Certain statements in this quarterly report on Form 10-Q,or Quarterly Report, and the information incorporated by reference into thisQuarterly Report are forward-looking as permitted by the Private SecuritiesLitigation Reform Act of 1995. These include statements regarding futureresults or expectations. Forward-looking statements can be identified byforward-looking language, including words such as “believes,” “anticipates,” “expects,”“estimates,” “intends,” “may,” “plans,” “projects,” “will” and similarexpressions, or the negative of these words. Such forward-looking statementsare based on facts and conditions as they exist at the time such statements aremade. Forward-looking statements are also based on predictions as to futurefacts and conditions, the accurate prediction of which may be difficult andinvolve the assessment of events beyond our control. Forward-looking statementsare further based on various operating assumptions. Caution must be exercisedin relying on forward-looking statements. Due to known and unknown risks,actual results may differ materially from expectations or projections. We donot undertake any obligation to update any forward-looking statement, whetherwritten or oral, relating to matters discussed in this Quarterly Report, exceptas may be required by applicable securities laws. All future written and oralforward-looking statements attributable to us or any person acting on ourbehalf are expressly qualified in their entirety by the cautionary statementscontained or referenced above. In addition, it is our policy generally not tomake any specific projections as to future earnings, and we do not endorse anyprojections regarding future performance that may be made by third parties.

 

The following factors, among others, could causeactual results to differ materially from those described in the forward-lookingstatements:

 

**Relating to our business generally:**

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

 

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

 

**Relating to our investment management segment:**

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

 

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**Relating to our principal investing segment:**

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

 

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

 

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**DEERFIELD CAPITAL CORP. AND ITSSUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS (UNAUDITED)**

** **
| ** **                                                                                                            | ** ** | **June 30,**               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                                                                                                            | ** ** | **2009**                        | ** ** | **2008**              | ** ** |
| ** **                                                                                                            | ** ** | **(In thousands, except share** | ** ** |
| ** **                                                                                                            | ** ** | **and per share amounts)**      | ** ** |
| **ASSETS**                                                                                                            | ** ** | ** **                      | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                                                                            |       | $                               | 41,846     |                  | $          | 32,791 |   |
| Due from broker                                                                                                       |       | 3,621                           |       | 15,065                |       |
| Restricted cash and  cash equivalents                                                                                 |       | 27,201                          |       | 76,892                |       |
| Available-for-sale  securities—at fair value                                                                     |       | —                          |       | 2,338                 |       |
| Investments at fair  value, including $309,278 and $340,866 pledged                                                   |       | 318,310                         |       | 347,977               |       |
| Other investments                                                                                                     |       | 4,780                           |       | 4,764                 |       |
| Derivative assets                                                                                                     |       | 61                              |       | 132                   |       |
| Loans held for sale                                                                                                   |       | 9,363                           |       | 218,137               |       |
| Loans held for  investment                                                                                            |       | 309,021                         |       | 255,351               |       |
| Allowance for loan  losses                                                                                            |       | (28,589                         | )          | (19,979               | )          |
| Loans held for  investment, net of allowance for loan losses                                                          |       | 280,432                         |       | 235,372               |       |
| Investment advisory fee  receivables                                                                                  |       | 2,009                           |       | 4,012                 |       |
| Interest receivable                                                                                                   |       | 3,287                           |       | 5,843                 |       |
| Other receivable                                                                                                      |       | 1,264                           |       | 4,249                 |       |
| Prepaid and other  assets                                                                                             |       | 8,410                           |       | 11,831                |       |
| Fixed assets, net                                                                                                     |       | 8,498                           |       | 9,143                 |       |
| Intangible assets, net                                                                                                |       | 25,558                          |       | 28,310                |       |
| TOTAL ASSETS                                                                                                          |       | $                               | 734,640    |                  | $          | 996,856 |   |
|                                                                                                                  |       |                            |       |                  |       |
| **LIABILITIES**                                                                                                       |       |                            |       |                  |       |
| Repurchase agreements,  including $83 and $407 of accrued interest                                                    |       | $                               | 294,470    |                  | $          | 326,112 |   |
| Due to broker                                                                                                         |       | 1,800                           |       | 1,514                 |       |
| Derivative liabilities                                                                                                |       | 953                             |       | 13,529                |       |
| Interest payable                                                                                                      |       | 1,661                           |       | 6,606                 |       |
| Accrued and other  liabilities                                                                                        |       | 4,210                           |       | 15,112                |       |
| Long term debt                                                                                                        |       | 427,530                         |       | 716,417               |       |
| TOTAL LIABILITIES                                                                                                     |       | 730,624                         |       | 1,079,290             |       |
|                                                                                                                  |       |                            |       |                  |       |
| **STOCKHOLDERS’  EQUITY (DEFICIT)**                                                                              |       |                            |       |                  |       |
| Preferred stock, par  value $0.001:                                                                                   |       |                            |       |                  |       |
| 100,000,000 shares  authorized; 14,999,992 shares issued and zero outstanding                                         |       | —                          |       | —                |       |
| Common stock, par value  $0.001:                                                                                      |       |                            |       |                  |       |
| 500,000,000 shares  authorized; 6,455,466 and 6,455,466 shares issued and 6,454,924 and 6,449,102  shares outstanding |       | 6                               |       | 6                     |       |
| Additional paid-in  capital                                                                                           |       | 866,534                         |       | 865,869               |       |
| Accumulated other  comprehensive loss                                                                                 |       | (49                             | )          | (4,256                | )          |
| Accumulated deficit                                                                                                   |       | (879,648                        | )          | (944,053              | )          |
| DEERFIELD CAPITAL CORP.  STOCKHOLDERS’ DEFICIT                                                                   |       | (13,157                         | )          | (82,434               | )          |
| Noncontrolling interest  in consolidated entity                                                                       |       | 17,173                          |       | —                |       |
| TOTAL STOCKHOLDERS’  EQUITY (DEFICIT)                                                                            |       | 4,016                           |       | (82,434               | )          |
|                                                                                                                  |       |                            |       |                  |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                            |       | $                               | 734,640    |                  | $          | 996,856 |   |

 

See notes to condensed consolidated financialstatements.

 

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**DEERFIELD CAPITAL CORP. AND ITSSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                                                             | ** ** | **Three months ended June 30,**                                       | ** **   | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|--------------|---------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2009**                                                                                  | ** **   | **2008**                                          | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                             | ** ** | **(In thousands, except share and per share amounts)** | ** **   |
| **Revenues**                                                                           |       |                                                                                      |         |                                              |       |   |   |   |   |
| Interest income                                                                        |       | $                                                                                         |  14,098 |                                              | $          |  21,824 |   | $ |  27,880 |   | $ |  83,174 |   |
| Interest expense                                                                       |       | 5,666                                                                                     |         | 12,421                                            |       | 12,665 |   | 60,021 |   |
| Net interest income                                                                    |       | 8,432                                                                                     |         | 9,403                                             |       | 15,215 |   | 23,153 |   |
| Provision for loan  losses                                                             |       | 9,119                                                                                     |         | 2,302                                             |       | 11,226 |   | 4,502 |   |
| Net interest (expense)  income after provision for loan losses                         |       | (687                                                                                      | )            | 7,101                                             |       | 3,989 |   | 18,651 |   |
| Investment advisory  fees                                                              |       | 4,009                                                                                     |         | 12,359                                            |       | 8,746 |   | 24,478 |   |
| Total net revenues                                                                     |       | 3,322                                                                                     |         | 19,460                                            |       | 12,735 |   | 43,129 |   |
|                                                                                   |       |                                                                                      |         |                                              |       |   |   |   |   |
| **Expenses**                                                                           |       |                                                                                      |         |                                              |       |   |   |   |   |
| Compensation and  benefits                                                             |       | 3,029                                                                                     |         | 7,635                                             |       | 6,383 |   | 16,736 |   |
| Professional services                                                                  |       | 728                                                                                       |         | 2,343                                             |       | 1,518 |   | 3,730 |   |
| Insurance expense                                                                      |       | 771                                                                                       |         | 733                                               |       | 1,535 |   | 1,467 |   |
| Other general and  administrative expenses                                             |       | 4,814                                                                                     |         | 1,850                                             |       | 5,760 |   | 3,280 |   |
| Depreciation and  amortization                                                         |       | 1,629                                                                                     |         | 2,580                                             |       | 3,264 |   | 5,267 |   |
| Occupancy                                                                              |       | 569                                                                                       |         | 609                                               |       | 1,208 |   | 1,230 |   |
| Management and  incentive fee expense to related party                                 |       | 295                                                                                       |         | —                                            |       | 295 |   | — |   |
| Cost savings  initiatives                                                              |       | 28                                                                                        |         | 70                                                |       | 225 |   | 327 |   |
| Impairment of  intangible assets and goodwill                                          |       | 126                                                                                       |         | 1,128                                             |       | 126 |   | 29,034 |   |
| Total expenses                                                                         |       | 11,989                                                                                    |         | 16,948                                            |       | 20,314 |   | 61,071 |   |
|                                                                                   |       |                                                                                      |         |                                              |       |   |   |   |   |
| **Other  Income and Gain (Loss)**                                                      |       |                                                                                      |         |                                              |       |   |   |   |   |
| Net loss on  available-for-sale securities                                             |       | —                                                                                    |         | (3,856                                            | )          | (31 | ) | (3,856 | ) |
| Net gain (loss) on  investments at fair value                                          |       | 1,173                                                                                     |         | (1,747                                            | )          | 6,311 |   | (202,466 | ) |
| Net gain (loss) on  loans                                                              |       | 24,876                                                                                    |         | 5,505                                             |       | 30,691 |   | (21,037 | ) |
| Net gain (loss) on  derivatives                                                        |       | 2,981                                                                                     |         | 6,070                                             |       | 2,577 |   | (217,145 | ) |
| Dividend income and  other net (loss) gain                                             |       | 152                                                                                       |         | 76                                                |       | 103 |   | 194 |   |
| Net gain on the  deconsolidation of Market Square CLO                                  |       | 29,551                                                                                    |         | —                                            |       | 29,551 |   | — |   |
| Net other income and  gain (loss)                                                      |       | 58,733                                                                                    |         | 6,048                                             |       | 69,202 |   | (444,310 | ) |
| Income (loss) before  income tax expense (benefit)                                     |       | 50,066                                                                                    |         | 8,560                                             |       | 61,623 |   | (462,252 | ) |
| Income tax expense  (benefit)                                                          |       | 160                                                                                       |         | 2,868                                             |       | 178 |   | (4,334 | ) |
|                                                                                   |       |                                                                                      |         |                                              |       |   |   |   |   |
| **Net  income (loss)**                                                                 |       | 49,906                                                                                    |         | 5,692                                             |       | 61,445 |   | (457,918 | ) |
| Less:  Cumulative convertible preferred stock dividends  and accretion            |       | —                                                                                    |         | —                                            |       | — |   | 2,393 |   |
| **Net  income (loss) attributable to common stockholders**                             |       | 49,906                                                                                    |         | 5,692                                             |       | 61,445 |   | (460,311 | ) |
| Net loss attributable  to noncontrolling interest                                      |       | 2,960                                                                                     |         | —                                            |       | 2,960 |   | — |   |
| **Net  income (loss) attributable to Deerfield Capital Corp.**                         |       | $                                                                                         |  52,866 |                                              | $          |  5,692 |   | $ |  64,405 |   | $ |  (460,311 | ) |
|                                                                                   |       |                                                                                      |         |                                              |       |   |   |   |   |
| **Net  income (loss) attributable to Deerfield Capital Corp.****per  share - basic**   |       | $                                                                                         |  7.85   |                                              | $          |  0.83 |   | $ |  9.59 |   | $ |  (74.08 | ) |
| **Net  income (loss) attributable to Deerfield Capital Corp.****per  share - diluted** |       | $                                                                                         |  7.85   |                                              | $          |  0.83 |   | $ |  9.59 |   | $ |  (74.08 | ) |
|                                                                                   |       |                                                                                      |         |                                              |       |   |   |   |   |
| WEIGHTED-AVERAGE NUMBER  OF SHARES OUTSTANDING - BASIC                                 |       | 6,730,655                                                                                 |         | 6,881,715                                         |       | 6,716,570 |   | 6,213,318 |   |
| WEIGHTED-AVERAGE NUMBER  OF SHARES OUTSTANDING - DILUTED                               |       | 6,730,655                                                                                 |         | 6,881,715                                         |       | 6,716,570 |   | 6,213,318 |   |

 

See notes to condensed consolidated financialstatements.

 

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**DEERFIELD CAPITAL CORP. AND ITSSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT) (UNAUDITED)**

** **
| ** **                                                    | ** ** | **Deerfield  Capital Corp Stockholders** | ** ** | ** **     | ** ** | ** **  | ** ** | ** **        | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------|------------|----------------|------------|-------------|------------|-------------------|------------|
| ** **                                                    | ** ** | ** **                               | ** ** | ** **     | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** ** | ** ** | **Noncontrolling** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **Common  Stock**                        | ** ** | **Additional** | ** ** | **Other**   | ** ** | ** **        | ** ** | **interest  in** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                               | ** ** | **Par**        | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **consolidated** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                    | ** ** | **Shares**                               | ** ** | **Value**      | ** ** | **Capital** | ** ** | **Loss**          | ** ** | **Deficit** | ** ** | **entity** | ** ** | **Total** | ** ** | **Income** | ** ** |
| ** **                                                    | ** ** | **(In  thousands)**                      | ** ** |
| **Balance  - January 1, 2009**                           |       | 6,449                                    |       | $              |  6    |        | $          |  865,869     |       | $ |  (4,256 | ) | $ |  (944,053 | ) | $ |  — |   | $ |  (82,434 | ) |   |   |
| **Net  income**                                               |       |                                     |       |           |       |        |       |              |       | 64,405 |   | (2,960 | ) | 61,445 |   | $ |  61,445 |   |
| Contributions of  noncontrolling interest                     |       |                                     |       |           |       |        |       |              |       |   |   | 20,133 |   | 20,133 |   |   |   |
| Available-for-sale  securities - fair value adjustment        |       |                                     |       |           |       |        |       | 1,452             |       |   |   |   |   | 1,452 |   | 1,452 |   |
| Previously designated  derivatives - amortization of net loss |       |                                     |       |           |       |        |       | 95                |       |   |   |   |   |  95 |   | 95 |   |
| Deconsolidation of  Market Square CLO                         |       |                                     |       |           |       |        |       | 2,603             |       |   |   |   |   | 2,603 |   | 2,603 |   |
| Foreign currency  translation gain                            |       |                                     |       |           |       |        |       | 57                |       |   |   |   |   | 57 |   | 57 |   |
| Comprehensive income                                          |       |                                     |       |           |       |        |       |              |       |   |   |   |   |   |   | $ |  65,652 |   |
| Equity issuance cost -  Market Square CLO deconsolidation     |       |                                     |       |           |       | 368         |       |              |       |   |   |   |   | 368 |   |   |   |
| Share-based compensation                                      |       | 6                                        |       |           |       | 297         |       |              |       |   |   |   |   | 297 |   |   |   |
| **Balance  - June 30, 2009**                             |       | 6,455                                    |       | $              |  6    |        | $          |  866,534     |       | $ |  (49 | ) | $ |  (879,648 | ) | $ |  17,173 |   | $ |  4,016 |   |   |   |

 

See notes to condensed consolidated financialstatements.

 

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**DEERFIELD CAPITAL CORP. AND ITSSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

 
| ** **                                                                                                                         | ** ** | **Six months ended June 30,** | ** **   |
|------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|--------------|
| ** **                                                                                                                         | ** ** | **2009**                           | ** **   | **2008** | ** ** |
| ** **                                                                                                                         | ** ** | **(In thousands)**                 | ** **   |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                                                         |       |                               |         |   |   |
| Net income (loss)  attributable to Deerfield Capital Corp.                                                                         |       | $                                  |  64,405 |   | $ |  (457,918 | ) |
| **Adjustments  to reconcile net income (loss) attributable to Deerfield Capital Corp. to net  cash used in operating activities:** | ** ** | ** **                         | ** **   | ** ** | ** ** |
| Net loss attributable  to noncontrolling interest                                                                                  |       | (2,960                             | )            | — |   |
| Net premium and  discount amortization on investments, loans and debt issuance                                                     |       | (444                               | )            | 1,243 |   |
| Share-based  compensation                                                                                                          |       | 297                                |         | 437 |   |
| Net purchases of  investments at fair value                                                                                        |       | (7,430                             | )            | (341,845 | ) |
| Net (gain) loss from  investments at fair value                                                                                    |       | (6,311                             | )            | 202,466 |   |
| Net gain on the  deconsolidation of Market Square CLO                                                                              |       | (29,551                            | )            | — |   |
| Other-than-temporary  impairment on available-for-sale securities                                                                  |       | 31                                 |         | 3,856 |   |
| Net purchases of loans  held for sale                                                                                              |       | (866                               | )            | (7,398 | ) |
| Net (gain) loss on  loans                                                                                                          |       | (30,691                            | )            | 21,050 |   |
| Provision for loan  losses                                                                                                         |       | 11,226                             |         | 4,502 |   |
| Net changes in  undesignated derivatives                                                                                           |       | (12,767                            | )            | (159,938 | ) |
| Amortization of net  loss on previously designated derivatives                                                                     |       | 95                                 |         | 96,965 |   |
| Depreciation and  amortization                                                                                                     |       | 3,264                              |         | 5,267 |   |
| Impairment of  intangible assets and goodwill                                                                                      |       | 126                                |         | 29,034 |   |
| Non-cash rental expense                                                                                                            |       | 77                                 |         | 100 |   |
| Provision for income  tax                                                                                                          |       | 28                                 |         | — |   |
| Deferred tax expense  (benefit)                                                                                                    |       | 49                                 |         | (12,905 | ) |
| **Changes  in operating assets and liabilities:**                                                                                  |       |                               |         |   |   |
| Due from broker                                                                                                                    |       | 11,152                             |         | 93,579 |   |
| Interest receivable                                                                                                                |       | (112                               | )            | 26,808 |   |
| Other receivable                                                                                                                   |       | 4,181                              |         | 1,268 |   |
| Prepaid and other  assets                                                                                                          |       | (66                                | )            | (687 | ) |
| Accrued interest on  repurchase agreements                                                                                         |       | (324                               | )            | (19,613 | ) |
| Due to broker                                                                                                                      |       | 547                                |         | 1,836 |   |
| Interest payable                                                                                                                   |       | (3,945                             | )            | (8,667 | ) |
| Accrued and other  liabilities                                                                                                     |       | (10,912                            | )            | (7,169 | ) |
| **Net  cash used in operating activities**                                                                                         |       | (10,901                            | )            | (527,729 | ) |
|                                                                                                                               |       |                               |         |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                         |       |                               |         |   |   |
| Change in restricted  cash and cash equivalents                                                                                    |       | 43,996                             |         | (21,337 | ) |
| Purchase of  available-for-sale securities                                                                                         |       | —                             |         | (1,750 | ) |
| Proceeds from the sale  of available-for-sale securities                                                                           |       | —                             |         | — |   |
| Principal payments on  available-for-sale securities                                                                               |       | —                             |         | 22,824 |   |
| Proceeds from the sale  of investments at fair value previously classified as available-for-sale                                   |       | 12,779                             |         | 4,138,198 |   |
| Principal payments on  investments at fair value previously classified as available-for-sale                                       |       | 30,514                             |         | 170,387 |   |
| Origination and  purchase of loans held for investment                                                                             |       | (78,992                            | )            | (7,070 | ) |
| Principal payments on  loans held for investment                                                                                   |       | 13,843                             |         | 47,878 |   |
| Proceeds from sale of  loans held for investment                                                                                   |       | 12,390                             |         | 26,368 |   |
| Proceeds from sale of  loans held for sale previously classified as held for investment                                            |       | 11,960                             |         | 1,864 |   |
| Sales (purchases) of  fixed assets                                                                                                 |       | 7                                  |         | (9 | ) |
| **Net  cash provided by investing activities**                                                                                     |       | 46,497                             |         | 4,377,353 |   |
|                                                                                                                               |       |                               |         |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                         |       |                               |         |   |   |
| Net payments under  repurchase agreements                                                                                          |       | (31,317                            | )            | (3,875,296 | ) |
| Proceeds from Wachovia  Facility                                                                                                   |       | —                             |         | 3,000 |   |
| Payments made on  Wachovia Facility                                                                                                |       | (13,161                            | )            | (23,022 | ) |
| Payments made on long  term debt                                                                                                   |       | (2,136                             | )            | — |   |
| Payment of debt  issuance costs                                                                                                    |       | (136                               | )            | (533 | ) |
| Dividends paid                                                                                                                     |       | —                             |         | (21,736 | ) |
| Payments made on short  term debt                                                                                                  |       | —                             |         | (1,225 | ) |
| Contributions of  noncontrolling interest                                                                                          |       | 20,133                             |         | — |   |
| **Net cash  used in financing activities**                                                                                         |       | (26,617                            | )            | (3,918,812 | ) |
|                                                                                                                               |       |                               |         |   |   |
| Foreign currency  translation                                                                                                      |       | 76                                 |         | (13 | ) |
| Net increase (decrease)  in cash and cash equivalents                                                                              |       | 9,055                              |         | (69,201 | ) |
| Cash and cash  equivalents at beginning of period                                                                                  |       | 32,791                             |         | 113,733 |   |
| **Cash  and cash equivalents at end of period**                                                                                    |       | $                                  |  41,846 |   | $ |  44,532 |   |
|                                                                                                                               |       |                               |         |   |   |
| **SUPPLEMENTAL  DISCLOSURE:**                                                                                                      |       |                               |         |   |   |
| Cash paid for interest                                                                                                             |       | $                                  | 15,425       |   | $ |  96,866 |   |
| Cash paid for income  taxes                                                                                                        |       | 27                                 |         | 3,974 |   |
|                                                                                                                               |       |                               |         |   |   |
| **NONCASH  INVESTING AND FINANCING ACTIVITIES:**                                                                                   |       |                               |         |   |   |
| Settlement of interest  income as an addition to principal balance of loans                                                        |       | 1,874                              |         | 3,211 |   |
| Receipt of warrants                                                                                                                |       | —                             |         | 1,092 |   |
| Share-based  compensation                                                                                                          |       | —                             |         | 2,789 |   |
| Series A  cumulative convertible preferred stock dividend and accretion                                                       |       | —                             |         | 2,393 |   |

 

See notes to condensed consolidated financialstatements.

 

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**DEERFIELD CAPITAL CORP. AND ITSSUBSIDIARIES**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Deerfield Capital Corp. (“DFR” and, together with itssubsidiaries, the “Company”) is a Maryland corporation. The Company, throughits wholly-owned subsidiary, Deerfield Capital Management LLC (“DCM”), managesclient assets, including bank loans and other corporate debt, residentialmortgage backed securities (“RMBS”), government securities and asset-backedsecurities (“ABS”). In addition, its Principal Investing segment has aninvestment portfolio comprised of fixed income investments, including bankloans and other corporate debt and RMBS. Historically, the Company had electedto be taxed as a real estate investment trust (“REIT”) under the InternalRevenue Code of 1986, as amended (the “Code”). However, the Company’s REITstatus terminated in 2008 when the Company converted to a C corporation tomaximize the use of significant potential tax benefits and provide moreflexibility with respect to future capital investment.

 

DFR was externally managed by DCM from the commencementof its operations in December 2004 until December 21, 2007, when theCompany acquired Deerfield & Company LLC (“Deerfield”), the parentcompany of DCM, in a merger transaction (the “Merger”). As a result of theMerger, Deerfield and its subsidiaries became indirect wholly-ownedsubsidiaries of DFR, and DFR became internally managed.

 

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

 

After the close of business on October 16, 2008,the Company effected a 1-for-10 reverse stock split of its common stock. Allshare and per share amounts reflected throughout the condensed consolidatedfinancial statements and notes thereto have been retroactively restated toreflect the reverse stock split, unless otherwise noted.

 

On April 14, 2009, the Company announcedDeerfield Pegasus Loan Capital LP (“DPLC”), its investment venture with PegasusCapital Advisors L.P. (“Pegasus”).  Pegasus is a U.S. based private equityfirm.  Pegasus and the Company have committed to invest $75.0 million and$15.0 million, respectively, in DPLC with such amounts to be invested primarilyin corporate bank loans and other senior secured corporate loans.  DPLC ismanaged by DCM.  The commitments of each of Pegasus and the Company aresubject to numerous conditions, any or all of which may not be satisfied.  As of June 30, 2009, Pegasus and DFRhave funded $20.0 million and $4.0 million, respectively, of such commitments.See Note 11 for details related to the warrants the Company issued to Pegasusin connection with the formation of DPLC.

 

***Business Segments***

 

The Company operates within two business segments:

 

*Investment Management* — The Company manages assets withina variety of investment vehicles, including collateralized debt obligations (“CDOs”),separately managed accounts and other investment vehicles, and earns investmentadvisory fees for providing its services. The Company specializes in managingfixed income investments, including corporate debt, RMBS, government securitiesand ABS.

 

*Principal Investing* — The Company has a portfolio ofinvestments comprised primarily of fixed income investments, including bankloans and other corporate debt and RMBS. Income from this business segment isinfluenced by three factors: (i) the net spread, or difference, betweenthe interest income the Company earns on its investment portfolio and the costof its borrowings net of hedging derivatives, (ii) the net recognizedgains and losses, if any, on the Company’s investment portfolio and (iii) provisionfor loan losses, if any. Investments in senior secured loans (first lien andsecond lien term loans), senior subordinated debt facilities and other juniorsecurities, typically in middle market companies across a range of industries,are referred to as “Corporate Loans.”

 

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***Liquidity and Capital Resources***

 

The Company believes that its current cash and cashequivalents, unencumbered liquid assets and net equity in its financed RMBSportfolio along with cash flows from operations, among other things, areadequate to meet anticipated long term (greater than one year) liquidityrequirements. Unencumbered RMBS and unrestricted cash and cash equivalentsaggregated $45.1 million at June 30, 2009. In addition, net equity inthe financed RMBS portfolio (including associated interest rate swaps),excluding the unencumbered RMBS included above, totaled $16.6 million at June 30,2009. In total, the Company had unrestricted cash and cash equivalents,unencumbered RMBS and net equity in the financed RMBS portfolio of$61.7 million as of June 30, 2009. As of June 30, 2009, the fairvalue of the Company’s Agency RMBS (as defined below) and non-Agency RMBSportfolios were $308.0 million and $3.1 million, respectively. The Company’slargest repurchase agreement counterparty has required that it maintain aminimum of $20.0 million of cash in their custody in order to maintain itscurrent repurchase agreement margin percentages on the Company’s Agency RMBS.If the Company fails to satisfy this requirement, the counterparty will havethe right to immediately increase the margin percentage under the repurchaseagreements and may exercise other remedies.

 

On July 31, 2009,the Company entered into three supplemental indentures with the holders of thetrust preferred securities issued by each of Deerfield Capital Trust I,Deerfield Capital Trust II and Deerfield Capital Trust III.  See Note 18 for additional disclosureregarding the supplemental indentures.

 

Agency-issued RMBS are backed by mortgage loans andare guaranteed as to principal and interest by federally chartered entitiessuch as the Federal National Mortgage Association (“Fannie Mae”) or the FederalHome Loan Mortgage Corporation (“Freddie Mac”), and, in the case of theGovernment National Mortgage Association (“Ginnie Mae”), theU.S. government. The Company refers to these entities as “Agencies” and toRMBS guaranteed or issued by the Agencies as “Agency RMBS.” The Company’sAgency RMBS portfolio at June 30, 2009 consists of Fannie Mae and FreddieMac securities. The Company’s non-Agency RMBS portfolio at June 30, 2009consists of two securities with estimated fair values of $2.3 and$0.8 million that are currently rated “A-” and “B-”, respectively, byStandard & Poor’s.

 

**2.****        ****ACCOUNTING POLICIES AND RECENT ACCOUNTINGPRONOUNCEMENTS**

 

*Basis of Presentation* — The accompanying unaudited condensedconsolidated financial statements have been prepared by the Company 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 (“SEC”) pursuant toRegulation S-X and the instructions to Form 10-Q. Accordingly, theCompany does not include all of the information and footnotes for completefinancial statements as required by GAAP. The interim unaudited condensedconsolidated financial statements should be read in conjunction with theCompany’s audited financial statements as of and for the year ended December 31,2008, which are included in the Company’s Annual Report on Form 10-K filedwith the SEC on March 16, 2009 (the “2008 10-K”). In the opinion of theCompany’s management, all adjustments, consisting of only normal recurringaccruals, necessary for a fair presentation of the Company’s financialposition, results of operations and cash flows have been included. The natureof the Company’s business is such that the results of any interim periodinformation are not necessarily indicative of results for a full year.

 

*Principles of Consolidation* — The condensed consolidatedfinancial statements include the financial statements of DFR and itssubsidiaries which are (i) wholly-owned, (ii) subsidiaries in whichDFR has a controlling interest and which the Company follows the consolidationguidance in Statement of Financial Accounting Standards (“SFAS”) No. 160, *Noncontrolling Interests in Consolidated FinancialStatements — an amendment of ARB No. 51* (“SFAS No. 160”)and (iii) entities that are variable interest entities (“VIEs”) in whichthe Company is the primary beneficiary under Financial Accounting StandardsBoard (“FASB”) Interpretation No. 46 (revised 2004), *Consolidation of Variable Interest Entities*(“FIN 46(R)”).Under FIN 46(R), a company is the primary beneficiary of a VIE if it absorbs amajority of the VIE’s expected losses or receives a majority of the VIE’sexpected residual returns, or both. All intercompany balances and transactionshave been eliminated in consolidation.

 

As of June 30, 2009 and for the three and sixmonths ended June 30, 2009 and 2008, the Company consolidated DFR MiddleMarket CLO Ltd. (“DFR MM CLO”) as it is deemed to be the primary beneficiary ofthis VIE.  The Company also consolidatedMarket Square CLO Ltd. (“Market Square CLO”) as of December 31, 2008 andfor the three and six months ended June 30, 2009 and 2008. On June 30,2009, the Company sold all of its preference shares in Market Square CLO to anunrelated third party in exchange for an upfront payment and a delayed purchaseprice in the form of a right to receive a portion of the future distributions,if any, on the preference shares.  As aresult of the sale, the Company determined it was no longer the primary beneficiaryof Market Square CLO and therefore deconsolidated Market Square CLO.  TheCompany is, however, deemed to retain a beneficial interest in the preferenceshares of Market Square CLO as a result of the delayed purchase price. The carrying value of the beneficial interest was de minimis as of June 30,2009.  As of June 30, 2009, none ofthe Market Square CLO assets, liabilities or equity are included in the Company’scondensed consolidated balance sheet; however, all of the financial impacts tothe condensed consolidated statement of operations 

 

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fromthe previous consolidation of Market Square CLO were recognized through June 30,2009.  The Company recognized a gain onthe deconsolidation of Market Square CLO of $29.6 million in the condensedconsolidated statement of operations for the three and six months ended June 30,2009.

 

Although the Company consolidates 100% of the assetsand liabilities of DFR MM CLO, the Company’s maximum exposure to loss on itsinvestment in this entity is limited to its initial investment of$69.0 million. The economic impact of the Company’s investment in DFR MMCLO is determined by the cash flows distributed to the Company by DFR MM CLO onits investment in $50.0 million of preferred shares, subject to diversion ofcash flows away from the Company as provided in accordance with the indenturefor DFR MM CLO, and the Company’s investment in $19.0 million of debt of DFR MMCLO.  For the three and six months endedJune 30, 2009 the net loss of $3.5 million and net gain of $0.8 million,respectively, recorded under GAAP for DFR MM CLO was not indicative of theeconomic impact to the Company of cash flow distributions from DFR MM CLO of$4.8 million and $5.0 million, respectively. Cash flows from the Company’s investment in preferred shares of DFR MMCLO began to be diverted during the second quarter of 2009 in accordance withthe DFR MM CLO indenture; however, cash flows are still being received on theCompany’s investment in DFR MM CLO debt. The debt holders of DFR MM CLO have recourse only to the assets of thisentity and not to the general assets of the Company. The Company consolidatedassets of $291.3 million and liabilities of $232.1 million related to DFR MMCLO as of June 30, 2009.

 

During the three months ended June 30, 2009, theCompany also consolidated DPLC as a result of the Company’s controllinginterest therein pursuant to the consolidation guidance issued in SFAS No. 160.  The Company also consolidated DPLC GeneralPartner LLC (“DPLC GP”), the general partner of DPLC through which the Companymade its investment in DPLC. The Company has a controlling financial interestin DPLC and DPLC GP as a result of owning more than 50% of the outstandingvoting interest in DPLC GP.  Although theCompany consolidates 100% of the assets and liabilities and the results ofoperations of DPLC and DPLC GP, the Company’s maximum exposure to loss on itsinvestment in this entity is limited to its investment in DPLC GP, which as of June 30,2009 totaled $3.9 million. Net income (loss) attributable to DFR excludes thenet loss attributable to noncontrolling interest. The Company consolidatedassets of $22.8 million and liabilities of $2.4 million related to DPLC asof June 30, 2009.

 

*Reclassifications* — Certain amounts in the condensedconsolidated financial statements and notes as of December 31, 2008 andfor the three and six months ended June 30, 2008 have been reclassified toconform to the presentation as of and for the three and six months ended June 30,2009. Occupancy and Cost savings initiatives, which were included in Othergeneral and administrative expenses and Compensation and benefits,respectively, in the condensed consolidated statements of operations for thethree and six months ended June 30, 2008, are presented as separate lineitems in the current quarter condensed consolidated statements of operations.

 

*Significant Accounting Policies* — The Company’s significant accountingpolicies are discussed in the Notes to the Consolidated Financial Statementsincluded in the 2008 10-K.

 

*Recent Accounting Pronouncements* — In December 2007, the FASB issuedSFAS No. 160, which established accounting and reporting standards for thenoncontrolling interest in a subsidiary and for the deconsolidation of asubsidiary.  During the three months ended June 30, 2009, the Companyapplied SFAS No. 160 to the consolidation of DPLC and the deconsolidationof Market Square CLO.

 

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

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments and HedgingActivities* (“SFAS No. 161”), which amends and expands thedisclosure requirements of SFAS No. 133,*Accounting for Derivative Instruments and Hedging Activities*(“SFAS No. 133”). SFAS No. 161 requires qualitative disclosuresregarding objectives and strategies for using derivatives, quantitativedisclosures regarding fair value amounts of gains and losses on derivativeinstruments and disclosures regarding credit-risk-related contingent featuresin derivative contracts. The Company adopted SFAS No. 161 and included therequired additional disclosures in Note 7.

 

In June 2008, the FASB issuedFSP EITF 03-6-1,*DeterminingWhether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities* (“FSP EITF 03-6-1”). FSPEITF 03-6-1 addresses whether instruments granted in share-based paymenttransactions are participating securities prior to vesting and, therefore, needto be included in the earnings allocation in computing earnings per share underthe two-class method described in FASB Statement No. 128,*Earnings per Share*. The Company 

 

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adoptedFSP EITF 03-6-1 on January 1, 2009, and the adoption had no impact onthe Company’s condensed consolidated financial statements.

 

In April 2009, the FASB issued FSP FAS 107-1 andAPB 28-1, *Interim Disclosures about FairValue of Financial Instruments* (“FSP FAS 107-1 and APB 28-1”).  FSP FAS 107-1 and APB 28-1 requires disclosures regarding fair value offinancial instruments for interim reporting periods of publicly tradedcompanies as well as in annual financial statements.  The Company adoptedFSP FAS 107-1 and APB 28-1 and included the required disclosures in Note3.

 

In April 2009, the FASB issued FSP FAS 157-4, *Determining Fair Value When the Volume and Level ofActivity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly* (“FSP FAS 157-4”). FSP FAS 157-4 was issued to provide additional guidance for estimating fairvalue when the volume and level of activity have significantly decreased and toprovide guidance on identifying circumstances that indicate a transaction isnot orderly.  In addition, FSP FAS 157-4 requires an entity to disclose,in interim and annual periods, the inputs and valuation techniques used tomeasure fair value and provide a discussion of changes in valuation techniquesand related inputs, if any, during the period.  The Company adopted FSPFAS 157-4 and considered this guidance in determining and disclosing the fairvalues included in the Company’s condensed consolidated financial statements.

 

In April 2009, the FASB issued FSP FAS 115-2 andFAS 124-2, *Recognition and Presentation ofOther-Than-Temporary Impairments*(“FSP FAS 115-2 and FAS 124-2”). This statement was issued to amend the other-than-temporary impairment guidancein GAAP for debt securities to make the guidance more operational and toimprove the presentation and disclosure of other-than-temporary impairments ondebt and equity securities in the financial statements.  FSP FAS 115-2 andFAS 124-2 does not amend existing recognition and measurement guidance relatedto other-than-temporary impairments of equity securities.  The Companyadopted FSP FAS 115-2 and FAS 124-2 in the preparation of the Company’scondensed consolidated financial statements.

 

In May 2009, the FASB issued SFAS No. 165,*Subsequent Events*(“SFAS No. 165”).  SFAS No. 165 establishes generalstandards of accounting for, and disclosure of, events that occur after thebalance sheet date but before financial statements are issued or are availableto be issued.  In particular, this statement sets forth: (i) theperiod after the balance sheet date during which management of a reportingentity should evaluate events or transactions that may occur for potentialrecognition or disclosure in the financial statements, (ii) thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements and (iii) thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date.  The Company adopted SFAS No. 165and has included the required disclosures in Note 18.

 

In June 2009, the FASBissued FASB Statement No. 166, *Accountingfor Transfers of Financial Assets — an amendment of FASB Statement No. 140*(“SFAS No. 166”).  Thisstatement was issued to address concerns about the previously existing guidancegoverning transfers of financial assets. SFAS No. 166 provides clarification concerning measuring whether atransferor and all of the entities included in the transferor’s financialstatements have surrendered control over transferred financial assets andstates that a determination must consider the transferor’s continuinginvolvements in the transferred financial assets.  In addition, this statement removes theconcept of a qualifying special-purpose entity from SFAS No. 140 andremoves the exception from applying FIN 46(R) to qualifyingspecial-purpose entities.  SFAS No. 166is effective for transfers of financial assets that occur during the Company’sinterim and annual reporting periods that begin after November 15,2009.  Management is currently evaluatingthe effects that SFAS No. 166 will have on the Company’s condensedconsolidated financial statements and disclosures included in those condensedconsolidated financial statements.

 

In June 2009, the FASB issued FASB Statement No. 167,*Amendments to FASB Interpretation No. 46 (R) *(“SFASNo. 167”).  This statement wasissued to address concerns about financial statement preparers’ ability tostructure transactions to avoid consolidation, balanced with the need for morerelevant, timely and reliable information about an entity’s involvement in aVIE.  This statement requires an enterpriseto perform an analysis to determine whether the enterprise’s variable interestor interests give it a controlling financial interest in a VIE.  This analysis identifies the primarybeneficiary of a VIE as the enterprise that has both the power to direct theactivities of a VIE that most significantly impact the entity’s economicperformance and the obligation to absorb losses of the entity that couldpotentially be significant to the VIE or the right to receive benefits from theentity that could potentially be significant to the VIE. Additionally, anenterprise is required to asses whether it has an implicit financialresponsibility to ensure that a VIE operates as designed when determiningwhether it has the power to direct the activities of the VIE that mostsignificantly impacts the entity’s economic performance.  * *SFAS No. 167 also amends FIN 46 (R) to eliminate thequantitative approach to determining the primary beneficiary of a VIE andrequires ongoing reassessments of VIE status. SFAS No. 167 is effective for the Company’s interim and annualreporting periods that begin after November 15, 2009.  Management is currently evaluating theeffects that SFAS No. 167 will have on the Company’s condensedconsolidated financial statements and disclosures included in those condensedconsolidated financial statements. Management’s initial conclusion is that a significant portion of theCDOs that the Company manages would need to be consolidated as a result of theadoption of SFAS No. 167.

 

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In June 2009, the FASB issued FASB Statement No. 168,*The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles—a replacement of FASBStatement No. 162*(“SFAS No. 168”). The FASB AccountingStandards Codification (the “Codification”) will be the single source ofauthoritative nongovernmental U.S. GAAP. Rules and interpretive releases ofthe SEC under authority of federal securities laws are also sources ofauthoritative GAAP for SEC registrants. All existing accounting standards aresuperseded as described in SFAS No. 168. All other accounting literaturenot included in the Codification is nonauthoritative. SFAS No. 168 iseffective for interim and annual periods ending after September 15, 2009.SFAS No. 168 is not expected to have a significant impact on the Company’sfinancial statements.

 

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

 

Effective January 1, 2008, the Company adoptedSFAS No. 157,*Fair Value Measurements*(“SFAS No. 157”). SFAS No. 157 defines fair value,establishes a framework used to measure fair value and enhances disclosurerequirements for fair value measurements. In accordance with SFAS No. 157,the Company has categorized its 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 assetscarried at Level 1 generally are equity securities listed on an activeexchange. The Company held no Level 1 securities as of June 30, 2009.

 

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

 

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

 

*Level 3* — inputs to the valuation methodology includesignificant unobservable inputs to the fair value measurement. This includessituations where there is little, if any, market activity for the asset orliability. However, a substantial number of the Level 3 asset valuationsare provided by independent third parties.

 

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

 

The Company’s full valuation methodology and SFAS No. 157accounting policy are discussed in the Notes to the Consolidated FinancialStatements included in the 2008 10-K.  There were no significantchanges in the Company’s valuation methodologies during the three and sixmonths ended June 30, 2009.

 

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

 

The following table presents the financial instrumentscarried at fair value on a recurring basis as of June 30, 2009, by captionin the condensed consolidated balance sheet and by level within the SFAS No. 157valuation hierarchy:

 
| ** **                         | ** ** | **Level 1**        | ** **   | **Level 2** | ** ** | **Level 3**   | ** ** | **Carrying Value** | ** **   |
|------------------------------------|------------|--------------------|--------------|-------------|------------|---------------|------------|--------------------|--------------|
| ** **                         | ** ** | **(In thousands)** | ** **   |
| Available-for-sale  securities     |       | $                  |  — |        | $          |  —  |       | $                  |  — |   | $ |  — |   |
| Investments  at fair value:        |       |               |         |        |       |          |       |               |         |
| RMBS                               |       | —             |         | 308,044     |       | 3,110         |       | 311,154            |         |
| Loans                              |       | —             |         | —      |       | 6,841         |       | 6,841              |         |
| Other                              |       | —             |         | —      |       | 315           |       | 315                |         |
| Derivative  assets                 |       | —             |         | —      |       | 61            |       | 61                 |         |
| Total  financial instrument assets |       | $                  |  — |        | $          |  308,044 |       | $                  |  10,327 |   | $ |  318,371 |   |
|                               |       |               |         |        |       |          |       |               |         |
| Derivative  liabilities            |       | $                  |  — |        | $          |  953     |       | $                  |  — |   | $ |  953 |   |

 

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

 

The table below includes a rollforward of the balancesheet amounts for the three months ended June 30, 2009 (including thechange in fair value) for financial instruments classified by the Companywithin Level 3 of the valuation hierarchy.

 
| ** **                         | ** ** | ** **                                                         | ** **  | ** **          | ** ** | ** **               | ** ** | ** **         | ** **   | ** **             | ** ** | ** **              | ** ** | **Changes  in Unrealized** | ** **   |
|------------------------------------|------------|--------------------------------------------------------------------|-------------|---------------------|------------|--------------------------|------------|--------------------|--------------|------------------------|------------|-------------------------|------------|----------------------------|--------------|
| ** **                         | ** ** | **Fair  Value Measurements Using Significant Unobservable Inputs** | ** **  | **Gains  (Losses)** | ** ** |
| ** **                         | ** ** | **Estimated**                                                      | ** **  | **Net  Realized/**  | ** ** | **Purchases,  (Sales),** | ** ** | **Net  Transfers** | ** **   | **Deconsolidation**    | ** ** | **Estimated**           | ** ** | **Related  to Financial**  | ** **   |
| ** **                         | ** ** | **Fair  Value**                                                    | ** **  | **Unrealized**      | ** ** | **Issuances  and**       | ** ** | **In  (Out)**      | ** **   | **of**                 | ** ** | **Fair  Value**         | ** ** | **Instruments  Held**      | ** **   |
| ** **                         | ** ** | **April 1,  2009**                                            | ** **  | **Gains/(Losses)**  | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** **   | **Market  Square CLO** | ** ** | **June 30,  2009** | ** ** | **at  June 30, 2009** | ** **   |
| ** **                         | ** ** | **(In  thousands)**                                                | ** **  |
| Available-for-sale  securities     |       | $                                                                  |  2,619 |                | $          |  1,147              |  (1)  | $                  |  — |                   | $          |  —            |       | $                          |  (3,766 | ) | $ |  — |   | $ |  — |  (1) |
| Investments at fair  value:        |       |                                                               |        |                |       |                     |       |               |         |                   |       |                    |       |                       |         |
| RMBS                               |       | 4,841                                                              |        | (1,180              | )(2)       | (551                     | )          | —             |         | —                 |       | 3,110                   |       | (1,207                     | )(2)         |
| Loans                              |       | —                                                             |        | 357                 |  (2)  | 6,484                    |       | —             |         | —                 |       | 6,841                   |       | 338                        |  (2)    |
| Other                              |       | 707                                                                |        | 109                 |  (2)  | 365                      |       |               |         | (866                   | )          | 315                     |       | (75                        | )(2)         |
| Derivative assets                  |       | 21                                                                 |        | 40                  |  (3)  | —                   |       | —             |         |                   |       | 61                      |       | 40                         |  (3)    |
| Total financial  instrument assets |       | $                                                                  |  8,188 |                | $          |  473                |       | $                  |  6,298  |                   | $          |  —            |       | $                          |  (4,632 | ) | $ |  10,327 |   | $ |  (904 | ) |

 

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

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

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

 

The table below includes a rollforward of the balancesheet amounts for the six months ended June 30, 2009 (including the changein fair value), for financial instruments classified by the Company withinLevel 3 of the valuation hierarchy.

 
| ** **                         | ** ** | ** **                                                         | ** **  | ** **          | ** ** | ** **               | ** ** | ** **         | ** **   | ** **             | ** ** | ** **              | ** ** | **Changes  in Unrealized** | ** **   |
|------------------------------------|------------|--------------------------------------------------------------------|-------------|---------------------|------------|--------------------------|------------|--------------------|--------------|------------------------|------------|-------------------------|------------|----------------------------|--------------|
| ** **                         | ** ** | **Fair  Value Measurements Using Significant Unobservable Inputs** | ** **  | **Gains  (Losses)** | ** ** |
| ** **                         | ** ** | **Estimated**                                                      | ** **  | **Net  Realized/**  | ** ** | **Purchases,  (Sales),** | ** ** | **Net  Transfers** | ** **   | **Deconsolidation**    | ** ** | **Estimated**           | ** ** | **Related  to Financial**  | ** **   |
| ** **                         | ** ** | **Fair  Value**                                                    | ** **  | **Unrealized**      | ** ** | **Issuances  and**       | ** ** | **In  (Out)**      | ** **   | **of**                 | ** ** | **Fair  Value**         | ** ** | **Instruments  Held**      | ** **   |
| ** **                         | ** ** | **January 1,  2009**                                          | ** **  | **Losses**          | ** ** | **(Settlements),  Net**  | ** ** | **of  Level 3**    | ** **   | **Market  Square CLO** | ** ** | **June 30,  2009** | ** ** | **at  June 30, 2009** | ** **   |
| ** **                         | ** ** | **(In  thousands)**                                                | ** **  |
| Available-for-sale  securities     |       | $                                                                  |  2,338 |                | $          |  1,428              |  (1)  | $                  |  — |                   | $          |  —            |       | $                          |  (3,766 | ) | $ |  — |   | $ |  (31 | )(1) |
| Investments at fair  value         |       |                                                               |        |                |       |                     |       |               |         |                   |       |                    |       |                       |         |
| RMBS                               |       | 5,394                                                              |        | (1,420              | )(2)       | (864                     | )          | —             |         | —                 |       | 3,110                   |       | (1,465                     | )(2)         |
| Loans                              |       | —                                                             |        | 357                 |  (2)  | 6,484                    |       | —             |         | —                 |       | 6,841                   |       | 338                        |  (2)    |
| Other                              |       | 160                                                                |        | (147                | )(2)       | 1,168                    |       |               |         | (866                   | )          | 315                     |       | (235                       | )(2)         |
| Derivative assets                  |       | 132                                                                |        | (71                 | )(3)       | —                   |       | —             |         |                   |       | 61                      |       | (71                        | )(3)         |
| Total financial  instrument assets |       | $                                                                  |  8,024 |                | $          |  147                |       | $                  |  6,788  |                   | $          |  —            |       | $                          |  (4,632 | ) | $ |  10,327 |   | $ |  (1,464 | ) |
|                               |       |                                                               |        |                |       |                     |       |               |         |                   |       |                    |       |                       |         |
| Derivative liabilities             |       | $                                                                  |  402   |                | $          |  120                |  (3)  | $                  |  (522   | )                      | $          |  —            |       | $                          |  — |   | $ |  — |   | $ |  — |  (3) |

 

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

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

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

 

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

 

Certain assets are measured at fair value on anonrecurring basis, meaning that the instruments are measured at fair valueonly in certain circumstances (for example, when held at the lower of cost ormarket). The following table presents the assets carried on the condensedconsolidated balance sheet by caption and by level within the SFAS No. 157valuation hierarchy, as of June 30, 2009, for which a nonrecurring changein fair value has been recorded during the three months ended June 30,2009:

 
| ** **                                                   | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Carrying Value** | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| ** **                                                   | ** ** | **(In thousands)** | ** ** |
| Loans held for sale                                          |       | $                  | —     |        | $          | —      |       | $                  | 7,523      |   | $ | 7,523 |   |
| Loans held for  investment, net of allowance for loan losses |       | —             |       | —      |       | 4,432       |       | 4,432              |       |
| Intangible assets, net                                       |       | —             |       | —      |       | 1,083       |       | 1,083              | (1)        |
| Total assets at fair  value on a nonrecurring basis          |       | $                  | —     |        | $          | —      |       | $                  | 13,038     |   | $ | 13,038 |   |

 

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(1)         The Company recognized $0.1 million ofimpairment on the intangible asset associated with the management contract forKnollwood CDO II Ltd. as a result of the decline in expected future managementfee cash flows from that CDO.

 

In the table above, “Loans held for sale” includeschanges in fair value of loans which are carried on the balance sheet at thelower of cost or fair value. “Loans held for investment” represents loans whichare measured at fair value as a result of the establishment or subsequentchange in the allowance for loan losses as of June 30, 2009.

 

The following table presents the total change in valueof financial assets for which a fair value adjustment has been included in thecondensed consolidated financial statements for the three and six months ended June 30,2009, related to financial instruments still held at June 30, 2009:

 
| ** **                            | ** ** | **Three months ended** | ** ** | **Six months ended**   | ** ** |
|---------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| ** **                            | ** ** | **(In thousands)**     | ** ** |
| Loans held for sale                   |       | $                      | (4,044     | )(1)                   | $          | (9,985 | )(1) |
| Loans held for  investment            |       | (9,119                 | )(2)       | (9,777                 | )(2)       |
| Intangible assets, net                |       | (126                   | )(3)       | (126                   | )(3)       |
| Total nonrecurring fair  value losses |       | $                      | (13,289    | )                      | $          | (19,888 | ) |

 

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

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

(3)         Impairment charges to intangible assetsare reported within impairment of intangible assets and goodwill in thecondensed consolidated statements of operations.

 

FSP FAS 107-1 and APB 28-1 requires quarterlydisclosure of the fair value of financial instruments for which it ispracticable to estimate that value. Estimated fair values presented below arecalculated as discussed above. For securities which the fair value option wasnot elected, quoted market prices, if available, are utilized as estimates offair values. In the absence of available quoted market prices, fair values havebeen derived based on management’s assumptions, the estimated amount and timingof future cash flows and estimated discount rates. Different assumptions couldsignificantly affect these estimates.

 

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The carrying amounts and estimated fair values of theCompany’s financial instruments, for which the disclosure of fair values isrequired, were as follows as of June 30, 2009:

 
| ** **                                            | ** ** | ** **         | ** ** | **Estimated** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                            | ** ** | **Carrying**       | ** ** | **Fair**      | ** ** |
| ** **                                            | ** ** | **Value**          | ** ** | **Value**     | ** ** |
| ** **                                            | ** ** | **(In thousands)** | ** ** |
| Financial assets:                                     |       |               |       |          |       |
| Cash and cash  equivalents (1)                        |       | $                  | 41,846     |          | $          | 41,846 |   |
| Restricted cash and  cash equivalents (1)             |       | 27,201             |       | 27,201        |       |
| Investments at fair  value (2)                        |       | 318,310            |       | 318,310       |       |
| Other investments (3)                                 |       | 4,780              |       | 4,780         |       |
| Derivative assets (2)                                 |       | 61                 |       | 61            |       |
| Loans held for sale (2)                               |       | 9,363              |       | 9,684         |       |
| Loans, net of allowance  for loan losses (2) (3) |       | 280,432            |       | 257,363       |       |
| Investment advisory fee  receivables (1)              |       | 2,009              |       | 2,009         |       |
|                                                  |       |               |       |          |       |
| Financial liabilities:                                |       |               |       |          |       |
| Repurchase agreements  (1)                            |       | 294,470            |       | 294,470       |       |
| Derivative liabilities  (2)                           |       | 953                |       | 953           |       |
| Long term debt:                                       |       |               |       |          |       |
| Wachovia Facility (1)                                 |       | 771                |       | 771           |       |
| DFR MM CLO (4)                                        |       | 231,000            |       | 119,360       |       |
| Trust preferred  securities (4)                       |       | 123,717            |       | 15,749        |       |
| Series A &  Series B Notes (4)     |       | 72,042             |       | 24,408        |       |
|                                                       |            |                    |            |               |            |  |  |

 

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

(2)         The estimated fair values were determinedin accordance with SFAS No. 157 as described in detail above.

(3)   Itwas not practicable to estimate the fair value of certain loans and otherinvestments because they are not traded in an active market; therefore, thecarrying value displayed is an approximation of fair value for loans with acarrying value of $137.4 million and other investments with a carrying value of$4.8 million. If an independent pricing service cannot provide fair valueestimates for a given loan, the Company may determine estimated fair valuebased on some or all of the following: (a) current financial informationof the borrowing company and performance against its operating plan; (b) changesin the fair value of collateral supporting the loan; (c) changes to themarket for the borrowing company’s service or product and (d) present valueof projected future cash flows.

(4)   Theestimated fair values were calculated utilizing the guidance from SFAS No. 157.The Company utilized comparable market data and internal models to calculatethe estimated fair value of the long term debt.

 

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

 

During the three and six months ended June 30,2009, all of the Company’s available-for-sale securities were held in MarketSquare CLO.  On June 30, 2009, theCompany sold all of its preference shares in and deconsolidated Market SquareCLO.

 

Temporary impairment of available-for-sale securitiesresults from the fair value of securities falling below their amortized costbasis, primarily due to changes in the interest rate environment and in creditspreads.  If the fair value of anavailable-for-sale security is less than its amortized cost basis as of thebalance sheet date, the available-for-sale security is assessed to determinewhether the impairment is other than temporary.

 

If the Company intends to sell the available-for-salesecurity, an other-than-temporary impairment is deemed to have occurred.  If the Company does not intend to sell theavailable-for-sale security, the Company assesses whether it more likely thannot that the Company will be required to sell the security before the recoveryof its amortized cost basis.  If theCompany believes it is more likely than not it will be required to sell thesecurity before recovery of its amortized cost basis, an other-than-temporaryimpairment is deemed to have occurred. If, in the Company’s judgment, an other-than-temporary impairment existsbecause the Company intends to sell the security or it will more likely thannot be required to sell the security before the recovery of its amortized costbasis, the cost basis of the security is written down to the then-current fairvalue through earnings (as if the loss had been realized in the period ofother-than-temporary impairment).

 

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If the Company does not expect to recover the entireamortized cost basis of an available-for-sale security, an other-than-temporaryimpairment is deemed to have occurred, even if the Company does not intend tosell the security. As part of this assessment, the Company compares the presentvalue of cash flows expected to be collected from the security with theamortized cost basis of the security.  Ifthe present value of cash flows expected to be collected is less than theamortized cost basis of the security, an other-than-temporary impairmentclassified as a credit loss is deemed to have occurred.

 

The determination of other-than-temporary impairmentand other-than-temporary impairment classified as a credit loss is a subjectiveprocess, and different judgments and assumptions could affect the timing ofloss realization, if any. The determination of other-than-temporary impairmentand other-than-temporary impairment classified as a credit loss is made at leastquarterly.

 

The Company considers many factors, including but notlimited to, the following when determining whether an other-than-temporaryimpairment classified as a credit loss for a security or investment exists:

 

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

·                                          whether the security has been downgradedby a rating agency; and

·                                          the financial condition of the investeeand the prospect for future recovery.

 

If the Company does not intend to sell the securityand it is not more likely than not that the entity will be required to sell thesecurity before recovery of its amortized cost basis less any current periodcredit loss, the other-than temporary impairment is separated into (a) theamount representing the credit loss and (b) the amount related to otherfactors.  The total amount ofother-than-temporary impairment related to the credit loss is recorded throughearnings (as if the loss had been realized in the period of other-than-temporaryimpairment).  The amount of the totalother-than-temporary impairment related to other factors is recognized in othercomprehensive income.

 

For the three and six months ended June 30, 2009,the Company recognized zero and $31,000, respectively, of other-than-temporaryimpairments related to certain CMBS. For the three and six months ended June 30,2008, the Company recognized $3.9 million of other-than-temporary impairmentson available-for-sale securities.

 

**5.****        ****INVESTMENTS AT FAIR VALUE**

 

The following table summarizes the Company’ssecurities classified as investments at fair value as of June 30, 2009:

 
| ** **               | ** ** | **Estimated**      | ** ** |
|--------------------------|------------|--------------------|------------|
| **Security Description** | ** ** | **Fair Value**     | ** ** |
| ** **               | ** ** | **(In thousands)** | ** ** |
| RMBS:                    |       |               |       |
| Agency RMBS              |       | $                  | 308,044    |   |
| Non-Agency RMBS          |       | 3,110              |       |
| Loans held in DPLC       |       | 6,841              |       |
| Other investments        |       | 315                |       |
| Total                    |       | $                  | 318,310    |   |

 

The Company elected to record all loans held in DPLCat fair value in accordance with SFAS No. 159, *The FairValue Option for Financial Assets and Liabilities — including an amendment ofFASB Statement No. 115* (“SFAS No. 159”).  This election was made to align theaccounting basis for these loans for their consolidation into DFR with theaccounting basis of such loans for DPLC’s financial and investor reportingwhere they are valued at fair value.   Asof June 30, 2009, the difference between the aggregate estimated fairvalue of loans held in DPLC of $6.8 million and the outstanding principalbalance of loans held in DPLC of $7.7 million was $0.9 million.   As of June 30, 2009, there were noloans held in DPLC that were 90 days or more past due on interest payments oron nonaccrual status.  Interest income onloans held in DPLC is recorded in interest income on the condensed consolidatedincome statements and represents the current period interest accrual.  SFAS No. 159 requires an estimate of thegains and losses included in earnings during the period which are attributableto changes in instrument specific credit risk. For floating rate loans, all changes in estimated fair value are attributedto instrument specific credit risk.  Forfixed rate instruments, an allocation of the changes in value for the period ismade between those changes in estimated fair value that are interest raterelated and changes that are credit rated. As of and for the three and six months ended June 30, 2009, allloans held in DPLC and recorded at fair value are floating rate loans, and thenet gains (losses) included in net (gain) loss on loans attributed toinstrument specific credit risk for the three and six months ended June 30,2009 was $0.4 million.

 

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The Company records changes in fair value ofinvestments at fair value in its condensed consolidated statements ofoperations. The following table summarizes the Company’s securities classifiedas investments at fair value as of June 30, 2009, according to theirweighted average life:

 
| ** **                                       | ** ** | ** **         | ** ** | ** **     | ** ** | **Weighted** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|----------------|------------|--------------|------------|
| ** **                                       | ** ** | **Amortized**      | ** ** | **Estimated**  | ** ** | **Average**  | ** ** |
| **Weighted Average Life**                        | ** ** | **Cost**           | ** ** | **Fair Value** | ** ** | **Coupon**   | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** ** | ** **     | ** ** |
| Greater than one year  and less than five years  |       | $                  | 51,009     |           | $          | 46,509       |       | 5.94 | % |
| Greater than five years  and less than ten years |       | 269,219            |       | 265,000        |       | 4.67         | %          |
| Greater than ten years                           |       | 6,732              |       | 6,801          |       | 4.76         | %          |
| Total                                            |       | $                  | 326,960    |           | $          | 318,310      |       | 4.82 | % |

 

The weighted average lives, in the table above, arebased upon contractual maturity for loans held in DPLC and other investmentsand primarily based on a prepayment model for RMBS that considers currentyields, forward yields, the slope of the yield curve, current mortgage ratesand the contractual rate of the outstanding loans, the loan’s age, margin andvolatility. Weighted average life is an estimate of how many years it will taketo receive half of the outstanding principal. Actual lives of RMBS aregenerally shorter than stated contractual maturities, are affected by thecontractual maturities of the underlying mortgages, periodic payments ofprincipal and prepayments of principal and may differ materially from those setforth above.

 

For the three and six months ended June 30, 2009,the Company sold zero and $12.8 million of RMBS, respectively, and receivedRMBS principal paydowns of $15.5 million and $30.0 million, respectively.During the three months ended March 31, 2008, the RMBS portfolioexperienced a significant decrease in value, fueled by the ongoing creditcrisis. This negative environment had several impacts on the Company’s abilityto successfully finance and hedge its RMBS portfolio. As a result during thethree months ended March 31, 2008, the Company sold a significant portionof its RMBS portfolio to improve liquidity.

 

The following table presents the realized andunrealized gains (losses) on investments at fair value as reported in theCompany’s condensed consolidated statements of operations:

 
| ** **                 | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                 | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                 | ** ** | **(In thousands)**                   | ** ** |
| Realized losses            |       | $                                    | (352       | )                                  | $          | (76 | ) | $ | (348 | ) | $ | (169,142 | ) |
| Unrealized gains  (losses) |       | 1,525                                |       | (1,671                             | )          | 6,659 |   | (33,324 | ) |
| Total gains (losses)       |       | $                                    | 1,173      |                               | $          | (1,747 | ) | $ | 6,311 |   | $ | (202,466 | ) |

 

As of June 30, 2009, there were $1.8 million ofunsettled purchases and $1.9 million of unsettled sales of loans classified asinvestments at fair value.

 

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

 

The following summarizes the Company’s loans held forsale and loans held for investment as of June 30, 2009:

 
| ** **                        | ** ** | **Loans Held**      | ** ** | **Loans Held**     | ** ** | ** ** | ** ** |
|-----------------------------------|------------|---------------------|------------|--------------------|------------|------------|------------|
| **Type of Loan**                  | ** ** | **for Sale (1)**    | ** ** | **for Investment** | ** ** | **Total**  | ** ** |
| ** **                        | ** ** | **(In  thousands)** | ** ** |
| Corporate leveraged loans:        |       |                |       |               |       |       |       |
| Loans held in DFR MM  CLO (2)     |       | $                   | —     |               | $          | 299,751    |       | $ | 299,751 |   |
| Loans held in Wachovia  Facility  |       | 1,251               |       | —             |       | 1,251      |       |
| Other corporate  leveraged loans  |       | 8,112               |       | —             |       | 8,112      |       |
| Commercial real estate  loans (3) |       | —              |       | 9,270              |       | 9,270      |       |
|                              |       | $                   | 9,363      |               | 309,021    |       | 318,384    |   |
| Allowance for loan  losses        |       |                |       | (28,589            | )          | (28,589    | )          |
|                              |       |                |       | $                  | 280,432    |       | $          | 289,795 |   |

 

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(1)             Carrying value of loans held for sale is lower of costor estimated fair value.

 

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(2)             Loans held in DFR MM CLO classified as loans held forinvestment reported gross of $24.5 million allowance for loan losses.

(3)             Commercial real estate loans classified as loans heldfor investment reported gross of $4.1 million allowance for loan losses.

 

The following summarizes the Company’s allowance forloan losses as of June 30, 2009:

 
| ** **                    | ** ** | **Number**   | ** ** | **Par**            | ** ** | **Allowance**       | ** ** |
|-------------------------------|------------|--------------|------------|--------------------|------------|---------------------|------------|
| **Type of Loan**              | ** ** | **of Loans** | ** ** | **Value**          | ** ** | **for Loan Losses** | ** ** |
| ** **                    | ** ** | ** **   | ** ** | **(In thousands)** | ** ** |
|                          |       |         |       |               |       |                |       |
| Loans held in DFR MM  CLO     |       | 4            |       | $                  | 27,786     |                | $          | 24,484 |   |
| Commercial real estate  loans |       | 3            |       | 8,058              |       | 4,105               |       |
| Total                         |       | 7            |       | $                  | 35,844     |                | $          | 28,589 |   |

 

As of June 30, 2009, the Company’s loans held forsale and loans held for investment totaled $289.8 million, net ofallowance for loan losses. Loans classified as held for sale and carried at thelower of cost or estimated fair value totaled $9.4 million, net of avaluation allowance of $10.0 million, as of June 30, 2009. Loansclassified as held for investment and carried at amortized cost totaled $309.0million, less an allowance for loan losses of $28.6 million, as of June 30,2009. As of June 30, 2009, the Company held certain loans that settleinterest accruals by increasing the principal balance of the loan outstanding.For the three and six months ended June 30, 2009, the Company settledinterest receivables through increases to the loans’ outstanding principalbalance in the amount of $0.9 million and $1.9 million, respectively.

 

Loans held in DFR MM CLO consist partially of loanswhich are not broadly syndicated and are, therefore, less liquid. These loansare primarily considered to be held for investment and are reported atamortized cost with an allowance for loan losses, if necessary, unless theCompany decides to sell one of these loans, in which case the loan istransferred to loans held for sale.

 

Loans held in the Company’s alternative assetrevolving warehouse funding facility with Wachovia Capital Markets, LLC (the “WachoviaFacility”) and loans classified as other corporate leveraged loans consist ofloans that are not broadly syndicated and are, therefore, less liquid. Theseloans had historically been primarily considered to be held for investment andwere reported at amortized cost with an allowance for loan losses, ifnecessary, unless the Company decided to sell one of these loans, in which casethe loan was transferred to loans held for sale. During the year ended December 31,2008, the Company began actively seeking to sell all of the loans held in theWachovia Facility as the Company triggered an acknowledged termination eventthereunder on November 30, 2008. The Company sold a significant portion ofthe loans held within the Wachovia Facility during the year ended December 31,2008 and transferred all loans held within the Wachovia Facility to loans heldfor sale.  During the three months ended March 31, 2009, the Companysold loans held within the Wachovia Facility with a par value of $31.5 millionfor $10.8 million, net of interest of $0.2 million.  The Company realizeda loss of $6.2 million reported in net gain (loss) on loans held for investmentand loans held for sale in the condensed consolidated statements of operationsduring the three months ended March 31, 2009 as a result of thesesales.  The Company had no further sales of loans within the WachoviaFacility during the six months ended June 30, 2009.

 

In addition, during the year ended December 31,2008, the Company began to opportunistically sell the other corporate leveragedloans in connection with its strategy of increasing liquidity in the PrincipalInvesting segment and focusing on growing the Investment Management segment. Asa result, during the year ended December 31, 2008, the Company transferredall other corporate leveraged loans to loans held for sale.

 

As of June 30, 2009, the Company’s commercialreal estate loans consisted of four loans classified as held for investmenttotaling $9.3 million less an allowance for loan losses of$4.1 million. The Company did not recognize interest income on these loansfor the three and six months ended June 30, 2009.

 

The following summarizes the activity within theallowance for loan losses for the six months ended June 30, 2009 and 2008:

 
| ** **                                   | ** ** | **Allowance for Loan Losses** | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **2009**                      | ** ** | **2008** | ** ** |
| ** **                                   | ** ** | **(In thousands)**            | ** ** |
| Allowance for loan  losses at January 1 |       | $                             | 19,979     |   | $ | 5,300 |   |
| Provision for loan  losses                   |       | 11,226                        |       | 4,502 |   |
| Charge-offs                                  |       | (2,701                        | )          | (600 | ) |
| Recoveries                                   |       | 85                            |       | — |   |
| Transfers to loans held  for sale            |       | —                        |       | (1,319 | ) |
| Allowance for loan  losses at June 30   |       | $                             | 28,589     |   | $ | 7,883 |   |

 

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The Company recorded realized losses on loans held forsale and loans held for investment of $1.9 million and $7.1 million in net gain(loss) on loans on the condensed consolidated statements of operations for thethree and six months ended June 30, 2009, respectively.  The Companyrecorded realized losses on loans held for sale and loans held for investmentof $7.7 million and $12.6 million in net gain (loss) on loans on the condensedconsolidated statements of operations for the three and six months ended June 30,2008, respectively.  The Company recordedunrealized gains on loans held for sale of $26.8 million and $37.8 million innet gain (loss) on loans in the condensed consolidated statements of operationsfor the three and six months ended June 30, 2009, respectively.  The Company recorded unrealized gains onloans held for sale of $13.2 million and unrealized losses of $8.4 million innet gain (loss) on loans in the condensed consolidated statements of operationsfor the three and six months ended June 30, 2008, respectively.  Unrealized gains on loans held for saleinclude recoveries up to original cost or value on the date the loan wastransferred from loans held for investment to loans held for sale.

 

Prior to the Company’s sale of all of its preferenceshares in Market Square CLO on June 30, 2009, the Company consolidated allof the assets and liabilities of Market Square CLO.  Loans held in Market Square CLO primarilyconsisted of syndicated bank loans classified as held for sale.  During the three and six months ended June 30,2009, the Company recorded unrealized gains of $30.8 million and $45.2 million,respectively, and realized losses of $2.1 million and $2.1 million,respectively, on loans held in Market Square CLO in net gain (loss) on loans inthe condensed consolidated statements of operations.  During the three and six months ended June 30,2008, the Company recorded unrealized gains of $7.3 million and unrealizedlosses of $11.4 million, respectively, and realized losses of $1.5 million and$2.1 million, respectively, on loans held in Market Square CLO in net gain(loss) on loans in the condensed consolidated statements of operations.

 

The Company did not recognize $1.1 million and$2.0 million, respectively, of interest income earned, but not yet received, onloans held for investment for the three and six months ended June 30,2009. In addition, the Company did not recognize $1.9 million and $3.6million, respectively, of interest income earned, but not yet received, onloans held for sale for the three and six months ended June 30, 2009.

 

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

 

The Company seeks to manage a portion of its exposureto the effects of interest rate changes. Such exposure may arise from theissuance and forecasted rollover of short term liabilities or from liabilitieswith a contractual variable rate based on the London Interbank Offered Rate (“LIBOR”).As of June 30, 2009, the Company did not have any derivative instrumentsdesignated as hedging instruments, and all derivative instruments are carriedat fair value.

 

The following table is a summary of the Company’sderivative instruments as of June 30, 2009:

 
| ** **          | ** ** | ** ** | ** ** | **Notional**       | ** ** | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|---------------------|------------|------------|------------|--------------------|------------|------------|------------|-----------------|------------|-------------------|------------|
| ** **          | ** ** | **Count**  | ** ** | **Amount**         | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **          | ** ** | ** ** | ** ** | **(In thousands)** | ** ** |
| Interest rate swaps |       | 2          |       | $                  | 30,000     |       | $          | —          |       | $                 | 863        |   | $ | (863 | ) |
| Interest rate cap   |       | 1          |       | 40,000             |       | —     |       | 90              |       | (90               | )          |
| Warrants            |       | 3          |       | n/a                |       | 61         |       | —          |       | 61                |       |
|                |       | 6          |       | $                  | 70,000     |       | $          | 61              |       | $                 | 953        |   | $ | (892 | ) |

 

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n/a —not applicable

 

The following table is a summary of the net gain(loss) on derivatives included in the statements of operations:

 
| ** **                      | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                      | ** ** | **(In thousands)**                   | ** ** |
| Interest rate swaps             |       | $                                    | 2,939      |                               | $          | 4,688 |   | $ | 2,766 |   | $ | (214,551 | ) |
| Credit default swaps            |       | —                               |       | 211                                |       | (119 | ) | (1,934 | ) |
| Total return swaps              |       | —                               |       | 821                                |       | — |   | (404 | ) |
| Interest rate floors  and caps  |       | 1                                    |       | 43                                 |       | 1 |   | (513 | ) |
| Warrants                        |       | 41                                   |       | 307                                |       | (71 | ) | 257 |   |
| Net gain (loss) on  derivatives |       | $                                    | 2,981      |                               | $          | 6,070 |   | $ | 2,577 |   | $ | (217,145 | ) |

 

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***Interest Rate Swaps***

 

In general, when a fixed-rate or hybridadjustable-rate RMBS is funded by a short term borrowing, the Company may enterinto an interest rate swap agreement that effectively fixes a portion of theborrowing costs for a period close to the anticipated weighted-average life ofthe fixed-rate portion of the related RMBS. This strategy is designed toprotect a portion of the Company’s portfolio from increased funding costs dueto rising interest rates because the borrowing costs are not fixed for theduration of the fixed-rate period of the related RMBS. The Company did notenter into any interest rate swaps during the three and six months ended June 30,2009.  The Company terminated twointerest rate swaps with a notional value of $75.0 million and one interest rateswap with a notional value of $60.0 million matured during the three and sixmonths ended June 30, 2009.

 

The weighted average fixed rate payable on theinterest rate swaps as of June 30, 2009 was 4.07%.  The Company iscurrently in violation of substantially all of its International Swap DealersAssociation (“ISDA”) agreements with its interest rate swap counterparties.Each of these ISDA agreements contains an equity decline trigger that theCompany breached during the first quarter of 2008. This violation generallygives the counterparties the right to terminate the ISDA agreements and therelated interest rate swaps. The Company has notified its active counterpartiesof the breach, and none of those counterparties has expressed an intention toterminate the ISDA agreements. To date, the violations of the Company’s ISDAagreements have not had a material adverse effect on its operations.

 

As of January 1, 2008, in conjunction with theadoption of SFAS No. 159, the Company de-designated $3.8 billion(notional) of interest rate swaps previously designated as a hedge with a netnegative fair value of $85.9 million at de-designation, including accruedinterest. Prior to the de-designation, designated interest rate swaps werecarried at fair value with changes in value recorded directly into equitythrough other comprehensive loss, to the extent they were effective as a hedge,in accordance with the guidance under SFAS No. 133*, Accounting for Derivatives and Hedging Activities,*as amended and interpreted. As of the adoption date, the other comprehensiveloss related to the de-designation of interest rate hedges was$69.9 million. To the extent that the forecasted rolls on repurchaseagreement transactions continued as anticipated, the Company would have amortizedthis loss and the $27.3 million in other comprehensive loss related topreviously de-designated swaps from other comprehensive loss into interestexpense over the remaining original hedge period, and all future changes infair value of the interest rate swaps would be reflected in the consolidatedstatements of operations. However, due to the significant RMBS sales activityand corresponding repurchase agreement repayment during the three months ended March 31,2008, forecasted rolls on the repaid repurchase agreements did not continue asanticipated. As a result, a loss of $91.7 million was recognized duringthe three months ended March 31, 2008 in the consolidated statements ofoperations in net loss on derivatives, and a corresponding cumulative net lossrelating to newly and previously de-designated interest rate swaps in othercomprehensive loss was removed. The remaining $0.1 million in othercomprehensive loss related to the terminated and de-designated swaps as of June 30,2009 will be amortized over the remaining original hedge period. Additionally,the Company recorded a net increase to interest expense of $46,000 and $61,000during the three months ended June 30, 2009 and 2008, respectively, and anet increase to interest expense of $95,000 and $5.3 million during the sixmonths ended June 30, 2009 and 2008, respectively, related to theamortization of de-designated and terminated interest rate swaps.

 

***Interest Rate Cap***

 

The Company’s interest rate cap is structured suchthat the Company will receive payments based on the spread in rates, if thethree-month LIBOR rate increases above certain agreed upon contractual rate,and the Company will make payments based on a nominal fixed interestrate.  This interest rate cap was entered into to manage interest rateexposure in DFR MM CLO.

 

***Warrants***

 

The Company holds warrants to purchase shares ofcompanies with respect to which the Company is also a debt holder. Thesewarrants were issued in connection with renegotiations of the loan agreements.

 

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

 

Repurchase agreements are short term borrowings fromfinancial institutions that bear interest rates that have historically moved inclose relationship to the one-month, two-month or three-month LIBOR. As of June 30,2009, the Company had repurchase agreements outstanding in the amount of$294.5 million (including $83,000 of accrued interest). The repurchaseagreements had remaining maturities between 2 and 30 days and aweighted-average borrowing rate of 0.69%.

 

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As of June 30, 2009, the Company had amounts atrisk with the following repurchase agreement counterparties:

 
| ** **                                | ** ** | ** **             | ** ** | **Weighted-Average  Maturity of Repurchase** | ** ** |
|-------------------------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|
| ** **                                | ** ** | **Amount at Risk (1)** | ** ** | **Agreements**                                         | ** ** |
| ** **                                | ** ** | **(In thousands)**     | ** ** | **(In days)**                                          | ** ** |
| **Repurchase  Agreement Counterparties:** | ** ** | ** **             | ** ** | ** **                                             | ** ** |
| Deutsche Bank  Securities Inc.            |       | $                      | 5,461      |                                                   | 14         |   |
| Fortis Securities LLC                     |       | 9,890                  |       | 2                                                      |       |
| Total                                     |       | $                      | 15,351     |                                                   | 4          |   |

 

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(1)             Equal to the fair value of securities pledged, minusrepurchase agreement liabilities and related accrued interest payable.

 

During the three and six months ended June 30,2009, repurchase agreement liabilities declined by $24.2 million and $31.6million, respectively, as a result of RMBS principal paydowns and RMBS sales,which resulted in associated repayments of repurchase agreement liabilities.The Company’s repurchase agreement liabilities are significantly concentratedwith one counterparty that provides financing totaling 84.0% of the $294.5 millionof repurchase agreement liabilities as of June 30, 2009. See Note 9 foradditional discussion concerning securities received and pledged as collateral.

 

**9.****        ****SECURITIES RECEIVED AND PLEDGED ASCOLLATERAL**

 

To the extent that the Company receives collateral inconnection with derivative and repurchase agreement transactions, it isgenerally permitted to sell or repledge these securities. As of June 30,2009, the Company did not have any securities held as collateral.

 

The Company also pledges its own assets tocollateralize its repurchase agreements and in connection with derivativetransactions. These securities owned and pledged, where the counterparty hasthe right by contract or custom to sell or repledge the financial instruments,were approximately $309.3 million as of June 30, 2009 and consisted ofRMBS pledged as initial collateral on repurchase agreements. In addition, as ofJune 30, 2009, the Company had $1.2 million of cash with counterparties ascollateral on derivatives and $0.5 million of cash as additional collateral onrepurchase agreements, which is included in due from broker on the condensedconsolidated balance sheet.

 

**10.LONG TERM DEBT**

 

The following table summarizes the Company’s long termdebt as of June 30, 2009:

 
| ** **                             | ** ** | ** **         | ** ** | **Weighted** | ** ** |
|----------------------------------------|------------|--------------------|------------|--------------|------------|
| ** **                             | ** ** | **Carrying**       | ** ** | **Average**  | ** ** |
| ** **                             | ** ** | **Value**          | ** ** | **Rate**     | ** ** |
| ** **                             | ** ** | **(In thousands)** | ** ** | ** **   | ** ** |
| **Recourse:**                          | ** ** | ** **         | ** ** | ** **   | ** ** |
| Trust Preferred  Securities            |       | $                  | 123,717    |         | 3.81       | % |
| Series A and  Series B Notes |       | 72,042             |       | 6.21         | %          |
| Total Recourse                         |       | 195,759            |       | 4.69         | %          |
| **Non-Recourse:**                      |       |               |       |         |       |
| Wachovia Facility (1)                  |       | 771                |       | 2.81         | %          |
| DFR MM CLO (2)                         |       | 231,000            |       | 1.80         | %          |
| Total Non-Recourse                     |       | 231,771            |       | 1.80         | %          |
| Total long term debt                   |       | $                  | 427,530    |         | 3.13       | % |

 

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(1)             The Wachovia Facility was fully repaid subsequent to June 30,2009.

(2)             Excludes $19.0 million of DFR MM CLO debt that isowned by the Company and eliminated upon consolidation. Had this debt beenincluded, the weighted-average borrowing rate would be 2.05%.

 

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Recourse debt refers to debt that is a generalobligation of the Company.  Non-recourse debt refers to debt with recourseonly to specific assets pledged as collateral to the lenders, such as warehousefacilities and the debt issued by CDOs that are consolidated as VIEs. Thecreditors of the non-recourse debt have no recourse to the other assets of theCompany. None of the long term debt is subject to potential margin calls foradditional pledges of cash or assets.  The carrying value of the collateralof the entities which the non-recourse debt holders have recourse for therepayment of outstanding debt are $1.5 million and $288.2 million for theWachovia Facility and DFR MM CLO, respectively.

 

On May 8, 2009, the Company entered into a secondamended and restated forbearance agreement related to the Wachovia Facilityextending the period through which no action will be taken in respect of anyprior noncompliance with the covenant requiring the Company to maintainstockholders’ equity of at least $240.0 million as well as certain othercovenants under the Wachovia Facility through the earlier of July 7, 2009and the date of any breach of the forbearance agreement by the Company. The Wachovia Facility was fully repaid and all of the Company’s obligationsthereunder were satisfied subsequent to June 30, 2009.

 

On July 31, 2009, theCompany entered into three supplemental indentures with the holders of thetrust preferred securities issued by each of Deerfield Capital Trust I,Deerfield Capital Trust II and Deerfield Capital Trust III.  See Note 18 for additional disclosureregarding the supplemental indentures.

 

**11. STOCKHOLDERS’ EQUITY**

 

***Performance Shares***

 

During the three months ended June 30, 2009, theCompany granted 12,019 restricted stock units (the “Performance Shares”) toeach of the five non-employee directors of the Company’s board of directors(the “Board”) as a component of their compensation.  The Company recorded $250,000 in expensewithin other general and administrative expense on the condensed consolidatedincome statement during the three months ended June 30, 2009 related tothese grants.  Each of the PerformanceShares represents the right to receive one share of the Company’s common stockon May 19, 2012, subject to forfeiture and acceleration upon theoccurrence of certain specified events. The number of Performance Sharesgranted to each non-employee director is subject to adjustment for dividends orother distributions paid between June 11, 2009 and May 19, 2012 andmay also 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 the Company’s capitalization.

 

During 2008, the Company granted Performance Shares toeach of the five non-employee directors of the Board as a component of theircompensation and to certain of its employees as partial payment of their 2007bonus. Each of the Performance Shares represents the right to receive one shareof the Company’s common stock on March 3, 2011, subject to forfeiture andacceleration upon the occurrence of certain specified events. The number ofPerformance Shares granted to each non-employee director and employee issubject to adjustment for dividends or other distributions paid between March 3,2008 and March 3, 2011 and may also be adjusted, as determined by theBoard, in connection with any stock dividends, stock splits, subdivisions orconsolidations of shares (including reverse stock splits) or similar changes inthe Company’s capitalization.

 

The following table summarizes Performance Sharesactivity for the six months ended June 30, 2009:

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

 

***Restricted StockGrants***

 

During the three months ended March 31, 2009,vesting was accelerated on an additional 541 shares of common stock for anemployee terminated in 2009 as a result of the November 2008 Plan. SeeNote 15 for further information regarding the November 2008 Plan.  Inaddition, during the three months ended March 31, 2009, 541 shares ofcommon stock vested under the terms of the grant.  During the three monthsended June 30, 2009, an employee forfeited 108 shares of commonstock.   The unamortized amount of the share-basedpayments totaled $32,000 as of June 30, 2009, and is being recognized on astraight-line basis over the remaining vesting period as an expense tocompensation and benefits in the condensed consolidated statements ofoperations and an off-setting credit to additional paid-in capital.

 

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The following table summarizes changes in restrictedstock grants (number of shares) granted by Deerfield prior to the Merger andobtained as a result of the Merger for the six months ended June 30, 2009:

 
| ** **                          | ** ** | **Number of Shares** | ** ** |
|-------------------------------------|------------|----------------------|------------|
| Nonvested,  January 1, 2009    |       | 1,623                |       |
| Vested                              |       | (1,082               | )          |
| Forfeited                           |       | (108                 | )          |
| Nonvested as of  June 30, 2009 |       | 433                  |       |

 

***Unvested Warrants***

 

In connection with the formation of DPLC, the Companyissued to Pegasus Deerfield (AIV), LLC, an affiliate of Pegasus (“PegasusDeerfield”), (i) a five-year warrant to purchase 2,500,000 shares of theCompany’s common stock at an exercise price of $4.25 per share (“Warrant A”)and (ii) a five-year warrant to purchase 500,000 shares of the Company’scommon stock at an exercise price of $10.00 per share (“Warrant B” and,together with Warrant A, the “Warrants”).  The Warrants are subject tocertain vesting conditions, including that none of the Warrants vest prior to April 9,2011 and that the Warrants will vest only if Pegasus maintains a certainminimum investment in DPLC.  In addition, Pegasus will be required by acertain specified date to make an election to either retain the Warrants orreceive a share of the incentive allocations and investment advisory fees paidto the Company and DCM in respect of certain future investment funds and separatelymanaged accounts managed by DCM that invest primarily in syndicated bank loansto and bonds issued by non-investment grade borrowers.  In the event thatPegasus elects to receive these subsequent fund economics, they will forfeitthe Warrants.  Simultaneously with the execution of the Warrants, theCompany entered into a registration rights agreement, dated as of April 9,2009, with Pegasus Deerfield that provides registration rights with respect tothe shares of the Company’s common stock underlying the Warrants.  The Warrants have not yet vested, and ameasurement date has not yet been established because Pegasus Deerfield has notyet met the performance requirements and a sufficiently large disincentive fornonperformance of such requirements does not exist; therefore, no expenseassociated with the warrants has been recorded for the three and six monthsended June 30, 2009.

 

**12.          COMPUTATIONOF EARNINGS (LOSS) PER SHARE**

 

The following table presents the calculation of basicand diluted earnings (loss) per share:

 
| ** **                                                                             | ** ** | **Three months ended June 30,**      | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                             | ** ** | **2009**                                  | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                             | ** ** | **(In thousands, except per share data)** | ** ** |
|                                                                                   |       |                                      |       |                               |       |   |   |   |   |
| **Net  income (loss)**                                                                 |       | $                                         | 49,906     |                               | $          | 5,692 |   | $ | 61,445 |   | $ | (457,918 | ) |
| Less: Cumulative  convertible preferred stock dividends and accretion                  |       | —                                    |       | —                             |       | — |   | 2,393 |   |
| **Net  income (loss) attributable to common stockholders**                             |       | 49,906                                    |       | 5,692                              |       | 61,445 |   | (460,311 | ) |
| Net (income) loss  attributable to noncontrolling interest                             |       | 2,960                                     |       | —                             |       | 2,960 |   | — |   |
| **Net  income (loss) attributable to Deerfield Capital Corp.**                         |       | $                                         | 52,866     |                               | $          | 5,692 |   | $ | 64,405 |   | $ | (460,311 | ) |
|                                                                                   |       |                                      |       |                               |       |   |   |   |   |
| Weighted average shares  used in basic and diluted calculations                        |       | 6,731                                     |       | 6,882                              |       | 6,717 |   | 6,213 |   |
|                                                                                   |       |                                      |       |                               |       |   |   |   |   |
| **Net  income (loss) attributable to Deerfield Capital Corp.****per  share - basic**   |       | $                                         | 7.85       |                               | $          | 0.83 |   | $ | 9.59 |   | $ | (74.08 | ) |
|                                                                                   |       |                                      |       |                               |       |   |   |   |   |
| **Net  income (loss) attributable to Deerfield Capital Corp.****per  share - diluted** |       | $                                         | 7.85       |                               | $          | 0.83 |   | $ | 9.59 |   | $ | (74.08 | ) |

 

For the three and six months ended June 30, 2009,restricted stock grants for 433 shares of the Company’s common stock are notincluded in the calculation of diluted net income per share because theireffect was anti-dilutive under the treasury stock method.  For the three and six months ended June 30,2008, restricted stock grants for 6,429 shares of the Company’s common stockare not included in the calculation of diluted net income (loss) per sharebecause their effect was anti-dilutive under the treasury stock method. For thethree and six months ended June 30, 2009, Warrant A and Warrant B, issued inconnection with the formation of DPLC, are not included in the calculation ofdilutive net income (loss) per share because their effect was anti-dilutive.  For the six months ended June 30, 2008, the14,999,992 shares of Series A Preferred Stock (not adjusted to reflect the1-for-10 reverse stock split 

 

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effectedon October 16, 2008) are not included in calculation of diluted net lossper share because their effect was anti-dilutive. On March 11, 2008, the Series APreferred Stock converted into 14,999,992 shares of common stock (not adjustedto reflect the 1-for-10 reverse stock split effected on October 16, 2008),which are included in the calculation of basic earnings (loss) per share.

 

**13.          ACCUMULATEDOTHER COMPREHENSIVE LOSS**

 

The following is a summary of the components ofaccumulated other comprehensive loss:

 
| ** **                                   | ** ** | **For the six months ended June 30, 2009** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                   | ** ** | **Available-for-**                              | ** ** | **Cash Flow** | ** ** | **Foreign Currency** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Sale Securities**                             | ** ** | **Hedges** | ** ** | **Translation** | ** ** | **Total** | ** ** |
| ** **                                   | ** ** | **(In thousands)**                              | ** ** |
| Beginning balance -  January 1, 2009    |       | $                                               | (4,055     | ) | $ | (199 | ) | $ | (2 | ) | $ | (4,256 | ) |
| Unrealized net gain for  the period          |       | 1,452                                           |       | — |   | — |   | 1,452 |   |
| Deconsolidation of  Market Square CLO        |       | 2,603                                           |       | — |   | — |   | 2,603 |   |
| Foreign currency gain                        |       | —                                          |       | — |   | 57 |   | 57 |   |
| Reclassification  adjustments:               |       |                                            |       |   |   |   |   |   |   |
| Hedging amortization  recognized in earnings |       | —                                          |       | 95 |   | — |   | 95 |   |
| Ending balance -  June 30, 2009         |       | $                                               | —     |   | $ | (104 | ) | $ | 55 |   | $ | (49 | ) |

 

**14.          INCOMETAXES**

 

The Company has recorded deferred income taxes as of June 30,2009 in accordance with SFAS No. 109,*Accounting for Income Taxes*(“SFAS No. 109”). The Companyrecords deferred tax assets and liabilities for the future tax consequencesattributable to differences between the GAAP carrying amounts and theirrespective income tax bases.  As required by SFAS No. 109, DFRevaluated the likelihood of realizing tax benefits in future periods, whichrequires the recognition of a valuation allowance to reduce any deferred taxassets to an amount that is more likely than not to be realized.

 

As of June 30, 2009, the Company concluded that,due to the ongoing disruption and uncertainty in the credit markets, a fullvaluation allowance on the deferred tax asset would be recorded. Accordingly,as of June 30, 2009, the Company has recognized a gross deferred tax assetof $356.3 million, a deferred tax liability of $2.0 million and a valuationallowance for deferred tax assets in the amount of $354.3 million. As such, theCompany recognized no net deferred tax asset as of June 30, 2009. Infuture reporting periods, the Company will continue to reassess its ability torecognize additional deferred tax assets, which will impact the Company’srecorded income tax expense or benefit on the condensed consolidated statementof operations at that time.

 

As of June 30, 2009 the Company had a federal netoperating loss (“NOL”) of approximately $195.0 million, which will be availableto offset future taxable income, subject to the limitations described below. Ifnot used, this NOL will begin to expire in 2028. The Company also had netcapital losses (“NCLs”) in excess of capital gains of $416.7 million as of June 30,2009, which can be carried forward to offset future capital gains, subject tothe limitations described below. If not used, this carryforward will begin toexpire in 2012. No assurance can be provided that the Company will have futuretaxable income or future capital gains to benefit from its NOL and NCLcarryovers. In addition, the Company’s NOL and NCL carryovers may be limited bySections 382 and 383 of the Internal Revenue Code of 1986, as amended (the “Code”),if the Company undergoes an ownership change as defined in those sections (“OwnershipChange”).  Generally, there is an Ownership Change if, at any time, one ormore 5.0% shareholders (as defined in the Code) have aggregate increases intheir ownership of the Company of more than 50 percentage points looking backover the relevant testing period, which can occur as a result of acquisitionsand certain dispositions of common stock by the Company’s 5.0%shareholders.  If an Ownership Changeoccurs, the Company’s ability to use its NOLs, NCLs and certain recognizedbuilt-in losses to reduce its taxable income in a future year would generallybe limited to an annual amount (the “Section 382 Limitation”) equal to thefair value of the Company immediately prior to the Ownership Change multipliedby the “long term tax-exempt interest rate.” In the event of an OwnershipChange, NOLs and NCLs that exceed the Section 382 Limitation in any yearwill continue to be allowed as carryforwards for the remainder of thecarryforward period, and such NOLs and NCLs can be used to offset taxableincome for years within the carryforward period subject to the Section 382Limitation in each year. However, if the carryforward period for any NOL or NCLwere to expire before that loss is fully utilized, the unused portion of thatloss would be lost.

 

For the three and six months ended June 30, 2009,the Company recognized income tax expense of $0.2 million, primarily as aresult of differences in the calculation of alternative minimum taxable incomeversus regular taxable income.

 

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On May 19, 2009, the Company held an annualstockholders meeting (the “Annual Meeting”) at which the Company’s stockholdersapproved an amendment to the Company’s charter to restrict certain acquisitionsand dispositions of the Company’s securities and to remove references to theCompany’s operation as a REIT as one of the purposes of the Company (the “CharterAmendment”). The restrictions on acquisitions and dispositions of the Company’ssecurities contained in the Charter Amendment are intended to preserve thebenefit of the Company’s NOLs, NCLs and certain other tax attributes for taxpurposes. The Charter Amendment was filed with the Maryland State Department ofAssessments and Taxation on May 20, 2009.  In connection with the Charter Amendment, the Company’s stockholderrights plan that was adopted on March 11, 2009 automatically terminated.

 

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

 

If the Board determines that a transfer would beprohibited, then, upon the Company’s written demand, the purported transfereewill transfer the securities that are the subject of the prohibited transfer,or cause such securities to be transferred, to an agent designated by theBoard. The agent will sell the securities to a buyer or buyers, which mayinclude the Company, in one or more arm’s-length transactions that comply withthe Charter Amendment. If the purported transferee has resold the securitiesbefore receiving the Company’s demand to surrender them to the agent, thepurported transferee will be deemed to have sold the securities for the agentand will be required to transfer to the agent any distributions received withrespect to such securities and any proceeds of the sale of such securities(except for any proceeds which the Company grants the purported transfereewritten permission to retain and which do not exceed the amount that thepurported transferee would have received from the agent if the agent had resoldsuch securities). The proceeds of the sale of any such securities will beapplied first to the agent to cover its costs and expenses, second to thepurported transferee, up to the lesser of the amount paid by the purportedtransferee for the securities or the fair market value of the securities at thetime of the attempted transfer, and third to one or more charitableorganizations selected by the Board. In no event will the proceeds of the saleof such securities inure to the Company’s benefit.

 

**15.          COSTSAVINGS INITIATIVES**

 

On March 1, 2008, in response to the adversecredit markets the Company implemented an initial cost saving initiative (the “March 2008Plan”) and reduced the Company’s headcount by 13 employees, or approximately10% of the then current workforce, across a broad range of functions. Thisresulted in severance expense of $0.3 million during the three months ended March 31,2008. In November 2008, in response to the continued deterioration inmarket conditions, the Company implemented a second cost saving initiative (the“November 2008 Plan”). The November 2008 Plan involved reducingheadcount by 24 employees, or approximately 26% of the then current workforce,reducing bonus compensation and instituting a salary freeze. The compensationpayable to those 24 employees accounted for approximately 37% of the Company’sannual compensation expense in 2008. The November 2008 Plan headcountreductions were largely related to the fixed income arbitrage trading businessand the associated back-office infrastructure.

 

The following table provides a rollforward of theactivity included within the accrued and other liabilities line item in thecondensed consolidated balance sheets related to the March 2008 Plan andthe November 2008 Plan:

 
| ** **                      | ** ** | **Employee Severance   Accrual** | ** ** | **Exit Costs   Accrual** | ** ** | **Total** | ** ** |
|---------------------------------|------------|----------------------------------|------------|--------------------------|------------|-----------|------------|
| ** **                      | ** ** | **(In thousands)**               | ** ** |
| Balance -  January 1, 2009 |       | $                                | 1,083      |                     | $          | 175       |       | $ | 1,258 |   |
| Provisions                      |       | 183                              |       | 42                       |       | 225       |       |
| Payments                        |       | (1,228                           | )          | (129                     | )          | (1,357    | )          |
| Balance - June 30,  2009   |       | $                                | 38         |                     | $          | 88        |       | $ | 126 |   |

 

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**16.          SEGMENT REPORTING**

 

The Company operates in two reportable segments,Investment Management and Principal Investing. Management evaluates theperformance of each business unit based on segment results, expenses andrevenues. It is also important to understand when viewing segment results thatthey include direct and allocated expenses and revenues.

 

The following summarizes the financial informationconcerning the Company’s reportable segments (as described in Note 1):

 
| ** **                                                     | ** ** | **For the three months ended June 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                                | ** ** |
| ** **                                                     | ** ** | **Investment   Management**                       | ** ** | **Principal   Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                              |       |   |   |   |   |   |   |
| Interest income                                                |       | $                                                 | 16         |   | $ | 14,082 |   | $ | — |   | $ | 14,098 |   |
| Interest expense                                               |       | 1,314                                             |       | 4,352 |   | — |   | 5,666 |   |
| Net interest (expense)  income                                 |       | (1,298                                            | )          | 9,730 |   | — |   | 8,432 |   |
| Provision for loan  losses                                     |       | —                                            |       | 9,119 |   | — |   | 9,119 |   |
| Net interest (expense)  income after provision for loan losses |       | (1,298                                            | )          | 611 |   | — |   | (687 | ) |
| Investment advisory  fees                                      |       | 5,428                                             |       | — |   | (1,419 | )(1) | 4,009 |   |
| Total net revenues                                             |       | $                                                 | 4,130      |   | $ | 611 |   | $ | (1,419 | ) | $ | 3,322 |   |
| Depreciation and  amortization                                 |       | $                                                 | 1,629      |   | $ | — |   | $ | — |   | $ | 1,629 |   |
| Income tax expense                                             |       | $                                                 | 10         |   | $ | 150 |   | $ | — |   | $ | 160 |   |
| Net (loss) income                                              |       | $                                                 | (1,982     | ) | $ | 51,888 |   | $ | — |   | $ | 49,906 |   |

 
| ** **                                                     | ** ** | **For the three months ended June 30, 2008** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                                | ** ** |
| ** **                                                     | ** ** | **Investment   Management**                       | ** ** | **Principal   Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                              |       |   |   |   |   |   |   |
| Interest income                                                |       | $                                                 | 155        |   | $ | 21,669 |   | $ | — |   | $ | 21,824 |   |
| Interest expense                                               |       | 1,583                                             |       | 10,838 |   | — |   | 12,421 |   |
| Net interest (expense)  income                                 |       | (1,428                                            | )          | 10,831 |   | — |   | 9,403 |   |
| Provision for loan  losses                                     |       | —                                            |       | 2,302 |   | — |   | 2,302 |   |
| Net interest (expense)  income after provision for loan losses |       | (1,428                                            | )          | 8,529 |   | — |   | 7,101 |   |
| Investment advisory  fees                                      |       | 16,783                                            |       | — |   | (4,424 | )(1) | 12,359 |   |
| Total net revenues                                             |       | $                                                 | 15,355     |   | $ | 8,529 |   | $ | (4,424 | ) | $ | 19,460 |   |
| Depreciation and  amortization                                 |       | $                                                 | 2,580      |   | $ | — |   | $ | — |   | $ | 2,580 |   |
| Income tax expense                                             |       | $                                                 | 479        |   | $ | 2,389 |   | $ | — |   | $ | 2,868 |   |
| Net income                                                     |       | $                                                 | 728        |   | $ | 4,964 |   | $ | — |   | $ | 5,692 |   |

 
| ** **                                                     | ** ** | **For the six months ended June 30, 2009** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                     | ** ** | **(In thousands)**                              | ** ** |
| ** **                                                     | ** ** | **Investment  Management**                      | ** ** | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                            |       |   |   |   |   |   |   |
| Interest income                                                |       | $                                               | 62         |   | $ | 27,818 |   | $ | — |   | $ | 27,880 |   |
| Interest expense                                               |       | 2,658                                           |       | 10,007 |   | — |   | 12,665 |   |
| Net interest (expense)  income                                 |       | (2,596                                          | )          | 17,811 |   | — |   | 15,215 |   |
| Provision for loan  losses                                     |       | —                                          |       | 11,226 |   | — |   | 11,226 |   |
| Net interest (expense)  income after provision for loan losses |       | (2,596                                          | )          | 6,585 |   | — |   | 3,989 |   |
| Investment advisory  fees                                      |       | 11,629                                          |       | — |   | (2,883 | )(1) | 8,746 |   |
| Total net revenues                                             |       | $                                               | 9,033      |   | $ | 6,585 |   | $ | (2,883 | ) | $ | 12,735 |   |
| Depreciation and  amortization                                 |       | $                                               | 3,264      |   | $ | — |   | $ | — |   | $ | 3,264 |   |
| Income tax expense                                             |       | $                                               | 28         |   | $ | 150 |   | $ | — |   | $ | 178 |   |
| Net (loss) income                                              |       | $                                               | (3,905     | ) | $ | 65,350 |   | $ | — |   | $ | 61,445 |   |

 
| ** **          | ** ** | **As of June 30, 2009** | ** ** |
|---------------------|------------|------------------------------|------------|
| ** **          | ** ** | **(In thousands)**           | ** ** |
| Identifiable assets |       | $                            | 50,177     |   | $ | 686,834 |   | $ | (2,371 | )(2) | $ | 734,640 |   |
|                     |            |                              |            |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                                                     | ** ** | **For the six months ended June 30, 2008** | ** **    |
|----------------------------------------------------------------|------------|--------------------------------------------|---------------|
| ** **                                                     | ** ** | **(In thousands)**                         | ** **    |
| ** **                                                     | ** ** | **Investment  Management**                 | ** **    | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                           |       |                                       |          |   |   |   |   |   |   |
| Interest income                                                |       | $                                          |  497     |   | $ |  82,677 |   | $ |  — |   | $ |  83,174 |   |
| Interest expense                                               |       | 3,554                                      |          | 56,467 |   | — |   | 60,021 |   |
| Net interest (expense)  income                                 |       | (3,057                                     | )             | 26,210 |   | — |   | 23,153 |   |
| Provision for loan  losses                                     |       | —                                     |          | 4,502 |   | — |   | 4,502 |   |
| Net interest (expense)  income after provision for loan losses |       | (3,057                                     | )             | 21,708 |   | — |   | 18,651 |   |
| Investment advisory  fees                                      |       | 32,860                                     |          | — |   | (8,382 | )(1) | 24,478 |   |
| Total net revenues                                             |       | $                                          |  29,803  |   | $ |  21,708 |   | $ |  (8,382 | ) | $ |  43,129 |   |
| Depreciation and  amortization                                 |       | $                                          |  5,267   |   | $ |  — |   | $ |  — |   | $ |  5,267 |   |
| Income tax (benefit)  expense                                  |       | $                                          |  (8,191  | ) | $ |  3,857 |   | $ |  — |   | $ |  (4,334 | ) |
| Net loss                                                       |       | $                                          |  (20,046 | ) | $ |  (437,872 | ) | $ |  — |   | $ |  (457,918 | ) |

 
| ** **          | ** ** | **As of June 30, 2008** | ** **    |
|---------------------|------------|-------------------------|---------------|
| ** **          | ** ** | **(In thousands)**      | ** **    |
| Identifiable assets |       | $                       |  197,246 |   | $ |  2,239,542 |   | $ |  (2,087 | )(2) | $ |  2,434,701 |   |
|                     |            |                         |               |  |  |  |  |  |  |  |  |  |  |

 

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

 

The Principal Investingsegment financial information presented above includes the financial results ofDFR MM CLO as of and for the three and six months ended June 30, 2009 and2008, Market Square CLO for the three and six months ended June 30, 2009and as of June 30, 2008 and DPLC as of and for the three and six monthsended June 30, 2009.

 

**17.  COMMITMENTS AND CONTINGENCIES**

 

***Legal Proceedings***

 

As previously reported, the SEC is conducting aninvestigation relating to certain practices associated with the offer, purchaseor sale of collateralized mortgage obligations and real estate mortgageinvestment conduits (“REMICs”) and the creation of re-REMICs. The investigationconcerns certain mortgage securities transactions effected by DCM for theCompany in 2005 and 2006. The Company cannot predict the outcome of thisinvestigation.

 

In the ordinary course of business, the Company may besubject to legal and regulatory proceedings that are generally incidental toits ongoing operations. While there can be no assurance of the ultimatedisposition of such proceedings, the Company does not believe their dispositionwill have a material adverse effect on the Company’s condensed consolidatedfinancial statements.

 

***2009 Interim Chairman Compensation Agreement***

 

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

 

***Resolution ofNotice of Non-Compliance with NYSE Amex Continued Listing Standard***

 

On April 15, 2009, the Company was notified bythe NYSE Amex LLC (the “NYSE Amex”), that it was not in compliance with a NYSEAmex continued listing standard applicable to its common stock. On June 29,2009, the Company received notification from the NYSE Amex that the Company hadresolved the continued listing deficiency referenced in the NYSE Amex’s letterdated April 15, 2009.  The Company’sbelieves DFR’s listing is currently in good standing with the NYSE Amex.

 

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***Other Commitments***

 

The Company had unfunded investment commitments onbank loans of $7.0 million as of June 30, 2009. The timing and amount ofadditional funding on these bank loans are at the discretion of the borrower,to the extent the borrower satisfies certain requirements in the loandocumentation.  Additionally, the Companyhas a remaining unfunded commitment of $11.0 million to DPLC, which is subjectto numerous conditions, any or all of which may not be satisfied.

 

**18.  SUBSEQUENT EVENTS**

 

In connection with the preparation of the condensedconsolidated financial statements and in accordance with the recently issuedSFAS No. 165, the Company evaluated subsequent events after the balancesheet date of June 30, 2009 through August 10, 2009, the date ofissuance of the financial statements.

 

On July 31, 2009,the Company entered into the three supplemental indentures (the “SupplementalIndentures”) with the holders of the trust preferred securities issued by eachof Deerfield Capital Trust I, Deerfield Capital Trust II and Deerfield CapitalTrust III (collectively, the “Trust Preferred Securities”).  The Supplemental Indentures amend theconsolidated net worth covenants (the “Net Worth Covenants”) contained in theindentures governing the Trust Preferred Securities to (i) permanentlydecrease the net worth required by the Net Worth Covenants from $175 million to$50 million and (ii) provide that the initial measurement date forcompliance with the Net Worth Covenants will be September 30, 2012.  In addition, the Supplemental Indenturescontain provisions prohibiting the Company from (i) incurring additionalindebtedness for the life of the Trust Preferred Securities, except forindebtedness permitted to be incurred in accordance with provisions that aresubstantially similar to the provisions of the agreements governing the Series ASenior Secured Notes and Series B Senior Secured Notes issued inconnection with the Merger (the “Series A and Series B Notes”) and (ii) declaringadditional dividends or distributions on its capital stock for the life of theTrust Preferred Securities, except as permitted in accordance with provisionsthat are substantially similar to the provisions of the agreements governingthe Series A and Series B Notes. The Supplemental Indentures also provide the representative of theholders of the Trust Preferred Securities with certain inspection rights.  The Supplemental Indentures supersede thetemporary waiver of the Net Worth Covenants obtained from the holders of theTrust Preferred Securities in 2008.  TheCompany paid the holders of the Trust Preferred Securities a fee of $250,000 onJuly 31, 2009 and committed to pay such holders an additional fee of$250,000 on or before July 31, 2010 in connection with the SupplementalIndentures.

 

The Wachovia Facility wasfully repaid and all of the Company’s obligations thereunder were satisfiedsubsequent to June 30, 2009.

 

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

 

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

 

**Overview**

 

We are a Maryland corporation with an InvestmentManagement segment that manages approximately $9.9 billion of client assets($311.9 million of which is also included in our Principal Investingportfolio), as of July 1, 2009, including bank loans and other corporatedebt, residential mortgage-backed securities, or RMBS, government securitiesand asset-backed securities, or ABS. In addition, our Principal Investingsegment has an investment portfolio of approximately $612.9 million as of June 30,2009, comprised of fixed income investments, including bank loans and othercorporate debt and RMBS. Historically, we had elected to be taxed as a realestate investment trust, or REIT. However, our status as a REIT terminated in2008 when we converted to a C corporation to maximize the use of potentialsignificant tax benefits and provide more flexibility with respect to futurecapital investment.

 

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

 

After the close of business on October 16, 2008,we effected a 1-for-10 reverse stock split of our common stock. All share andper share amounts throughout this Quarterly Report have been retroactivelyrestated to reflect the reverse stock split, unless otherwise noted.

 

On April 14, 2009, we announced the formation ofDeerfield Pegasus Loan Capital LP, or DPLC, our investment venture with PegasusCapital Advisors L.P., or Pegasus.  Pegasus is a U.S. based private equityfirm.  Pegasus and DFR have committed to invest $75.0 million and $15.0million, respectively, in DPLC with such amounts to be invested primarily incorporate bank loans and other senior secured corporate loans.  DPLC ismanaged by DCM.  The commitments of each of Pegasus and DFR are subject tonumerous conditions, any or all of which may not be satisfied.  As of June 30, 2009, Pegasus and DFRhave funded $20.0 million and $4.0 million, respectively, of such commitments.

 

In connection with the formation of DPLC, we issued toPegasus Deerfield (AIV), LLC, an affiliate of Pegasus, or Pegasus Deerfield, (i) afive-year warrant to purchase 2,500,000 shares of our common stock at anexercise price of $4.25 per share, or Warrant A, and (ii) a five-yearwarrant to purchase 500,000 shares of our common stock at an exercise price of$10.00 per share, or Warrant B and, together with Warrant A, theWarrants. The Warrants are subject to certain vesting conditions includingthat none of the Warrants vest prior to April 9, 2011 and that theWarrants vest only if Pegasus maintains a certain minimum investment in DPLC.In addition, Pegasus will be required by a certain specified date to make anelection to either retain the Warrants or receive a share of the incentiveallocations and investment advisory fees paid to us and DCM in respect ofcertain future investment funds and separately managed accounts managed by DCMthat invest primarily in syndicated bank loans to and bonds issued bynon-investment grade borrowers.  In the event that Pegasus elects toreceive these subsequent fund economics, it will forfeit the Warrants.Simultaneously with the execution of the Warrants, we entered into aregistration rights agreement, dated as of April 9, 2009, with PegasusDeerfield that provides registration rights with respect to the shares of ourcommon stock underlying the Warrants. The Warrants have not yet vested, and no expense associated with thewarrants has been recorded for the three and six months ended June 30,2009.

 

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As of June 30, 2009 and for the three and sixmonths ended June 30, 2009 and 2008, we consolidated DFR Middle Market CLOLtd., or DFR MM CLO, as we are deemed to be the primary beneficiary of thisvariable interest entity, or VIE.  Wealso consolidated Market Square CLO Ltd., or Market Square CLO, as of December 31,2008 and for the three and six months ended June 30, 2009 and 2008.  On June 30, 2009, we sold all of ourpreference shares in Market Square CLO to an unrelated third party in exchangefor an upfront payment and a delayed purchase price in the form of a right toreceive a portion of the future distributions, if any, on the preferenceshares.  As a result of the sale, wedetermined we are no longer the primary beneficiary of Market Square CLO andtherefore deconsolidated Market Square CLO.  We are, however, deemed to retaina beneficial interest in the preference shares of Market Square CLO as a resultof the delayed purchase price.  The carrying value of the beneficialinterest was de minimis as of June 30, 2009.  As of June 30, 2009, none of the MarketSquare CLO assets, liabilities or equity are included in our condensedconsolidated balance sheet; however, all of the financial impacts to ourcondensed consolidated statement of operations from our previous consolidationof Market Square CLO were recognized through June 30, 2009.  We recognized a gain on the deconsolidationof Market Square CLO of $29.6 million in our condensed consolidated statementof operations for the three and six months ended June 30, 2009.

 

During the three months ended June 30, 2009, wealso consolidated DPLC as a result of our controlling interest therein pursuantto the consolidation guidance in Statement of Financial Accounting Standards,or SFAS, No. 160, *Noncontrolling Interestsin Consolidated Financial Statements — an amendment of ARB No. 51*,or SFAS No. 160.  We consolidated 100% of the assets and liabilitiesof DPLC and the general partner of DPLC, DPLC General Partner LLC, or DPLC GP,through which we made our investment in DPLC.  We have a controllingfinancial interest in DPLC and DPLC GP as a result of our owning more than 50%of the outstanding voting interest in DPLC GP.  Although we consolidate100% of the assets and liabilities and the results of operations of DPLC andDPLC GP, our maximum exposure to loss on our investment in these entities islimited to our investment in DPLC GP, which as of June 30, 2009 totaled$3.9 million. Net income (loss) attributable to DFR excludes the net lossattributable to noncontrolling interest.  We consolidated assets of$22.8 million and liabilities of $2.4 million related to DPLC as of June 30,2009.

 

***Our Business***

 

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

 

*InvestmentManagement Segment*

 

Our Investment Management segment is operated throughDCM. DCM manages investment accounts for various types of clients, includingseparately managed accounts (separate, non-pooled accounts established byclients), CDOs and other investment vehicles. Except for the separately managedaccounts, these clients are collective investment vehicles that pool thecapital contributions of multiple investors, which are typically financialinstitutions, such as insurance companies and banks, employee benefits plansand “funds of funds” (investment funds that in turn allocate their assets to avariety of other investment funds). Our teams that manage these accounts aresupported by various other groups within DCM, such as risk management, systems,accounting, operations and legal. DCM enters into an investment managementagreement with each client, pursuant to which the client grants DCM discretionto purchase and sell securities and other financial instruments.

 

Our primary source of revenue from our InvestmentManagement segment is the investment advisory fees paid by the accounts wemanage. These fees typically consist of management fees based on the account’sassets and, in some cases, performance fees based on the profits we generatefor the account.

 

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*Assets Under Management*

 

As of July 1, 2009, DCM’s total assets undermanagement, or AUM, was approximately $9.9 billion held in 28 CDOs, one otherinvestment vehicle and six separately managed accounts.

 

The following table summarizes the AUM for each of ourproduct categories:

 
| ** **                       | ** ** | **Number of** | ** ** | **AUM as of**         | ** **      |
|----------------------------------|------------|---------------|------------|-----------------------|-----------------|
| ** **                       | ** ** | **Accounts**  | ** ** | **July 1, 2009** | ** **      |
| ** **                       | ** ** | ** **    | ** ** | **(In thousands)**    | ** **      |
| CDOs (1)                         |       |          |       |                  |            |
| CLOs                             |       | 12            |       | $                     |  4,098,226 |   |
| Asset-backed securities          |       | 12            |       | 4,561,067             |            |
| Corporate bonds                  |       | 4             |       | 855,050               |            |
| Total CDOs                       |       | 28            |       | 9,514,343             |            |
| Other investment  vehicle (2)    |       | 1             |       | 22,106                |            |
| Separately managed accounts  (3) |       | 6             |       | 322,928               |            |
| Total AUM (4)                    |       |          |       | $                     |  9,859,377 |   |

 

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| (1) | CDO AUM numbers generally reflect the aggregate principal or notional  balance of the collateral and, in some cases, the cash balance held by the  CDOs and are as of the date of the last trustee report received for each CDO  prior to July 1, 2009. The AUM for our Euro-denominated CDOs has been  converted into U.S. dollars using the spot rate of exchange on June 30,  2009.                                                                                                                                                                                                                  |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Other investment vehicle AUM represents the AUM of DPLC.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (3) | AUM for certain of the separately managed accounts is a multiple of  the capital actually invested in such account. Management fees for these  accounts are paid on this higher AUM amount.                                                                                                                                                                                                                                                                                                                                                                                                                       |
| (4) | Included in Total AUM are $289.8 million and $22.1  million related to DFR MM CLO and DPLC, respectively, for July 1, 2009,  which amounts are also included in the total AUM reported for the Principal  Investing portfolio as of June 30, 2009. DCM manages DFR MM CLO but is  not contractually entitled to receive any management fees so long as 100% of  the equity is held by DC LLC or an affiliate thereof.   DCM manages DPLC and receives management  fees for its services.  All other  amounts included in the Principal Investing portfolio are excluded from Total  AUM. |

 

*Principal Investing Segment*

 

Income from our Principal Investing segment isinfluenced by four factors: (i) the net spread, or difference, between theinterest income we earn on our investment portfolio and the cost of ourborrowings included in (ii) as gain/loss, (ii) the recognized gainsand losses on our investment portfolio, (iii) provision for loan losses,if any, and (iv) the volume or aggregate amount of such investments. Ournet interest income will vary based upon, among other things, the differencebetween the interest rates earned on our interest-earning investments, theborrowing costs of the liabilities used to finance those investments and thevolume of such investments. We use leverage to seek to enhance our returns,which can also magnify losses. The cost of borrowings to finance ourinvestments comprises a significant portion of our operating expenses.

 

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

 
| ** **                                   | ** ** | **June 30, 2009** | ** **    |
|----------------------------------------------|------------|------------------------|---------------|
| ** **                                   | ** ** | **Carrying**           | ** **    | **% of Total** | ** ** |
| **Principal Investments**                    | ** ** | **Value**              | ** **    | **Investments** | ** ** |
| ** **                                   | ** ** | **(In thousands)**     | ** **    | ** ** | ** ** |
| ** **                                   |       |                   |          |   |   |
| RMBS                                         |       | $                      |  311,154 |   | 48.5 | % |
| Corporate leveraged  loans:                  |       |                   |          |   |   |
| Loans held in DFR MM  CLO                    |       | 299,751                |          | 46.7 | % |
| Loans held in the  Wachovia Facility         |       | 1,251                  |          | 0.2 | % |
| Other corporate  leveraged loans             |       | 8,112                  |          | 1.3 | % |
| Loans held in DPLC                           |       | 6,841                  |          | 1.1 | % |
| Commercial real estate  loans and securities |       | 9,270                  |          | 1.4 | % |
| Equity securities                            |       | 4,780                  |          | 0.7 | % |
| Other investments                            |       | 315                    |          | 0.1 | % |
| **Total  Investments**                       |       | 641,474                |          | 100.0 | % |
| Allowance for loan  losses                   |       | (28,589                | )             |   |   |
| **Net  Investments**                         |       | $                      |  612,885 |   |   |   |

 

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**Our Strategy**

 

We are focused on growing the Investment Managementsegment of our business by launching new investment products that willdiversify our revenue streams and take advantage of our core competencies ofcredit analysis and asset management. We intend to make investments in certainof these new investment products. We believe that the growth of fee-basedincome through the management of alternative investment products will providethe most attractive risk-adjusted return on capital.  On April 14,2009, we announced DPLC, our investment venture with Pegasus.  Pegasus andDFR have committed to invest $75.0 million and $15.0 million, respectively, inDPLC with such amounts to be invested primarily in corporate bank loans andother senior secured corporate loans that DFR and Pegasus believe are priced atattractive levels.  DPLC is managed by DCM.  The commitments of eachof Pegasus and DFR are subject to numerous conditions, any or all of which maynot be satisfied.

 

On July 17, 2008, we acquired the managementcontract for Robeco CDO II Limited, or Robeco CDO, a CDO collateralizedprimarily by high-yield corporate bonds. On February 11, 2009, we assumedthe management contract for Mayfair Euro CDO I B.V., or Mayfair Euro CDO, aEuro-denominated CDO collateralized primarily by investment grade andhigh-yield corporate bonds. These actions were in line with our previously announcedstrategy to acquire or assume CDO management contracts from other investmentmanagers, and we are continuing to pursue the acquisition or assumption ofadditional management contracts.

 

We are focused on managing our Principal Investingsegment by opportunistically selling Corporate Loans held outside of DFR MM CLOLtd., or DFR MM CLO, and redeploying our capital into other fee-basedstrategies. In the near term, we expect to continue to hold our RMBS portfolioboth for the net interest income it provides and as a source of liquidity.

 

Additionally, we continue to explore strategicopportunities in order to maximize value for our stockholders.

 

**Charter Amendment**

 

On May 19, 2009, we held an annual stockholdersmeeting, or the Annual Meeting, at which our stockholders approved an amendmentto our charter to restrict certain acquisitions and dispositions of oursecurities and to remove references to our operation as a REIT as one of ourpurposes, or the Charter Amendment. The restrictions on acquisitions anddispositions of our securities contained in the Charter Amendment are intendedto preserve the benefit of our federal net operating losses, or NOLs, netcapital losses, or NCLs and certain other tax attributes for tax purposes. TheCharter Amendment was filed with the Maryland State Department of Assessmentsand Taxation on May 20, 2009.   Inconnection with the Charter Amendment, our stockholder rights plan that wasadopted on March 11, 2009 automatically terminated.

 

The Charter Amendment is designed to prevent anownership change, or and Ownership Change, as defined in Sections 382 and 383of the Internal Revenue Code of 1986, as amended, or the Code.  Sections 382 and 383 of the Code imposesignificant limitations on the ability of a corporation to use its NOLs, andNCLs to offset income in circumstances where such corporation has experiencedan Ownership Change, and may also limit a corporation’s ability to use anybuilt-in losses recognized within five years of any Ownership Change.Generally, there is an Ownership Change if, at any time, one or more 5.0%shareholders (as defined in the Code) have aggregate increases in theirownership of DFR of more than 50 percentage points looking back over therelevant testing period, which can occur as a result of acquisitions andcertain dispositions of common stock by our 5.0% shareholders.

 

The Charter Amendment generally prohibits any director indirect sale, transfer, assignment, exchange, issuance, grant, redemption,repurchase, conveyance, pledge or other disposition of shares of our commonstock or rights or options to purchase our common stock or any other intereststhat would be treated as stock under the income tax regulations promulgatedunder the Code, if as a result of such sale, transfer, assignment, exchange,issuance, grant, redemption, repurchase, conveyance, pledge or otherdisposition, any person or group becomes a 5% shareholder (as defined in theCode), which generally includes a person or group that beneficially owns 5% ormore of the market value of the total outstanding shares of our common stock,or the percentage of our common stock owned by a 5% shareholder (as defined inthe Code) would be increased. As a result of these restrictions, certaintransfers of stock by existing 5% shareholders are prohibited. In addition toother exceptions, a person will not be treated as violating the CharterAmendment as a result of acquiring shares of stock, directly or indirectly, asa result of the issuance of a warrant, the exercise thereof or the transfer oracquisition of such warrant or stock acquired thereby, where such warrant hadfirst been issued upon approval of our Board of Directors, or Board, unless anduntil the person to whom such warrant was issued thereafter acquires any stockthat is unrelated to the warrant. Our Board has granted limited exemptions tothe Charter Amendment as disclosed in our Current Report on Form 8-K filedwith the SEC on May 19, 2009.

 

If our Board determines that a transfer would beprohibited, then, upon our written demand, the purported transferee willtransfer the securities that are the subject of the prohibited transfer, orcause such securities to be transferred, to an agent designated by our Board.The agent will sell the securities to a buyer or buyers, which may include us,in one or more arm’s-length transactions that comply with the CharterAmendment. If the purported transferee has resold the securities beforereceiving our demand to surrender

 

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themto the agent, the purported transferee will be deemed to have sold thesecurities for the agent and will be required to transfer to the agent anydistributions received with respect to such securities and any proceeds of thesale of such securities (except for any proceeds which we grant the purportedtransferee written permission to retain and which do not exceed the amount thatthe purported transferee would have received from the agent if the agent hadresold such securities). The proceeds of the sale of any such securities willbe applied first to the agent to cover its costs and expenses, second to thepurported transferee, up to the lesser of the amount paid by the purportedtransferee for the securities or the fair market value of the securities at thetime of the attempted transfer, and third to one or more charitableorganizations selected by our Board. In no event will the proceeds of the saleof such securities inure to our benefit.

 

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

 

On April 15, 2009, we were notified by the NYSEAmex LLC, or the NYSE Amex, that we were not in compliance with a NYSE Amexcontinued listing standard applicable to our common stock. On June 29,2009, we received notification from the NYSE Amex that we had resolved thecontinued listing deficiency referenced in the NYSE Amex’s letter dated April 15,2009.  We believe our listing iscurrently in good standing with the NYSE Amex.

 

**Trends**

 

The following trends that we have observed and believeto exist may also affect our business:

 

*Credit market dislocation.*  The well-publicized disruptions inthe financial markets that began in 2007 and escalated throughout 2008 havecontinued into 2009.   Responding to thedisruptions, the U.S. government has implemented numerous programs aimed atstabilizing credit markets and improving overall financial system liquidity.   Among the actions announced or implementedduring the first six months of 2009 were the Legacy Loan Program, the TermAsset Backed Securities Loan Facility, the Home Affordability and StabilityPlan programs and open market purchases of up to $300 billion in long maturitytreasury bonds and $500 billion in mortgage securities issued by Fannie Mae andFreddie Mac.   Estimates of thecumulative amount spent or committed to date under the major programs designedto address the current market disruptions exceeds $5 trillion.  We believe the actions taken by the U.S. government,and other coordinated global actions have thus far been effective in preventingfurther deterioration in financial markets and the economy.  We cannot predict the effect that theseprograms will have on financial markets or our business over the longer term.

 

*Liquidity.*  A significant portion of theinvestments in our Principal Investing portfolio are financed.  We depend on a variety of financialinstitutions to provide that financing. Historically, we have financed our RMBS portfolio using repurchaseagreements. Events in 2008 caused many financial institutions to change theircredit standards and generally reduced the amount of repurchase agreementsavailable to borrowers, resulting in a decrease in overall market liquidity.This trend has reduced the number of financial institutions with which weconduct repurchase financings and, in 2008, prompted us to sell a significantportion of our RMBS portfolio at a time when we would not otherwise have chosento do so. Prompted in part by the impact of the government actions noted above,we believe some additional capacity in repurchase financing is now returning tothe market.  However, if our currentlenders are unwilling or unable to provide us with continued financing and wecan not secure financing elsewhere, we could be forced to sell a large portionof our RMBS portfolio at an inopportune time or on unfavorable terms. In theevent of such a sale, because the majority of our current RMBS portfolioconsists of Agency RMBS, we believe that we are better positioned to convertour investment securities to cash or to negotiate an extended borrowing termshould our lenders reduce the amount of the financing available to us.

 

*Corporate credit performance.*  Corporate default rates haveincreased over the past year as the U.S. economy weakened and financial marketsdeteriorated. More recently, stock prices have risen, and corporate earningsreports for many companies point to improving economic conditions.  Although there may be some further cyclicalincrease in corporate defaults over the coming months, we expect the stimulusprograms and improving economic conditions to begin moderating the pace of suchdefaults.  If the stimulus packages arenot effective in promoting growth, it is possible that recent signs ofimprovement will give way to renewed economic weakness.  A further weakening of the U.S. economy wouldlikely result in further increases in corporate default rates. Such an increasewould likely further reduce the returns associated with certain of ourinvestments, particularly the Corporate Loans held in both our PrincipalInvesting portfolio and in certain of the vehicles managed within ourInvestment Management segment. Increases in defaults could also cause us totrigger certain structural provisions in the CDOs that we own and manage. Thesestructural provisions include, but are not limited to, overcollateralizationrequirements that are meant to protect investors from deterioration in thecredit quality of the underlying collateral pool.

 

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*Credit spreads.*  Beginning in the second half of2007, credit markets experienced significantly higher yields and wider spreadsversus Treasury securities.  For example,the yield spread on the Barclay’s High Yield Bond Index increased from 295basis points over Treasuries at June 30, 2007 to a peak of 1830 basispoints in November of 2008.  Thewidening of credit spreads evidenced by that index was pervasive and resultedin a decline over that period in the fair value for most of our investments andin the securities we manage, which resulted in a decline in our book value anda reduction in our AUM. More recently, credit spreads have narrowed somewhat asevidenced by the spread on the Barclay’s High Yield Bond Index falling to 945basis points as of June 30, 2009. This narrowing of spreads has had a positive influence on the value ofmany of our investments, but may also have the effect of reducing the futureattractiveness of such investments and reducing future net interest income.

 

*Yield Curve.* The difference in yields offered on similarsecurities of different maturity (commonly referred to as the yield curve) canhave an important influence on our financial results.  Our earnings are in part derived from therate difference between the cost of our funding sources (such as repurchaseagreements) and the earning rate of the assets purchased (such as RMBS).  To the extent that there is a mismatch in thematurity of our funding sources in relation to the assets purchased, we mayhave exposure to a change in the shape of the yield curve.  Historically, we attempted to limit ourexposure to this risk by engaging in various types of hedging activities suchas the use of interest rate swaps.   Dueto current market conditions and the historically large differential betweenshort term and intermediate term yields, we are now operating with a largerduration gap and have reduced our hedging activities.  This decision has had the near-term effect ofincreasing the net interest income on our RMBS portfolio.  However, if short term yields rise inrelation to intermediate term yields (a flattening of the yield curve), wewould likely experience a reduction in net interest income.

 

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

 

We anticipate that, given current market conditions,it will be significantly more difficult to create new CDOs in the near termthan it has been in the past. Conditions in the credit markets have led tobanks charging higher fees to warehouse collateral for the CDOs prior to theirclosing and potential investors demanding significantly higher interest rateson CDO liabilities. To the extent that we are successful in creating new CDOs,the management fees we earn from managing those CDOs may be significantlylower. This may negatively affect our ability to grow our AUM and revenue.

 

During 2008, the CDO management market experiencedsome consolidation, evidenced by CDO management contracts being transferred toor acquired by other investment managers. On July 17, 2008, we acquiredthe management contract for Robeco CDO, and, on February 11, 2009, weassumed the management contract for Mayfair Euro CDO. We expect this consolidationtrend to continue in the near term, and we continue to pursue the acquisitionand assumption of additional management contracts.

 

*Market Environment.*  In response to a rapidlydeteriorating economic and credit environment, the Federal Reserve lowered thetargeted Federal Funds rate from 4.25% to 0.25% during 2008. As a result, theyield curve steepened, with the yield on the three-month U.S. Treasurybill decreasing by 316 basis points, while the yield on the five-yearU.S. Treasury note decreased by only 189 basis points.  Duringthe first six months of 2009, the shape of the yield curve steepened furtherwith short yields remaining relatively stable but yields on intermediatematurities experiencing marked increases. During this period, the yield on the three-month U.S. Treasury billincreased from 11 basis points to a yield of 19 basis points, while the yieldon the five-year U.S. Treasury note increased by 100 basis points, from 1.55%to a yield of 2.54%. The increase in the spread between short and longermaturities generally results in an increase in our net interest income on ourRMBS, as the financing of our RMBS is usually shorter in term than the fixedrate period of our RMBS, which is heavily weighted towards hybrid adjustablerate RMBS. Conversely, if the curve spread narrows or inverts, our net interestincome would likely decrease.

 

*Valuation of investments.*  Fewer financing options andtighter lending standards had the wide-spread effect of forcing investors tooffer for sale a significant amount of investment assets under distressedmarket circumstances. This increase in investment assets for sale, togetherwith investors’ diminished confidence in their ability to assess the quality ofcredit-sensitive investments, caused significant price volatility in previouslystable asset classes. As a result, the valuation process for certain types ofinvestments has become more uncertain and subjective, and prices obtainedthrough such process may not necessarily represent what we would receive in anactual sale of a given investment.

 

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**Critical Accounting Policies**

 

Our financial statements are prepared in accordancewith accounting principles generally accepted in the United States of America,or GAAP. These accounting principles require us to make some complex andsubjective decisions and assessments. Our most critical accounting policiesinvolve decisions and assessments that could affect our reported assets andliabilities, as well as our reported revenues and expenses. We believe that allof the decisions and assessments inherent in our financial statements werereasonable, based upon information available to us. We rely on management’sexperience and analysis of historical and current market data in order toarrive at what we believe to be reasonable estimates. Under varying conditions,we could report materially different amounts arising under these criticalaccounting policies.  We believe that the critical accounting policiesupon which our financial condition and results of operation depend, and whichinvolve the most complex subjective decisions or assessments, are included inthe discussion entitled “Critical Accounting Policies” in “*Part II — Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations*” in ourAnnual Report. There have been no material changes to the critical accountingpolicies disclosed in our Annual Report.

 

*RecentAccounting Pronouncements*

 

In December 2007, the Financial AccountingStandards Board, or FASB, issued SFAS No. 160 which established accountingand reporting standards for the noncontrolling interest in a subsidiary and forthe deconsolidation of a subsidiary.  During the three months ended June 30,2009, we applied SFAS No. 160 to the consolidation of DPLC and thedeconsolidation of Market Square CLO.

 

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

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments and HedgingActivities,*or SFAS No. 161, which amends and expands thedisclosure requirements of SFAS No. 133,*Accounting for Derivative Instruments and Hedging Activities*,or SFAS No. 133. SFAS No. 161 requires qualitative disclosuresregarding objectives and strategies for using derivatives, quantitativedisclosures regarding fair value amounts of gains and losses on derivativeinstruments and disclosures regarding credit-risk-related contingent featuresin derivative contracts. We adopted SFAS No. 161 and included the requireddisclosures in our condensed consolidated financial statements in thisQuarterly Report.

 

In June 2008, the FASB issued FSPEITF 03-6-1,*Determining WhetherInstruments Granted in Share-Based Payment Transactions Are ParticipatingSecurities,* or FSP EITF 03-6-1. FSP EITF 03-6-1 addresseswhether instruments granted in share-based payment transactions areparticipating securities prior to vesting and need to be included in theearnings allocation in computing earnings per share under the two-class methoddescribed in FASB Statement No. 128,*Earnings per Share*. We adopted FSP EITF 03-6-1 on January 1,2009, and the adoption had no impact on our condensed consolidated financialstatements.

 

In April 2009, the FASB issued FSP FAS 107-1 andAPB 28-1, *Interim Disclosures about FairValue of Financial Instruments,*or**FSP FAS 107-1 and APB 28-1.  FSP FAS 107-1 and APB 28-1requires disclosures regarding fair value of financial instruments for interimreporting periods of publicly traded companies as well as in annual financialstatements.  We adopted FSP FAS 107-1 and APB 28-1 and includedthe required disclosures in our notes to our condensed consolidated financialstatements in this Quarterly Report.

 

In April 2009, the FASB issued FSP FAS 157-4, *Determining Fair Value When the Volume and Level ofActivity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly,* or FSP FAS157-4.  FSP FAS 157-4 was issued to provide additional guidance forestimating fair value when the volume and level of activity have significantlydecreased and to provide guidance on identifying circumstances that indicate atransaction is not orderly.  In addition, FSP FAS 157-4 requires an entityto disclose, in interim and annual periods, the inputs and valuation techniquesused to measure fair value and a discussion of changes in valuation techniquesand related inputs, if any, during the period. We adopted FSP FAS 157-4and considered this guidance in determining and disclosing the fair valuesincluded in our condensed consolidated financial statements in this QuarterlyReport.

 

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In April 2009, the FASB issued FPSP FAS 115-2 andFAS 124-2, *Recognition and Presentation ofOther-Than-Temporary Impairments,*or**FSP FAS 115-2 and FAS 124-2.  This statement was issued toamend the other-than-temporary impairment guidance in GAAP for debt securitiesto make the guidance more operational and to improve the presentation anddisclosure of other-than-temporary impairments on debt and equity securities inthe financial statements.  FSP FAS 115-2 and FAS 124-2 does not amendexisting recognition and measurement guidance related to other-than-temporaryimpairments of equity securities.  We adopted FSP FAS 115-2 and FAS 124-2in our condensed consolidated financial statements in this Quarterly Report.

 

In May 2009, the FASB issued SFAS No. 165,*Subsequent Events*, or SFAS No. 165.  SFAS No. 165 establishes generalstandards of accounting for, and disclosure of, events that occur after thebalance sheet date but before financial statements are issued or are availableto be issued.  In particular, this statement sets forth: (i) theperiod after the balance sheet date during which management of a reportingentity should evaluate events or transactions that may occur for potentialrecognition or disclosure in the financial statements, (ii) thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements and (iii) thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date.  We adopted SFAS No. 165 andincluded the required disclosures in our notes to the condensed consolidatedfinancial statements in this Quarterly Report.

 

In June 2009, the FASBissued FASB Statement No. 166, *Accountingfor Transfers of Financial Assets — an amendment of FASB Statement No. 140*,or SFAS No. 166.  This statement wasissued to address concerns about the previously existing guidance governingtransfers of financial assets.  SFAS No. 166provides clarification concerning measuring whether a transferor and all of theentities included in the transferor’s financial statements have surrenderedcontrol over transferred financial assets and states that a determination mustconsider the transferor’s continuing involvements in the transferred financialassets.  In addition, this statementremoves the concept of a qualifying special-purpose entity from SFAS No. 140and removes the exception from applying FASB Interpretation No. 46(revised 2004), *Consolidation of VariableInterest Entities*, or**FIN46(R), to qualifying special-purpose entities. SFAS No. 166 is effective for transfers of financial assets thatoccur during our interim and annual reporting periods that begin after November 15,2009.  We are currently evaluating theeffects that SFAS No. 166 will have on our condensed consolidatedfinancial statements and disclosures included in those condensed consolidatedfinancial statements.

 

In June 2009, the FASB issued FASB Statement No. 167,*Amendments to FASB Interpretation No. 46 (R)*,or SFAS No. 167.  This statement wasissued to address concerns about financial statement preparers’ ability tostructure transactions to avoid consolidation, balanced with the need for morerelevant, timely and reliable information about an entity’s involvement in aVIE.  This statement requires anenterprise to perform an analysis to determine whether the enterprise’svariable interest or interests give it a controlling financial interest in aVIE.  This analysis identifies the primarybeneficiary of a VIE as the enterprise that has both the power to direct theactivities of a VIE that most significantly impact the entity’s economicperformance and the obligation to absorb losses of the entity that couldpotentially be significant to the VIE or the right to receive benefits from theentity that could potentially be significant to the VIE. Additionally, anenterprise is required to asses whether it has an implicit financialresponsibility to ensure that a VIE operates as designed when determiningwhether it has the power to direct the activities of the VIE that mostsignificantly impacts the entity’s economic performance.  * *SFAS No. 167 also amends FIN 46 (R) to eliminate thequantitative approach to determining the primary beneficiary of a VIE andrequires ongoing reassessments of VIE status. SFAS No. 167 is effective for our interim and annual reportingperiods that begin after November 15, 2009.  We are currently evaluating the effects thatSFAS No. 167 will have on our condensed consolidated financial statementsand disclosures included in those condensed consolidated financial statements.Our initial conclusion is that a significant portion of the CDOs that we managewould need to be consolidated as a result of the adoption of SFAS No. 167.

 

In June 2009, the FASB issued FASB Statement No. 168,*The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles—a replacement of FASBStatement No. 162*, or SFAS No. 168. The FASB AccountingStandards Codification, or the Codification, will be the single source ofauthoritative nongovernmental U.S. GAAP. Rules and interpretive releasesof the SEC under authority of federal securities laws are also sources ofauthoritative GAAP for SEC registrants. All existing accounting standards aresuperseded as described in SFAS No. 168. All other accounting literaturenot included in the Codification is nonauthoritative. SFAS No. 168 iseffective for our interim and annual periods ending after September 15,2009. SFAS No. 168 is not expected to have a significant impact on ourfinancial statements.

 

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**Financial Condition**

 

The following table summarizes the carrying value ofour investment portfolio by balance sheet classification as of June 30,2009:

 
| ** **                                        | ** ** | **Investments at**      | ** **    | **Other**       | ** ** | **Loans Held** | ** ** | **Loans Held**     | ** **    | ** ** | ** ** |
|---------------------------------------------------|------------|-------------------------|---------------|-----------------|------------|----------------|------------|--------------------|---------------|------------|------------|
| **Security Description**                          | ** ** | **Fair Value**          | ** **    | **Investments** | ** ** | **For Sale**   | ** ** | **For Investment** | ** **    | **Total**  | ** ** |
| ** **                                        | ** ** | **(In thousands)** | ** **    |
| RMBS                                              |       | $                       |  311,154 |            | $          |  —   |       | $                  |  —  |       | $          |  — |   | $ |  311,154 |   |
| Corporate leveraged  loans:                       |       |                    |          |            |       |           |       |               |          |       |       |
| Loans held in DFR MM  CLO (1)                     |       | —                  |          | —          |       | —         |       | 299,751            |          | 299,751    |       |
| Loans held in the  Wachovia Facility              |       | —                  |          | —          |       | 1,251          |       | —             |          | 1,251      |       |
| Other corporate leveraged  loans                  |       | —                  |          | —          |       | 8,112          |       | —             |          | 8,112      |       |
| Loans held in DPLC                                |       | 6,841                   |          | —          |       | —         |       | —             |          | 6,841      |       |
| Commercial real estate  loans and  securities (2) |       | —                  |          | —          |       | —         |       | 9,270              |          | 9,270      |       |
| Equity securities                                 |       | —                  |          | 4,780           |       | —         |       | —             |          | 4,780      |       |
| Other investments                                 |       | 315                     |          | —          |       | —         |       | —             |          | 315        |       |
| Total invested assets                             |       | $                       |  318,310 |            | $          |  4,780    |       | $                  |  9,363   |       | $          |  309,021 |   | $ |  641,474 |   |
|                                              |       |                    |          |            |       |           |       |               |          |       |       |
| Allowance for loan  losses                        |       |                    |          |            |       |           |       | (28,589            | )             | (28,589    | )          |
|                                              |       |                    |          |            |       |           |       |               |          |       |       |
|                                              |       |                    |          |            |       |           |       | $                  |  280,432 |       | $          |  612,885 |   |

 

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| (1) | Loans held in DFR MM CLO classified as loans held for investment are  reported gross of the $24.5 million allowance for loan losses as of  June 30, 2009.    |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Commercial real estate loans classified as loans  held for investment are reported gross of the $4.1 million allowance for  loan losses as of June 30, 2009. |

 

***Residential Mortgage-Backed Securities***

 

As of June 30, 2009, our Agency RMBS andnon-Agency RMBS portfolios decreased to a fair value of $308.0 million and$3.1 million, respectively, from $342.4 million and$5.4 million, respectively, as of December 31, 2008.  For thethree and six months ended June 30, 2009, we sold zero and $12.8 millionof RMBS, respectively, and received RMBS principal paydowns of $15.5 millionand $30.0 million, respectively.

 

As of June 30, 2009, our RMBS portfolio had a netamortized cost of 99.88% of its face amount. As of June 30, 2009 and 2008, we had unamortized net discount of$0.4 million and $0.6 million, respectively, included in the costbasis of our RMBS portfolio. As of June 30, 2009 and 2008, the currentweighted average life of the portfolio was 7.1 years and 7.1 years,respectively, which represents the average number of years for which eachdollar of unpaid principal remains outstanding.

 

Net portfolio duration, which is the differencebetween the duration of the RMBS portfolio and the duration of repurchaseagreements adjusted for the effects of our interest rate swap portfolio, was1.9 years based on model-driven modified duration results. However, based onactual price movements observed in the market, we believe the empiricalduration is significantly lower. In order to fully assess the possible impactof a change in interest rates on the RMBS portfolio, one should consider notonly the duration, but also the portfolio’s leverage and spread risk.

 

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The following table details our RMBS holdings as of June 30,2009:

 
| ** **                        | ** ** | ** **          | ** **    | ** **      | ** ** | **Weighted  Average** | ** ** |
|-----------------------------------|------------|---------------------|---------------|-----------------|------------|-----------------------|------------|
| ** **                        | ** ** | ** **          | ** **    | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | **Contractual** | ** ** | **Constant** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Par**             | ** **    | **Estimated**   | ** ** | ** **            | ** ** | **Months  to** | ** ** | **Yield  to** | ** ** | **Maturity** | ** ** | **Prepayment** | ** ** | **Modified** | ** ** |
| **Security  Description**         | ** ** | **Amount**          | ** **    | **Fair  Value** | ** ** | **Coupon**            | ** ** | **Reset  (1)** | ** ** | **Maturity** | ** ** | **(Month/Year)** | ** ** | **Rate  (2)** | ** ** | **Duration  (3)** | ** ** |
| ** **                        | ** ** | **(In  thousands)** | ** **    | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hybrid Adjustable Rate  RMBS:     |       |                | ** **    | ** **      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Rate reset in 1 year or  less     |       | $                   |  175,498 |            | $          |  180,362         |       | 4.71 | % | 6 |   | 2.60 | % | 01/35 |   | 9.6 |   | 1.3 |   |
| Rate reset in 1 to 3  years       |       | 76,745              |          | 79,410          |       | 5.13                  | %          | 24 |   | 2.98 | % | 09/35 |   | 9.0 |   | 2.0 |   |
| Rate reset in 5 to 7  years       |       | 33,904              |          | 22,651          |       | 5.53                  | %          | 77 |   | 17.63 | % | 12/35 |   | 14.7 |   | 5.7 |   |
| Fixed Rate RMBS:                  |       |                |          |            |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| 30 year                           |       | 34,289              |          | 28,731          |       | 6.16                  | %          | n/a |   | 15.97 | % | 04/34 |   | 21.0 |   | 3.4 |   |
| Total hybrid and fixed  rate RMBS |       | $                   |  320,436 |            | $          |  311,154         |       |   |   |   |   |   |   |   |   |   |   |   |   |

 

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

n/a — not applicable

n/m — not meaningful

 

Actual maturities of RMBS are generally shorter thanstated contractual maturities as they are affected by the contractual lives ofthe underlying mortgages, normal monthly amortization of principal andvoluntary prepayments of principal. The stated contractual final maturity ofthe mortgage loans underlying our RMBS portfolio ranges up to 30 yearsfrom date of issuance, but the expected maturity is subject to change based onthe actual and estimated prepayments of the underlying loans.

 

The constant prepayment rate, or CPR, attempts topredict the percentage of principal that will prepay over the next12 months based on historical principal paydowns and the current interestrate environment. As interest rates rise, the rate of refinancing typicallydeclines, which we believe may result in lower rates of prepayment and, as aresult, a lower portfolio CPR.

 

As of June 30, 2009, the mortgages underlying ourhybrid adjustable-rate RMBS had fixed interest rates for a weighted averageperiod of approximately 17 months after which time the interest ratesreset and become adjustable. The average length of time until contractualmaturity of those mortgages was approximately 26 years from date ofissuance as of June 30, 2009.

 

After the reset date, interest rates on our hybridadjustable-rate RMBS float based on spreads over various LIBOR andU.S. Treasury indices. These interest rates are subject to caps that limitthe amount the applicable interest rate can increase during any year, known asan annual cap, and through the maturity of the applicable security, known as alifetime cap. As of June 30, 2009, the weighted average lifetime rate capfor the portfolio was 10.1%, the weighted average maximum increase in the firstyear that the rates are adjustable, or initial cap, was 4.7% and the weightedaverage maximum annual increase for years subsequent to the first year was9.8%.

 

The following table summarizes our RMBS, according totheir weighted average life:

 
| ** **                                       | ** ** | **Amortized**           | ** **    | **Estimated**  | ** ** |
|--------------------------------------------------|------------|-------------------------|---------------|----------------|------------|
| **Weighted Average Life**                        | ** ** | **Cost**                | ** **    | **Fair Value** | ** ** |
| ** **                                       | ** ** | **(In thousands)** | ** **    |
| Greater than one year  and less than five years  |       | $                       |  46,860  |           | $          |  42,242 |   |
| Greater than five years  and less than ten years |       | 266,864                 |          | 262,426        |       |
| Greater than ten years                           |       | 6,342                   |          | 6,486          |       |
| Total                                            |       | $                       |  320,066 |           | $          |  311,154 |   |

 

The weighted average lives in the table above areprimarily based on a prepayment model that considers current yields, forwardyields, the slope of the yield curve, current mortgage rates and thecontractual rate of the outstanding loans, the loan’s age, margin andvolatility. Most of the data used in this model is provided throughsubscription-based financial information services. Weighted average life is anestimate of how many years it will take to pay half of the outstandingprincipal.  Actual lives of RMBS are generally shorter than statedcontractual maturities, are affected by the contractual maturities of theunderlying mortgages, periodic payments of principal and prepayments ofprincipal and differ materially from those set forth above.

 

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***Loans***

 

The following summarizes our loan portfolio, by loanclassification, as of June 30, 2009:

 
| ** **                        | ** ** | **Carrying Value** | ** **   |
|-----------------------------------|------------|--------------------|--------------|
| ** **                        | ** ** | **Investments at** | ** **   | **Loans Held** | ** ** | **Loans Held** | ** ** | ** ** | ** ** |
| **Type of Loan**                  | ** ** | **Fair Value**     | ** **   | **for Sale (1)** | ** ** | **for Investment** | ** ** | **Total** | ** ** |
| ** **                        | ** ** | **(In thousands)** | ** **   |
| Corporate leveraged  loans:       |       |               |         |   |   |   |   |   |   |
| Loans held in DFR MM  CLO (2)     |       | $                  |  — |   | $ |  — |   | $ |  299,751 |   | $ |  299,751 |   |
| Loans held in Wachovia  Facility  |       | —             |         | 1,251 |   | — |   | 1,251 |   |
| Other corporate  leveraged loans  |       | —             |         | 8,112 |   | — |   | 8,112 |   |
| Loans held in DPLC (3)            |       | 6,841              |         | — |   | — |   | 6,841 |   |
| Commercial real estate  loans (4) |       | —             |         | — |   | 9,270 |   | 9,270 |   |
|                              |       | $                  |  6,841  |   | $ |  9,363 |   | 309,021 |   | 325,225 |   |
| Allowance for loan  losses        |       |               |         |   |   | (28,589 | ) | (28,589 | ) |
|                              |       |               |         |   |   | $ |  280,432 |   | $ |  296,636 |   |

 

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| (1) | Carrying value of loans held for sale is lower of cost or estimated  fair value.                                                                                                                                                                                                                                                            |
|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Loans held in DFR MM CLO classified as loans held for investment  reported gross of $24.5 million allowance for loan losses                                                                                                                                                                                                            |
| (3) | Loans held in DPLC, represent syndicated bank loans held in our  investment venture with Pegasus.  We  elected to record these loans at fair value in accordance with SFAS  No. 159, *The Fair Value Option for Financial Assets  and Liabilities- including an amendment of FASB Statement No. 115*,  or SFAS No. 159. |
| (4) | Commercial real estate loans classified as loans  held for investment reported gross of $4.1 million allowance for loan  losses.                                                                                                                                                                                                       |

 

The following summarizes our allowance for loan lossesas of June 30, 2009:

 
| ** **                    | ** ** | **Number**   | ** ** | **Par**            | ** **   | **Allowance**       | ** ** |
|-------------------------------|------------|--------------|------------|--------------------|--------------|---------------------|------------|
| **Type of Loan**              | ** ** | **of Loans** | ** ** | **Value**          | ** **   | **for Loan Losses** | ** ** |
| ** **                    | ** ** | ** **   | ** ** | **(In thousands)** | ** **   |
|                          |       |         |       |               |         |                |       |
| Loans held in DFR MM  CLO     |       | 4            |       | $                  |  27,786 |                | $          |  24,484 |   |
| Commercial real estate  loans |       | 3            |       | 8,058              |         | 4,105               |       |
| Total                         |       | 7            |       | $                  |  35,844 |                | $          |  28,589 |   |

 

We did not recognize $1.1 million and $2.0million, respectively, of interest income earned, but not yet received, onloans held for investment for the three and six months ended June 30,2009. In addition, we did not recognize $1.9 million and $3.6 million ofinterest income earned, but not yet received, on loans held for sale for thethree and six months ended June 30, 2009.

 

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

 

DFR MM CLO is a VIE under FIN 46(R). We are theprimary beneficiary of the VIE, causing us to consolidate the entity. We own100% of the equity interests, issued as subordinated notes and ordinary shares,in DFR MM CLO, which we purchased for $50.0 million. We also purchased allof the “BBB/Baa2” rated notes of DFR MM CLO for $19.0 million. As of June 30,2009, DFR MM CLO had $316.8 million of loans outstanding, with a carryingvalue of $299.8 million, which is included in loans on the condensedconsolidated balance sheet, reduced by an allowance for loan losses of$24.5 million. As of June 30, 2009, DFR MM CLO has restricted cashand cash equivalents of $10.7 million, which are generally utilized topurchase additional loans and pay distributions to debt and equity holders, and$231.0 million of notes payable to third party investors, which isincluded in long term debt. The weighted average coupon on the loan portfoliowas 6.33%, and the weighted average contractual maturity of the loan portfoliowas 4.45 years as of June 30, 2009. DFR MM CLO is a bankruptcy remoteentity, and, although we consolidate 100% of the assets and liabilities of DFRMM CLO, our maximum exposure to loss on our investment in DFR MM CLO is limitedto our initial investment of $69.0 million. As of June 30, 2009, wehave received distributions from DFR MM CLO equal to $26.4 million sinceits inception.

 

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The following table summarizes the carrying value ofthe DFR MM CLO loan portfolio:

 
| **Type of Loan**           | ** ** | **June 30, 2009** | ** **    |
|----------------------------|------------|------------------------|---------------|
| ** **                 | ** ** | **(In thousands)**     | ** **    |
| First lien secured         |       | $                      |  132,930 | (1) |
| Second lien secured        |       | 153,279                | (2)           |
| Mezzanine                  |       | 13,542                 |          |
| ** **                 |       | 299,751                |          |
| Allowance for loan  losses |       | (24,484                | )             |
| ** **                 |       | $                      |  275,267 |   |

 

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

(2) Presented gross of $17.5 millionallowance for loan losses.

 

***Loans Held in DPLC***

 

DPLC is a bankruptcy remote entity that we arerequired to consolidate pursuant to SFAS No. 160 as a result of ourcontrolling interest therein.   Althoughwe consolidate 100% of the assets and liabilities of DPLC, our maximum exposureto loss on our investment in this entity is limited to our investment in theentity, which, as of June 30, 2009, totaled $3.9 million.   As of June 30, 2009, DPLC had$7.7 million of loans outstanding, with an estimated fair value of$6.8 million, which is included in investments at fair value on thecondensed consolidated balance sheet.  Weelected to record all loans held in DPLC at fair value in accordance with SFAS No. 159.  As of June 30, 2009, DPLC had$14.1 million of restricted cash and cash equivalents, which are generallyutilized to purchase additional loans and pay expenses. The weighted averagecoupon on the loan portfolio was 5.26% and the weighted average contractualmaturity of the loan portfolio was 4.68 years as of June 30, 2009.

 

***Loans held in the Wachovia Facility andOther Corporate Leveraged Loans***

 

The following table summarizes the carrying value ofthe loans held in the Wachovia Facility and our other corporate leveragedloans, which are all classified as loans held for sale as of June 30,2009:

 
| ** **          | ** ** | **Carrying Value (1)** | ** **   |
|---------------------|------------|------------------------|--------------|
| **Type of Loan**    | ** ** | **Wachovia Facility**  | ** **   | **Other Corporate  Leveraged Loans** | ** ** |
| ** **          | ** ** | **(In thousands)**     | ** **   |
| First lien secured  |       | $                      |  — |   | $ |  1,841 |   |
| Second lien secured |       | 764                    |         | — |   |
| Mezzanine           |       | 487                    |         | 300 |   |
| Holding company     |       | —                 |         | 5,971 |   |
|                |       | $                      |  1,251  |   | $ |  8,112 |   |

 

----

(1)  Carrying value of loans held for saleis lower of cost or fair value.

 

We had loans held in our alternative asset revolvingwarehouse funding facility with Wachovia Capital Markets, LLC, or the WachoviaFacility, and other corporate leveraged loans, totaling $1.3 million and$8.1 million, respectively, classified as loans held for sale on the condensedconsolidated balance sheet as of June 30, 2009. The weighted averagecoupon on the Wachovia Facility loan portfolio and other corporate leveragedloans was 3.25% and 0.20%, respectively, as of June 30, 2009.

 

Loans held in our Wachovia Facility and loansclassified as other corporate leveraged loans consist of loans that are notbroadly syndicated and are, therefore, less liquid. These loans hadhistorically been primarily considered to be held for investment and werereported at amortized cost with an allowance for loan losses, if necessary,unless we decided to sell one of these loans, in which case the loan wastransferred to loans held for sale.  During the year ended December 31,2008, we began actively seeking to sell all of the loans held in the WachoviaFacility as we triggered an acknowledged termination event thereunder on November 30,2008. We sold a significant portion of the loans held within the WachoviaFacility during the year ended December 31, 2008 and transferred all loans

 

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heldwithin the Wachovia Facility to loans held for sale.  During the threemonths ended March 31, 2009, we sold loans held within the WachoviaFacility with a par value of $31.5 million for $10.8 million, net of interestof $0.2 million.  We realized a loss of $6.2 million reported in net gain(loss) on loans in the condensed consolidated statements of operations duringthe three months ended March 31, 2009 as a result of these sales.  Inaddition, during the year ended December 31, 2008, we began toopportunistically sell our other corporate leveraged loans in connection withour strategy of increasing liquidity in the Principal Investing segment andfocusing on growing our Investment Management segment. As a result, during theyear ended December 31, 2008, we transferred all other corporate leveragedloans to loans held for sale.

 

***Commercial Real Estate Loans***

 

As of June 30, 2009, we held four commercial realestate loans with a carrying value of $9.3 million, which is included in loanson the condensed consolidated balance sheet, reduced by an allowance for loanlosses of $4.1 million.

 

***Derivatives and Hedging***

 

The following table is a summary of our derivativeinstruments as of June 30, 2009:

 
| ** **          | ** ** | ** ** | ** ** | **Notional**            | ** **   | ** ** | ** ** | ** **      | ** ** | **Estimated Net** | ** ** |
|---------------------|------------|------------|------------|-------------------------|--------------|------------|------------|-----------------|------------|------------------------|------------|
| ** **          | ** ** | **Count**  | ** ** | **Amount**              | ** **   | **Assets** | ** ** | **Liabilities** | ** ** | **Fair Value**    | ** ** |
| ** **          | ** ** | ** ** | ** ** | **(In thousands)** | ** **   |
| Interest rate swaps |       | 2          |       | $                       | 30,000       |       | $          | —          |       | $                      | 863        |   | $ | (863 | ) |
| Interest rate cap   |       | 1          |       | 40,000                  |         | —     |       | 90              |       | (90                    | )          |
| Warrants            |       | 3          |       | n/a                     |         | 61         |       | —          |       | 61                     |       |
|                |       | 6          |       | $                       |  70,000 |       | $          |  61        |       | $                      |  953  |   | $ |  (892 | ) |

 

----

n/a — not applicable

 

In general, when a fixed-rate or hybridadjustable-rate RMBS is funded by a short term borrowing, we may enter into aninterest rate swap agreement that effectively fixes a portion of the borrowingcosts for a period close to the anticipated weighted-average life of thefixed-rate portion of the related RMBS. This strategy is designed to protect a portionof our portfolio from increased funding costs due to rising interest ratesbecause the borrowing costs are not fixed for the duration of the fixed-rateperiod of the related residential mortgage-backed security.

 

**Results of Operations**

 

The following section provides a comparativediscussion of our condensed consolidated results of operations as of and forthe three months and six months ended June 30, 2009 and 2008.

 

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** **

***Summary***

 

The following table summarizes selected historicalconsolidated financial information:

 
| ** **                                                                     | ** ** | **Three  Months Ended June 30,**              | ** ** | **Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **2009**                                      | ** ** | **2008**                       | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                     | ** ** | **(In  millions, except for per share data)** | ** ** |
| ** **                                                                     | ** ** | ** **                                    | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Consolidated  Statements of Operations Data:**                               | ** ** | ** **                                    | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net interest income                                                            |       | $                                             |  8.4  |                           | $          |  9.4 |   | $ |  15.2 |   | $ |  23.2 |   |
| Net interest (expense)  income after provision for loan losses                 |       | $                                             |  (0.7 | )                              | $          |  7.1 |   | $ |  4.0 |   | $ |  18.7 |   |
| Investment advisory  fees                                                      |       | $                                             |  4.0  |                           | $          |  12.4 |   | $ |  8.7 |   | $ |  24.5 |   |
| Total expenses                                                                 |       | $                                             |  12.0 |                           | $          |  16.9 |   | $ |  20.3 |   | $ |  61.1 |   |
| Net other income and  gain (loss)                                              |       | $                                             |  58.7 |                           | $          |  6.0 |   | $ |  69.2 |   | $ |  (444.3 | ) |
| Net income (loss)                                                              |       | $                                             |  49.9 |                           | $          |  5.7 |   | $ |  61.4 |   | $ |  (457.9 | ) |
| Net income (loss)  attributable to common stockholders                         |       | $                                             |  49.9 |                           | $          |  5.7 |   | $ |  61.4 |   | $ |  (460.3 | ) |
| Net loss attributable  to noncontrolling interest                              |       | $                                             |  3.0  |                           | $          |  — |   | $ |  3.0 |   | $ |  — |   |
| Net income (loss)  attributable to Deerfield Capital Corp.                     |       | $                                             |  52.9 |                           | $          |  5.7 |   | $ |  64.4 |   | $ |  (460.3 | ) |
| Net income (loss)  attributable to Deerfield Capital Corp. per share - diluted |       | $                                             |  7.85 |                           | $          |  0.83 |   | $ |  9.59 |   | $ |  (74.10 | ) |
| Core earnings (1)                                                              |       | $                                             |  5.5  |                           | $          |  8.6 |   | $ |  10.6 |   | $ |  21.2 |   |
| Core earnings per share  - diluted (1)                                         |       | $                                             |  0.82 |                           | $          |  1.25 |   | $ |  1.57 |   | $ |  3.41 |   |

 
| ** **                                                   |   | **As of June 30,**                                          |          |     |   |           |   |
|--------------------------------------------------------------|--------|----------------------------------------------------------------------------|---------------|----------|--------|----------------|--------|
| ** **                                                   |   | **2009**                                                                   |          | **2008** |   |           |   |   |   |
| ** **                                                   |   | **(In millions, except for per share data)** |          |     |   |           |   |
| **Consolidated  Balance Sheet Data:**                        |   |                                                                       |          |     |   |           |   |   |   |
| Residential  mortgage-backed securities                      |   | $                                                                          |  311.2   |     | $      |  444.2    |   |   |   |   |   |
| U.S. Treasury bills                                          |   | $                                                                          |  —  |     | $      |  1,000.0  |   |   |   |   |   |
| Total assets                                                 |   | $                                                                          |  734.6   |     | $      |  2,434.7  |   |   |   |   |   |
| Repurchase agreements                                        |   | $                                                                          |  294.5   |     | $      |  1,409.0  |   |   |   |   |   |
| Long term debt:                                              |   |                                                                       |          |     |   |           |   |   |   |
| Recourse:                                                    |   |                                                                       |          |     |   |           |   |   |   |
| Trust preferred  securities                                  |   | $                                                                          |  123.7   |     | $      |  123.7    |   |   |   |   |   |
| Series A and  Series B Notes                       |   | $                                                                          |  72.0    |     | $      |  71.4     |   |   |   |   |   |
| Non-Recourse:                                                |   |                                                                       |          |     |   |           |   |   |   |
| Wachovia Facility                                            |   | $                                                                          |  0.8     |     | $      |  53.4     |   |   |   |   |   |
| DFR MM CLO                                                   |   | $                                                                          |  231.0   |     | $      |  231.0    |   |   |   |   |   |
| Market Square CLO                                            |   | $                                                                          |  —  |     | $      |  276.0    |   |   |   |   |   |
| Deerfield Capital Corp.  stockholders’ (deficit) equity |   | $                                                                          |  (13.1   | )        | $      |  224.8    |   |   |   |   |   |
| Total stockholders’  equity                             |   | $                                                                          |  4.0     |     | $      |  224.8    |   |   |   |   |   |
|                                                         |   |                                                                       |          |     |   |           |   |   |   |
| **AUM:**                                                     |   |                                                                       |          |     |   |           |   |   |   |
| Investment Management  segment (2) (3)                  |   | $                                                                          |  9,859.4 |     | $      |  12,976.3 |   |   |   |   |   |
| Principal Investing  segment (4)                             |   | $                                                                          |  612.9   |     | $      |  2,097.4  |   |   |   |   |   |
| **Metric:**                                                  |   |                                                                       |          |     |   |           |   |   |   |
| Book value per share  outstanding                            |   | $                                                                          |  0.62    |     | $      |  33.71    |   |   |   |   |   |

 

----

| (1) | Core earnings represents a non-GAAP financial measure. Please see the  “Reconciliation of Non-GAAP Financial Measure”, which follows, for a  reconciliation between the comparable GAAP measure and a discussion of the  importance placed on this measure by management.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | AUM for our Investment Management segment includes CDO AUM numbers,  which generally reflect the aggregate principal or notional balance of the  collateral and, in some cases, the cash balances held by the CDOs as of the  date of the last trustee report received for each CDO prior to the relevant  measurement date. The AUM for our Euro-denominated CDOs has been converted  into U.S. dollars using the appropriate spot rate of exchange. AUM for our  Investment Management segment also includes AUM for our separately managed  accounts, which, in certain cases, is a multiple of the capital actually  invested in such account. Management fees for these accounts are paid on this  higher AUM amount.                                                                                                                                                                                                                                                                           |
| (3) | Included in Investment Management segment AUM are $289.8 million and  $22.1 million related to DFR MM CLO and DPLC, respectively, for July 1,  2009, which amount are also included in the total AUM reported for the  Principal Investing portfolio as of June 30, 2009. Included in the  Investment Management segment AUM are $300.8 million and $295.3 million  related to DFR MM CLO and Market Square CLO, respectively, for July 1,  2008, which amounts are also included in the total AUM reported for the  Principal Investing portfolio as of June 30, 2008. DCM manages DFR MM  CLO but is not contractually entitled to receive any management fees so long  as 100% of the equity is held by DC LLC or an affiliate thereof.   DCM manages DPLC and receives management  fees for its services on the portion of the AUM which is not owned by  DFR.  All other amounts included in the  Principal Investing portfolio are excluded from Total AUM. |
| (4) | AUM for the Principal Investing segment is  reflected net of allowance for loan losses of $28.6 million and $7.9 million  as of June 30, 2009 and 2008, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |

 

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**Reconciliation of Non-GAAP Financial Measure**

 

We believe that core earnings, a non-GAAP financialmeasure, is a useful metric for evaluating and analyzing our performance. Thecalculation of core earnings, which we use to compare our own financial resultsfrom period to period, eliminates the impact of certain non-cash and specialcharges and income tax. The core earnings provided herein may not be comparableto similar measures presented by other companies as it is a non-GAAP financialmeasure and may therefore be defined differently by other companies.  Coreearnings includes the earnings from our VIE, DFR MM CLO, and from Market SquareCLO, which was a consolidated VIE until we sold all of our preference shares inand deconsolidated that entity as of June 30, 2009. Core earnings is notindicative of cash flows received from these VIEs.  We have previously disclosed another non-GAAPfinancial measure, economic book value per share, which eliminated losses inexcess of the equity at risk in Market Square CLO because those losses would beborne solely by the debt holders of Market Square CLO.  As a result of the deconsolidation of MarketSquare CLO, these losses in excess of our equity at risk were eliminated, andtherefore, we no longer believe that economic book value per share is a usefulmetric for evaluating and analyzing our performance.

 

**Core Earnings**

 

The table below provides a reconciliation between netincome (loss) and core earnings:

 
| ** **                                               | ** ** | **Three months ended June 30,**                                       | ** **   | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|--------------|---------------------------------------------------|------------|
| ** **                                               | ** ** | **2009**                                                                                  | ** **   | **2008**                                          | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                               | ** ** | **(In thousands, except share and per share amounts)** | ** **   |
|                                                     |       |                                                                                      |         |                                              |       |   |   |   |   |
| Net income (loss)                                        |       | $                                                                                         |  49,906 |                                              | $          |  5,692 |   | $ |  61,445 |   | $ |  (457,918 | ) |
| Add back:                                                |       |                                                                                      |         |                                              |       |   |   |   |   |
| Provision for loan  losses                               |       | 9,119                                                                                     |         | 2,302                                             |       | 11,226 |   | 4,502 |   |
| Cost saving initiatives                                  |       | 28                                                                                        |         | 70                                                |       | 225 |   | 327 |   |
| Depreciation and  amortization                           |       | 1,629                                                                                     |         | 2,580                                             |       | 3,264 |   | 5,267 |   |
| Impairment of  intangible assets and goodwill            |       | 126                                                                                       |         | 1,128                                             |       | 126 |   | 29,034 |   |
| Net other income and  (gain) loss                        |       | (58,733                                                                                   | )            | (6,048                                            | )          | (69,202 | ) | 444,310 |   |
| Income tax expense  (benefit)                            |       | 160                                                                                       |         | 2,868                                             |       | 178 |   | (4,334 | ) |
| Noncontrolling interest  core earnings (1)               |       | 3,297                                                                                     |         | —                                            |       | 3,297 |   | — |   |
| Core earnings                                            |       | $                                                                                         |  5,532  |                                              | $          |  8,592 |   | $ |  10,559 |   | $ |  21,188 |   |
|                                                     |       |                                                                                      |         |                                              |       |   |   |   |   |
| Core earnings per share  - diluted                       |       | $                                                                                         |  0.82   |                                              | $          |  1.25 |   | $ |  1.57 |   | $ |  3.41 |   |
| Weighted-average number  of shares outstanding - diluted |       | 6,730,655                                                                                 |         | 6,881,715                                         |       | 6,716,570 |   | 6,213,318 |   |

 

----

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

 

**Executive Summary of Results of Operations**

 

During the three and six months ended June 30,2009, we recorded net income of $49.9 million and $61.4 million, respectively,as compared to net income of $5.7 million and a net loss of $457.9 during thesame periods in 2008, respectively.  Although core earnings, calculated inthe table above, declined during the three months and six months ended June 30,2009 as compared to the same periods in 2008, it remained positive at $5.5 millionand $10.6 million for the three and six months ended June 30, 2009,respectively.

 

During the three and six months ended June 30,2009, we experienced a $16.1 million and $30.4 million decrease in net revenuesas compared to the same periods in 2008, respectively, comprised of decreasesin net interest income of $1.0 million and $7.9 million, respectively,increases in the provision for loan losses of $6.8 million and $6.7 million,respectively, and decreases in investment advisory fees of $8.4 million and$15.7 million, respectively.  The decrease in net interest income isprimarily a result of the significant RMBS sales and associated repayment ofrepurchase agreement liabilities during the three months ended March 31,2008, the sale of a significant amount of loans held in the Wachovia Facilityduring 2008 and the first quarter of 2009 and the placement of certain loans onnon-accrual status during 2008 and during the six months ended June 30,2009.  The decrease in investment advisory fees is primarily driven by theliquidation of the investment funds we previously managed during 2008, whichprovided $2.0 million and $5.9 million of fee revenue during the three and sixmonths ended June 30, 2008, respectively, and the reduction of CDOinvestment advisory fee revenue of $6.4 million and $9.9 million during thethree and six months ended June 30, 2009, respectively, as compared to thesame periods during 2008. The reduction in CDO investment advisory fee revenuesis primarily the result of the liquidation of five CDOs we previously managedand the deferral of subordinated management fees during the three and sixmonths ended June 30, 2009 as a result of the majority of the CLOs that wecurrently manage failing certain overcollateralization tests.

 

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During the three and six months ended June 30,2009, expenses decreased by $5.0 million and $40.8 million, respectively, ascompared to the same periods in 2008, primarily driven by reduced impairmentcharges on intangible assets and goodwill and reduced compensation and benefitsexpense.  During the six months ended June 30, 2008, our InvestmentManagement segment recorded $29.0 million in impairment charges onintangible assets and goodwill related to the deterioration in the creditmarkets, the liquidation of the smaller of the investment funds that wepreviously managed and the liquidation of one of our Euro-denominatedCLOs.  During the three and six months ended June 30, 2009, wereduced our compensation and benefits expense by $4.6 million and $10.4million, respectively, primarily as a result of headcount reductions during2008 and a revision to our incentive compensation plan during 2009.

 

During the three and six months ended June 30,2009, net other income and gain (loss) improved by $52.6 million and $513.5million, respectively, as compared to the same periods in 2008.  Duringthe three months ended June 30, 2009, we recorded net gains on thedeconsolidation of Market Square CLO, loans, derivatives and investments atfair value of $29.6 million, $24.9 million, $3.0 million and $1.2 million,respectively.  During the six monthsended June 30, 2009, we recorded net gains on loans, the deconsolidationof Market Square CLO, investments at fair value and derivatives of $30.7million, $29.6 million, $6.3 million and $2.6 million, respectively.  The most recent six month period is in sharpcontrast to the first six months of 2008, during which we were adverselyimpacted by the continuing deterioration of global credit markets, whichresulted in a loss of $444.3 million in net other income and gain (loss),largely a result of net losses on derivatives, investments at fair value andloans of $217.1 million, $202.5 million and $21.0 million,respectively.   The most pronouncedimpact was on our non-Agency RMBS portfolio. This portfolio experienced anunprecedented decrease in value during the first six months of 2008 fueled bythe ongoing liquidity crisis. This negative environment impacted our ability tosuccessfully finance and hedge this portfolio. As a result, we sold asignificant portion of our RMBS portfolio to improve our liquidity. Inconjunction with the sale of RMBS, we also repaid our repurchase agreementsused to finance the RMBS sold and terminated the associated interest rate swapsused to hedge the interest rate exposure on those repurchase agreements.

 

**Results of Operations by Segment**

 

Management evaluates the performance of each businessunit based on segment results. The following table presents the results ofoperations by segment:

 
| ** **            | ** ** | **Three months ended June 30, 2009** | ** **   |
|-----------------------|------------|--------------------------------------|--------------|
| ** **            | ** ** | **Investment  Management**           | ** **   | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **            | ** ** | **(In thousands)**                   | ** **   |
| Net revenues          |       | $                                    |  4,130  |   | $ |  611 |   | $ |  (1,419 | )(1) | $ |  3,322 |   |
| Expenses              |       | (6,148                               | )            | (7,260 | ) | 1,419 |  (1) | (11,989 | ) |
| Other income and gain |       | 46                                   |         | 58,687 |   | — |   | 58,733 |   |
| Income tax expense    |       | (10                                  | )            | (150 | ) | — |   | (160 | ) |
| Net (loss) income     |       | $                                    |  (1,982 | ) | $ |  51,888 |   | $ |  — |   | $ |  49,906 |   |

 
| ** **                    | ** ** | **Three months ended June 30, 2008** | ** **   |
|-------------------------------|------------|---------------------------------------------------------------|--------------|
| ** **                    | ** ** | **Investment  Management**                                    | ** **   | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(In thousands)**                                            | ** **   |
| Net revenues                  |       | $                                                             |  15,355 |   | $ |  8,529 |   | $ |  (4,424 | )(1) | $ |  19,460 |   |
| Expenses                      |       | (13,277                                                       | )            | (8,095 | ) | 4,424 |  (1) | (16,948 | ) |
| Other income and (loss)  gain |       | (871                                                          | )            | 6,919 |   | — |   | 6,048 |   |
| Income tax expense            |       | (479                                                          | )            | (2,389 | ) | — |   | (2,868 | ) |
| Net income                    |       | $                                                             |  728    |   | $ |  4,964 |   | $ |  — |   | $ |  5,692 |   |

 

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| ** **                    | ** ** | **Six months ended June 30, 2009** | ** **   |
|-------------------------------|------------|-------------------------------------------------------------|--------------|
| ** **                    | ** ** | **Investment  Management**                                  | ** **   | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(In thousands)**                                          | ** **   |
| Net revenues                  |       | $                                                           |  9,033  |   | $ |  6,585 |   | $ |  (2,883 | )(1) | $ |  12,735 |   |
| Expenses                      |       | (12,689                                                     | )            | (10,508 | ) | 2,883 |  (1) | (20,314 | ) |
| Other income and (loss)  gain |       | (221                                                        | )            | 69,423 |   | — |   | 69,202 |   |
| Income tax expense            |       | (28                                                         | )            | (150 | ) | — |   | (178 | ) |
| Net (loss) income             |       | $                                                           |  (3,905 | ) | $ |  65,350 |   | $ |  — |   | $ |  61,445 |   |

 
| ** **                    | ** ** | **Six months ended June 30, 2008** | ** **    |
|-------------------------------|------------|-------------------------------------------------------------|---------------|
| ** **                    | ** ** | **Investment  Management**                                  | ** **    | **Principal  Investing** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                    | ** ** | **(In thousands)**                                     | ** **    |
| Net revenues                  |       | $                                                           |  29,803  |   | $ |  21,708 |   | $ |  (8,382 | )(1) | $ |  43,129 |   |
| Expenses                      |       | (55,058                                                     | )             | (14,395 | ) | 8,382 |  (1) | (61,071 | ) |
| Other income and loss         |       | (2,982                                                      | )             | (441,328 | ) | — |   | (444,310 | ) |
| Income tax benefit  (expense) |       | 8,191                                                       |          | (3,857 | ) | — |   | 4,334 |   |
| Net loss                      |       | $                                                           |  (20,046 | ) | $ |  (437,872 | ) | $ |  — |   | $ |  (457,918 | ) |

 

----

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

 

Our Principal Investing segment results of operationsinclude the financial results of DFR MM CLO and Market Square CLO for the threeand six months ended June 30, 2009 and 2008 and includes the financialresults of DPLC for the three and six months ended June 30, 2009.

 

**Investment Management Segment**

 

***Revenues***

 

Our Investment Management segment revenues primarilyrepresent the fee income earned for the management of investment accounts forvarious types of clients. The following table summarizes our InvestmentManagement segment revenues:

 
| ** **                                    | ** ** | **Three months ended June 30,** | ** **  | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** **    |
|-----------------------------------------------|------------|---------------------------------|-------------|--------------|------------|---------------------------------------------------|------------|--------------|---------------|
| ** **                                    | ** ** | **2009**                        | ** **  | **2008**     | ** ** | **2009 vs. 2008**                                 | ** ** | **2009**     | ** **    | **2008** | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                    | ** ** | **(In thousands)**              | ** **  |
| **Investment  Management Segment Revenues**   |       |                            |        |         |       |                                              |       |         |          |   |   |   |   |
| Interest income                               |       | $                               |  16    |         | $          |  155                                         |       | $            |  (139    | ) | $ |  62 |   | $ |  497 |   | $ |  (435 | ) |
| Interest expense                              |       | 1,314                           |        | 1,583        |       | (269                                              | )          | 2,658        |          | 3,554 |   | (896 | ) |
| Net interest expense                          |       | (1,298                          | )           | (1,428       | )          | 130                                               |       | (2,596       | )             | (3,057 | ) | 461 |   |
| Investment advisory  fees (1)                 |       | 5,428                           |        | 16,783       |       | (11,355                                           | )          | 11,629       |          | 32,860 |   | (21,231 | ) |
| Total Investment  Management segment revenues |       | $                               |  4,130 |         | $          |  15,355                                      |       | $            |  (11,225 | ) | $ |  9,033 |   | $ |  29,803 |   | $ |  (20,770 | ) |

 

----

| (1) | Investment advisory fees include intercompany  investment advisory fees of $1.4 million and $4.4 million for the  three months ended June 30, 2009 and 2008, respectively, and $2.9  million and $8.4 million for the six months ended June 30, 2009 and  2008, respectively, calculated in conjunction with DCM’s management agreement  with DFR, which are eliminated upon consolidation. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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*NetInterest Income*

 

Interest income for the three months and six monthsended June 30, 2009 is primarily comprised of interest earned from ourcash balances.  Interest income for the three and six months ended June 30,2008 is primarily comprised of interest earned on preferred shares of CDOs of$0.1 million and $0.4 million, respectively. We owned preferred shares issued by one and nine of the CDOs that wemanaged as of June 30, 2009 and 2008, respectively.  The sale of thepreferred shares issued by eight of the CDOs that we managed during the yearended December 31, 2008 was the primary driver in the reduction ininterest income during the three and six months ended June 30, 2009, ascompared to the same period in 2008.  Interest expense is primarilycomprised of interest expense on the Series A Senior Secured Notes and Series BSenior Secured Notes issued in connection with the Merger, or the Series Aand Series B Notes, for the three and six months ended June 30, 2009and 2008.  The reduction in interest expense during the three and sixmonths ended June 30, 2009, as compared to the same period in 2008, wasthe result of a reduced interest rate environment.

 

*InvestmentAdvisory Fees*

 

For the three months ended June 30, 2009 and2008, investment advisory fees were $5.4 million and $16.8 million,respectively, on a segment basis, and $4.0 million and $12.4 million,respectively, on a consolidated basis due to the $1.4 million and$4.4 million, respectively, of fees earned by the Investment Managementsegment from the Principal Investing segment, which are eliminated uponconsolidation.  During the six months ended June 30, 2009 and 2008,investment advisory fees were $11.6 million and $32.9 million, respectively, ona segment basis, and $8.7 million and $24.5 million, respectively on aconsolidated basis due to the $2.9 million and $8.4 million, respectively, offees earned on the Principal Investing segment, which are eliminated uponconsolidation.  Our investment advisoryfee revenue during the periods presented was generated by our CDOs, ourinvestment funds, which were liquidated during 2008, our separately managedaccounts and DPLC.

 

***CDOs***

 

The following table summarizes our investment advisoryfee revenues from CDOs for the periods presented:

 
| ** **                            | ** ** | **Three months ended June 30,** | ** **  | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** **   |
|---------------------------------------|------------|-----------------------------------------------------|-------------|--------------|------------|---------------------------------------------------|------------|--------------|--------------|
| ** **                            | ** ** | **2009**                                            | ** **  | **2008**     | ** ** | **2009  vs. 2008**                                | ** ** | **2009**     | ** **   | **2008** | ** ** | **2009  vs. 2008** | ** ** |
| ** **                            | ** ** | **(In  thousands)**                                 | ** **  |
| **Senior  Management Fees:**          | ** ** | ** **                                          | ** **  | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | $                                                   |  1,487 |         | $          |  2,157                                       |       | $            |  (670   | ) | $ |  3,053 |   | $ |  4,795 |   | $ |  (1,742 | ) |
| ABS                                   |       | 760                                                 |        | 1,369        |       | (609                                              | )          | 1,812        |         | 2,826 |   | (1,014 | ) |
| Corporate Bonds                       |       | 645                                                 |        | 230          |       | 415                                               |       | 965          |         | 452 |   | 513 |   |
| **Total  Senior Mangement Fees**      |       | 2,892                                               |        | 3,756        |       | (864                                              | )          | 5,830        |         | 8,073 |   | (2,243 | ) |
|                                  |       |                                                |        |         |       |                                              |       |         |         |   |   |   |   |
| **Subordinated  Management Fees:**    | ** ** | ** **                                          | ** **  | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | 77                                                  |        | 3,521        |       | (3,444                                            | )          | 1,504        |         | 6,763 |   | (5,259 | ) |
| ABS                                   |       | 152                                                 |        | 71           |       | 81                                                |       | 152          |         | 288 |   | (136 | ) |
| Corporate Bonds                       |       | 296                                                 |        | 54           |       | 242                                               |       | 272          |         | 137 |   | 135 |   |
| **Total  Subordinate Mangement Fees** |       | 525                                                 |        | 3,646        |       | (3,121                                            | )          | 1,928        |         | 7,188 |   | (5,260 | ) |
|                                  |       |                                                |        |         |       |                                              |       |         |         |   |   |   |   |
| **Performance  Fees (1):**            | ** ** | ** **                                          | ** **  | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | 172                                                 | (2)         | —       |       | 172                                               |       | 172          | (2)          | — |   | 172 |   |
| ABS                                   |       | —                                              |        | 2,702        | (3)        | (2,702                                            | )          | —       |         | 2,774 | (3) | (2,774 | ) |
| Corporate Bonds                       |       | 73                                                  | (4)         | —       |       | 73                                                |       | 225          | (4)          | — |   | 225 |   |
| **Total  Performance Fees**           |       | 245                                                 |        | 2,702        |       | (2,457                                            | )          | 397          |         | 2,774 |   | (2,377 | ) |
|                                  |       |                                                |        |         |       |                                              |       |         |         |   |   |   |   |
| **Total  CDO Advisory Fees:**         | ** ** | ** **                                          | ** **  | ** **   | ** ** | ** **                                        | ** ** | ** **   | ** **   | ** ** | ** ** | ** ** | ** ** |
| CLOs                                  |       | 1,736                                               |        | 5,678        |       | (3,942                                            | )          | 4,729        |         | 11,558 |   | (6,829 | ) |
| ABS                                   |       | 912                                                 |        | 4,142        |       | (3,230                                            | )          | 1,964        |         | 5,888 |   | (3,924 | ) |
| Corporate Bonds                       |       | 1,014                                               |        | 284          |       | 730                                               |       | 1,462        |         | 589 |   | 873 |   |
| **Total CDO  Advisory Fees**          |       | $                                                   |  3,662 |         | $          |  10,104                                      |       | $            |  (6,442 | ) | $ |  8,155 |   | $ |  18,035 |   | $ |  (9,880 | ) |

 

----

| (1) | Performance fees are generally earned after certain investors’ returns  exceed a specified internal rate of return, or IRR. For purposes of this and  the following table, and in accordance with our accounting policies, we also  classify any previously deferred senior or subordinated management fees that  are subsequently paid as performance fees.                                                                                                          |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Performance fees on CLOs for the three and six months ended  June 30, 2009 represent previously deferred subordinated management  fees.                                                                                                                                                                                                                                                                                                                               |
| (3) | Performance fees on ABS CDOs for the three and six months ended  June 30, 2008 included a non-recurring performance fee of $2.7 million  received from one of our ABS CDOs.                                                                                                                                                                                                                                                                                           |
| (4) | Performance fees on Corporate Bonds CDOs for the  three months ended June 30, 2009 primarily represent previously deferred  subordinated management fees.  In  addition, performance fees for the six months ended June 30, 2009  include $0.2 million in fees related to a previously liquidated corporate  bond CDO as a result of a settlement received in connection with certain  litigation relating to one of the assets previously held in the CDO. |

 

48

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Our fees differ from account to account, but ingeneral, our fees from CDOs consist of a senior management fee (payable beforethe interest payable on the debt securities issued by the CDO) that ranges from5 basis points to 25 basis points annually of the principal balanceof the underlying collateral of the CDO, a subordinate management fee (payableafter the interest payable on the debt securities issued by the CDO and certainother expenses) that ranges from 5 basis points to 45 basis pointsannually of the principal balance of the underlying collateral of the CDO, and,in certain CDOs, performance fees that are paid after certain investors’returns exceed an internal rate of return, or IRR hurdle. The performance feesgenerally range from 10% to 20% of residual cash flows above the IRR hurdle andvary by transaction.

 

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

 

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

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

 
| ** **      | ** ** | **Three months ended June 30, 2008** | ** **       |
|-----------------|------------|--------------------------------------|------------------|
| ** **      | ** ** | ** **                           | ** **       | **Effective Rate (2)** | ** ** | **Weighted Average  Contractual Rate (3)** | ** ** |
| ** **      | ** ** | ** **                           | ** **       | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **      | ** ** | **Average AUM (1)**                  | ** **       | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **      | ** ** | **(In thousands)**                   | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (4)        |       | $                                    |  5,043,703  |   | 0.17 | % | 0.28 | % | 0.20 | % | 0.29 | % |
|            |       |                                 |             |   |   |   |   |   |   |   |   |
| ABS:            |       |                                 |             |   |   |   |   |   |   |   |   |
| High-grade ABS  |       | 3,666,061                            |             | 0.05 | % | 0.00 | % | 0.05 | % | 0.06 | % |
| Other ABS       |       | 2,857,233                            |             | 0.13 | % | 0.01 | % | 0.14 | % | 0.19 | % |
| Total ABS       |       | 6,523,294                            |             | 0.08 | % | 0.00 | % | 0.09 | % | 0.11 | % |
|            |       |                                 |             |   |   |   |   |   |   |   |   |
| Corporate bonds |       | 631,058                              |             | 0.15 | % | 0.03 | % | 0.20 | % | 0.20 | % |
| Total CDOs      |       | $                                    |  12,198,055 |   | 0.12 | % | 0.12 | % | 0.14 | % | 0.19 | % |

 

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

 
| ** **      | ** ** | **Six months ended June 30, 2008** | ** **       |
|-----------------|------------|------------------------------------|------------------|
| ** **      | ** ** | ** **                         | ** **       | **Effective Rate (2)** | ** ** | **Weighted Average  Contractual Rate (3)** | ** ** |
| ** **      | ** ** | ** **                         | ** **       | **Senior** | ** ** | **Subordinated** | ** ** | **Senior** | ** ** | **Subordinated** | ** ** |
| ** **      | ** ** | **Average AUM (1)**                | ** **       | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** | **Management Fee** | ** ** |
| ** **      | ** ** | **(In thousands)**                 | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| CLOs (4)        |       | $                                  |  5,149,811  |   | 0.19 | % | 0.26 | % | 0.21 | % | 0.29 | % |
|            |       |                               |             |   |   |   |   |   |   |   |   |
| ABS:            |       |                               |             |   |   |   |   |   |   |   |   |
| High-grade ABS  |       | 3,713,271                          |             | 0.05 | % | 0.01 | % | 0.05 | % | 0.06 | % |
| Other ABS       |       | 2,937,451                          |             | 0.13 | % | 0.01 | % | 0.14 | % | 0.19 | % |
| Total ABS       |       | 6,650,722                          |             | 0.08 | % | 0.01 | % | 0.09 | % | 0.11 | % |
|            |       |                               |             |   |   |   |   |   |   |   |   |
| Corporate bonds |       | 638,939                            |             | 0.14 | % | 0.04 | % | 0.20 | % | 0.20 | % |
| Total CDOs      |       | $                                  |  12,439,472 |   | 0.13 | % | 0.12 | % | 0.14 | % | 0.19 | % |

 

----

| (1) | Average AUM is calculated as the average of the AUM on the first day  of April, May, June and July for the three months ended  June 30, 2009 and 2008 and the average of the first day of January,  February, March, April, May, June and July for the six months ended  June 30, 2009 and 2008. CDO AUM numbers generally reflect the aggregate  principal or notional balance of the collateral and, in some cases, the cash  balance held by the CDO and are as of the date of the last trustee report  received for each CDO prior to the AUM date, as appropriate. The AUM for our  Euro-denominated CDOs has been converted to U.S. dollars using the spot rate  of exchange as of the respective AUM date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | The effective rate for the three months ended June 30, 2009 and  2008 is calculated by taking the management fees earned during the three  months ended June 30, 2009 and 2008, respectively, multiplied by four  (to annualize) and divided by the average AUM. The effective rate for the six  months ended June 30, 2009 and 2008 is calculated by taking management  fees earned during the period multiplied by two (to annualize) and divided by  the average AUM. The senior and subordinated management fee effective rates  may differ from the contractual fee rates for various reasons, including the  following: (a) we may have entered into agreement with specific  investors pursuant to which our management fees are paid to those investors  and (b) our senior or subordinated management fees may be deferred as a  result of certain structural provisions built into the documents governing  the CDO. In certain circumstances, we may at a later date, subject to certain  performance triggers, be entitled to repayment of the fees paid to investors  described in (a) above. In addition, we may at a later date, subject to  the satisfaction of certain structural provisions, be entitled to payment of  the deferred fees described in (b) above. |
| (3) | The weighted average contractual senior and subordinated management  fee rates are obtained by multiplying the contractual fee rates for each CDO  by that CDO’s average AUM and dividing that number by the total average AUM  for the relevant asset class.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| (4) | Market Square CLO and DFR MM CLO have been excluded from all  categories in this table as DCM manages these CLOs, but is not contractually  entitled to receive any management fees for these CLOs so long as 100% of the  equity is held by DC LLC or an affiliate thereof.  As a result of the sale of all of our  preference shares of Market Square CLO on June 30, 2009, DFR will be  entitled to receive future management fees from Market Square CLO.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (5) | The effective and contractual rates for Robeco CDO are calculated  based on the fees that we are entitled to receive pursuant to the asset  purchase agreement between DCM and Robeco Investment Management, Inc.  and are not the total fees paid by the CDO or the contractual fee rate set  forth in the management agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |

 

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The following table summarizes select details of thestructure of each of our CDOs:

 
| ** **                          | ** ** | **Closing Date** | ** ** | **July 1, 2009 AUM (1)** | ** ** | **First Optional  Call Date (2)** | ** ** | **Auction Call  Date (3)** | ** ** | **Termination of  Reinvestment  Period (4)** | ** ** | **Maturity  Year** | ** ** |
|-------------------------------------|------------|------------------|------------|-------------------------------|------------|-----------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|--------------------|------------|
| ** **                          | ** ** | **Month/Year**   | ** ** | **(In thousands)**            | ** ** | ** **                        | ** ** | **Month/Year**             | ** ** | ** **                                   | ** ** | ** **         | ** ** |
| **CLOs:**                           |       |             |       |                          |       |                              |       |                       |       |                                         |       |               |       |
| Rosemont CLO, Ltd.                  |       | 01/02            |       | $                             | 159,617    |                              | 10/05      |                       | n/a        |                                         | 01/07      |               | 2013       |   |
| Forest Creek CLO Ltd.               |       | 05/03            |       | 269,764                       |       | 07/07                             |       | n/a                        |       | 07/08                                        |       | 2015               |       |
| Long Grove CLO Ltd.                 |       | 06/04            |       | 379,860                       |       | 08/08                             |       | n/a                        |       | 05/10                                        |       | 2016               |       |
| Market Square CLO Ltd.              |       | 05/05            |       | 296,644                       |       | 07/07                             |       | n/a                        |       | 04/11                                        |       | 2017               |       |
| Cumberland II CLO Ltd.              |       | 09/05            |       | 389,717                       |       | 02/10                             |       | n/a                        |       | 11/11                                        |       | 2019               |       |
| Marquette Park CLO Ltd.             |       | 12/05            |       | 288,474                       |       | 04/10                             |       | n/a                        |       | 01/12                                        |       | 2020               |       |
| Bridgeport CLO Ltd.                 |       | 06/06            |       | 484,288                       |       | 10/09                             |       | n/a                        |       | 07/13                                        |       | 2020               |       |
| Burr Ridge CLO Plus Ltd.            |       | 12/06            |       | 288,929                       |       | 06/12                             |       | n/a                        |       | 03/13                                        |       | 2023               |       |
| Schiller Park CLO Ltd.              |       | 05/07            |       | 381,024                       |       | 07/11                             |       | n/a                        |       | 04/13                                        |       | 2021               |       |
| Bridgeport CLO II Ltd.              |       | 06/07            |       | 484,326                       |       | 12/10                             |       | n/a                        |       | 09/14                                        |       | 2021               |       |
| DFR Middle Market CLO  Ltd. (5)     |       | 07/07            |       | 289,790                       |       | 07/10                             |       | n/a                        |       | 07/10                                        |       | 2019               |       |
| Gillespie CLO PLC (6)               |       | 08/07            |       | 385,793                       |       | 02/13                             |       | n/a                        |       | 08/13                                        |       | 2023               |       |
| **Total  CLOs**                     |       |             |       | 4,098,226                     |       |                              |       |                       |       |                                         |       |               |       |
|                                |       |             |       |                          |       |                              |       |                       |       |                                         |       |               |       |
| **ABS  CDOs:**                      |       |             |       |                          |       |                              |       |                       |       |                                         |       |               |       |
| Mid Ocean CBO 2000-1  Ltd.          |       | 01/01            |       | 115,135                       |       | 04/06                             |       | n/a                        |       | 01/06                                        |       | 2036               |       |
| Mid Ocean CBO 2001-1  Ltd.          |       | 10/01            |       | 130,986                       |       | 02/06                             |       | n/a                        |       | 01/06                                        |       | 2036               |       |
| Oceanview CBO I, Ltd.               |       | 06/02            |       | 181,621                       |       | 06/06                             |       | 06/12                      |       | 06/06                                        |       | 2032, 2037 (7)     |       |
| Northlake CDO I, Limited            |       | 02/03            |       | 146,136                       |       | 03/06                             |       | 03/13                      |       | 03/07                                        |       | 2033               |       |
| Knollwood CDO Ltd.                  |       | 03/04            |       | 146,153                       |       | 04/07                             |       | 04/12                      |       | 04/08                                        |       | 2039               |       |
| River North CDO Ltd.                |       | 01/05            |       | 237,688                       |       | 02/09                             |       | 02/13                      |       | 02/09                                        |       | 2040               |       |
| Buckingham CDO Ltd.                 |       | 07/05            |       | 828,901                       |       | 08/10                             |       | 08/13                      |       | 08/10                                        |       | 2040               |       |
| Pinetree CDO Ltd.                   |       | 11/05            |       | 213,643                       |       | 01/10                             |       | 01/14                      |       | 01/10                                        |       | 2045               |       |
| Buckingham CDO II Ltd.              |       | 12/05            |       | 1,174,286                     |       | 03/11                             |       | 03/14                      |       | 03/11                                        |       | 2041               |       |
| Knollwood CDO II Ltd.               |       | 07/06            |       | 86,099                        |       | 07/09                             |       | 07/13                      |       | n/a                                          |       | 2046               |       |
| Buckingham CDO III Ltd.             |       | 08/06            |       | 1,190,013                     |       | 09/11                             |       | 09/14                      |       | 09/11                                        |       | 2051               |       |
| Aramis CDO                          |       | 03/07            |       | 110,406                       |       | 03/12                             |       | n/a                        |       | n/a                                          |       | 2047               |       |
| **Total  ABS CDOs**                 |       |             |       | 4,561,067                     |       |                              |       |                       |       |                                         |       |               |       |
| ** **                          |       |             |       |                          |       |                              |       |                       |       |                                         |       |               |       |
| **Corporate  Bond CDOs:**           |       |             |       |                          |       |                              |       |                       |       |                                         |       |               |       |
| Valeo Investment Grade  CDO Ltd.    |       | 01/01            |       | 294,443                       |       | 01/05                             |       | n/a                        |       | 01/06                                        |       | 2013               |       |
| Valeo Investment Grade  CDO II Ltd. |       | 05/01            |       | 292,400                       |       | 06/05                             |       | n/a                        |       | 06/06                                        |       | 2013               |       |
| Robeco CDO II Limited               |       | 08/01            |       | 139,397                       |       | 08/05                             |       | n/a                        |       | 02/06                                        |       | 2013               |       |
| Mayfair Euro CDO I B.V. (6)(7)      |       | 06/01            |       | 128,810                       |       | 05/06                             |       | n/a                        |       | 05/06                                        |       | 2013               |       |
| **Total  Corporate Bond CDOs**      |       |             |       | 855,050                       |       |                              |       |                       |       |                                         |       |               |       |
|                                |       |             |       |                          |       |                              |       |                       |       |                                         |       |               |       |
| **Total  CDO AUM**                  |       |             |       | $                             | 9,514,343  |                              |       |                       |       |                                         |       |               |       |   |

 

----

| (1) | CDO AUM numbers generally reflect the aggregate principal or notional  balance of the collateral and, in some cases, the cash balance held by the  CDOs and are as of the date of the last trustee report received for each CDO  prior to July 1, 2009.                                                                  |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | CDOs are generally callable by equity holders once per quarter  beginning on the “first option call date” and subject to satisfaction of  certain conditions.                                                                                                                                                       |
| (3) | ABS CDOs generally contain a provision requiring the manager thereof  to liquidate the collateral held therein on the “auction call date,” subject  to certain conditions, generally including that the proceeds from any such  liquidation be sufficient to redeem the notes and pay certain additional  expenses. |
| (4) | Termination of reinvestment period refers to the date after which we  can no longer use certain principal collections to purchase additional  collateral, and such collections are instead used to repay the outstanding  amounts of certain debt securities issued by the CDO.                                               |
| (5) | We are not contractually entitled to receive any management fees from  this CLO so long as 100% of the equity is held by DC LLC or an affiliate  thereof.                                                                                                                                                                     |
| (6) | The AUM for our Euro-denominated CDOs has been converted into U.S.  dollars using the spot rate of exchange on June 30, 2009.                                                                                                                                                                                            |
| (7) | Maturity date varies by tranche of notes.                                                                                                                                                                                                                                                                                     |

 

The CDOs that we manage generally contain certainstructural provisions, including, but not limited to, overcollateralizationrequirements and/or market value triggers that are meant to protect investorsfrom deterioration in the credit quality of the underlying collateral pool.Recent increased defaults and downgrades of the collateral underlying our CDOshave put downward pressure on overcollateralization ratios and increased thelikelihood that the CDOs we manage will experience events of default or triggerother structural protections. In certain cases, breaches of these structuralprovisions can lead to events of default under the indentures governing theCDOs and, ultimately, acceleration of the notes issued by the CDO and theliquidation of the underlying collateral. Certain of our CDOs containprovisions prohibiting the liquidation of the CDO following an event of defaultunless either the proceeds from the liquidation will be sufficient to pay offall of the notes issued by the CDO along with certain specified expenses or amajority or supermajority of certain specified classes of notes vote toliquidate the CDO. We believe that CDOs that contain these provisions are lesslikely to liquidate upon the occurrence of an event of default.

 

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CLO investment advisory fee revenue declined by $3.9million and $6.8 million for the three and six months ended June 30, 2009,respectively, as compared to the same periods in 2008. We managed four marketvalue CLOs during 2008, all of which contained liquidation triggers and eventsof default based on the market value of the CLO’s assets. The significantdecline in liquidity in the credit markets during the year ended December 31,2008 had a negative impact on the market values of the assets held in our CLOs.All four of our market value CLOs breached their market value trigger duringthe year ended December 31, 2008 and were subsequently liquidated. For thethree and six months ended June 30, 2008, we earned senior management feesof $0.5 million and $1.5 million, respectively, and subordinated managementfees of $0.5 million and $0.7 million, respectively, on these market valueCLOs.   The remainder of our CLOs are cash flow CLOs. Triggers andevents of default in these deals are not based on the market value of theportfolio.

 

In addition, subordinated management fees on CLOsdeclined by $3.4 million and $5.3 million, during the three and six monthsended June 30, 2009, respectively, as compared to the same periods in2008.  This was primarily the result of the failure of theovercollateralization tests for the majority of the CLOs during the six monthsended June 30, 2009, resulting in the deferral of subordinated managementfees on those CLOs. We earned subordinated management fees of $77,000 and $3.5million for the three months ended June 30, 2009 and 2008, respectively,and $1.5 million and $6.8 million for the six months ended June 30, 2009and 2008, respectively, related to those CLOs that have failed theirovercollateralization tests or that we expect will fail theirovercollateralization tests.  We expect our CLO subordinated investmentadvisory fees to continue to be deferred in the near term.  However, overtime and with continued improvement in market conditions, we expect the CLOs toregain compliance with their overcollateralization tests, and, subject to thesatisfaction of certain other conditions, we would expect to recoup at least aportion and potentially substantially all of the deferred subordinatedmanagement fees and to receive future subordinated management fees on a currentbasis.

 

The decline in ABS CDO revenue of $3.2 million and$3.9 million for the three and six months ended June 30, 2009,respectively, as compared to the same periods in 2008, is primarily the resultof three of the ABS CDOs triggering events of default during 2008 and thereduction in AUM for the remainder of our ABS CDOs as compared to the sameperiod in 2008.  Two of the ABS CDOs that we currently manage, KnollwoodCDO Ltd. and Knollwood CDO II Ltd., have triggered events of default resultingprimarily from downgrades of their underlying collateral. However, we believeit is unlikely that a liquidation of these CDOs will occur in the nearterm.  As a result of the significant decline in AUM of these two ABSCDOs, we experienced a decline in senior management fees during the three andsix months ended June 30, 2009 as compared to June 30, 2008 of $0.3million and $0.5 million, respectively related to these two ABS CDOs. Oneadditional ABS CDO that we managed during 2008, Western Springs CDO Ltd., orWestern Springs CDO, triggered an event of default in the first quarter of 2008and was subsequently liquidated. For the six months ended June 30, 2008,we earned senior management fees of $0.2 million and subordinated managementfees of $22,000 on Western Springs CDO. In addition, one CDO, with respect to whichwe earned subordinated fees of $0.1 million during the six months ended June 30,2008, failed its overcollateralization tests during 2008, resulting in thedeferral of those fees.

 

We are continuing to focus on our previously announcedstrategy of acquiring existing CDO management contracts. On July 17, 2008,we acquired the management contract for Robeco CDO, and, on February 11,2009, we assumed the management contract for Mayfair Euro CDO.

 

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***Other Investment Advisory Fees***

 

The following table summarizes the respectiveinvestment advisory fee revenues for our investment management contractsrelated to our separately managed accounts, fixed income arbitrage investmentfunds, other investment vehicles and other investment advisory fees:

 
| ** **                                  | ** ** | **Average  AUM (1)** | ** ** | **Management  Fees** | ** ** | **Performance  Fees** | ** ** |
|---------------------------------------------|------------|----------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                  |       | **(In thousands)**   |       |
| **Three  months ended June 30, 2009:** |       |                 |       |                 |       |                  |       |
| Separately managed  accounts                |       | $                    | 322,367    |                 | $          | 223                   |       | n/a |   |
|                                        |       |                 |       |                 |       |                  |       |
| Other investment  vehicle (2)               |       | $                    | 13,217     |                 | $          | 124                   |       | $ | — |   |
|                                        |       |                 |       |                 |       |                  |       |
| **Three  months ended June 30, 2008:** |       |                 |       |                 |       |                  |       |
| Fixed income arbitrage  investment funds    |       | $                    | 509,036    |                 | $          | 1,992                 |       | $ | — |   |
| Separately managed  accounts                |       | $                    | 423,364    |                 | $          | 263                   |       | n/a |   |

 
| ** **                                | ** ** | **Average  AUM (3)** | ** ** | **Management  Fees** | ** ** | **Performance  Fees** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **(In thousands)**   | ** ** |
| **Six  months ended June 30, 2009:** |       |                 |       |                 |       |                  |       |
| Separately managed  accounts              |       | $                    | 308,521    |                 | $          | 467                   |       | n/a |   |
|                                      |       |                 |       |                 |       |                  |       |
| Other investment  vehicle (2)             |       | $                    | 7,552      |                 | $          | 124                   |       | $ | — |   |
|                                      |       |                 |       |                 |       |                  |       |
| **Six  months ended June 30, 2008:** |       |                 |       |                 |       |                  |       |
| Fixed income arbitrage  investment funds  |       | $                    | 608,450    |                 | $          | 4,748                 |       | $ | 1,186 | (4) |
| Separately managed  accounts              |       | $                    | 413,653    |                 | $          | 509                   |       | n/a |   |

 

----

| (1) | Average  AUM for the three months ended June 30, 2009 and 2008 is calculated as  the average of the AUM on the first day of April, May and June 2009  and 2008, respectively.                         |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Represents  management fee revenues earned on DPLC. We recognize management fee revenues  on the portion of the AUM which is not related to our investment in DPLC.                                                  |
| (3) | Average  AUM for the six months ended June 30, 2009 and 2008 is calculated as the  average of the AUM on the first day of January, February, March, April,  May and June 2009 and 2008, respectively. |
| (4) | Performance  fees were related to our smaller investment fund which liquidated on  April 30, 2008.                                                                                                              |

n/a — not applicable

 

The reduction in other investment advisory fees duringthe three and six months ended June 30, 2009, as compared to the sameperiods in 2008, was primarily driven by the liquidation of our fixed incomearbitrage investment funds during 2008.  For the three and six monthsended June 30, 2008, we earned management fees of $1.9 million and$4.7 million, respectively, and incentive fees of zero and $1.2 million,respectively, related to these liquidated investment funds.

 

As a result of the formation of DPLC, we earnmanagement fees and incentive fees on the portion of the assets undermanagement which is not related to our investment in DPLC.

 

*Intercompanyinvestment advisory fees*

 

As a result of the Merger, we entered into a newmanagement agreement with DCM. Management fees paid pursuant to this agreementare eliminated upon consolidation in accordance with GAAP. Fees are paid on acost plus margin basis for investment advisory, management and operationalservices. All ancillary services, including back office support and certainoperating expenses, are charged at cost. For the three months ended June 30,2009 and 2008, the intercompany investment advisory fees earned were$1.4 million and $4.4 million, respectively.   For the six months ended June 30, 2009and 2008, the intercompany investment advisory fees earned were $2.9 millionand $8.4 million, respectively.

 

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***Expenses***

 

The followingtable summarizes our Investment Management segment expenses for the periodspresented:

 
| ** **                                          | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                          | ** ** | **2009**                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**                  | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                          | ** ** | **(In millions)**                    | ** ** |
| Salaries                                            |       | $                                    | 1.9        |         | $          | 3.4                                |       | $            | (1.5       | ) | $ | 4.1 |   | $ | 7.7 |   | $ | (3.6 | ) |
| Incentive compensation                              |       | 1.0                                  |       | 3.8          |       | (2.8                               | )          | 2.0          |       | 8.2 |   | (6.2 | ) |
| Employee benefits                                   |       | 0.1                                  |       | 0.4          |       | (0.3                               | )          | 0.3          |       | 0.9 |   | (0.6 | ) |
| Total compensation and  benefits                    |       | 3.0                                  |       | 7.6          |       | (4.6                               | )          | 6.4          |       | 16.8 |   | (10.4 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Audit and audit-related  fees                       |       | 0.1                                  |       | 0.2          |       | (0.1                               | )          | 0.2          |       | 0.5 |   | (0.3 | ) |
| Other professional fees                             |       | —                               |       | 0.1          |       | (0.1                               | )          | —       |       | 0.1 |   | (0.1 | ) |
| Total professional  services                        |       | 0.1                                  |       | 0.3          |       | (0.2                               | )          | 0.2          |       | 0.6 |   | (0.4 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Insurance expense                                   |       | 0.1                                  |       | 0.1          |       | —                             |       | 0.2          |       | 0.3 |   | (0.1 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Software and data feeds                             |       | 0.3                                  |       | 0.5          |       | (0.2                               | )          | 0.6          |       | 1.0 |   | (0.4 | ) |
| Other general and  administrative fees              |       | 0.3                                  |       | 0.4          |       | (0.1                               | )          | 0.5          |       | 0.5 |   | — |   |
| Total general and  administrative expense           |       | 0.6                                  |       | 0.9          |       | (0.3                               | )          | 1.1          |       | 1.5 |   | (0.4 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Fixed asset  depreciation                           |       | 0.3                                  |       | 0.3          |       | —                             |       | 0.6          |       | 0.7 |   | (0.1 | ) |
| Intangible asset  amortization                      |       | 1.3                                  |       | 2.3          |       | (1.0                               | )          | 2.7          |       | 4.6 |   | (1.9 | ) |
| Total depreciation and  amortization                |       | 1.6                                  |       | 2.6          |       | (1.0                               | )          | 3.3          |       | 5.3 |   | (2.0 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Occupancy                                           |       | 0.6                                  |       | 0.6          |       | —                             |       | 1.2          |       | 1.3 |   | (0.1 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Cost savings initiative                             |       | —                               |       | 0.1          |       | (0.1                               | )          | 0.2          |       | 0.3 |   | (0.1 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Impairment of  intangible assets                    |       | 0.1                                  |       | 1.1          |       | (1.0                               | )          | 0.1          |       | 9.0 |   | (8.9 | ) |
| Impairment of goodwill                              |       | —                               |       | —       |       | —                             |       | —       |       | 20.0 |   | (20.0 | ) |
| Total impairment of  intangible assets and goodwill |       | 0.1                                  |       | 1.1          |       | (1.0                               | )          | 0.1          |       | 29.0 |   | (28.9 | ) |
|                                                |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Total Investment  Management segment expenses       |       | $                                    | 6.1        |         | $          | 13.3                               |       | $            | (7.2       | ) | $ | 12.7 |   | $ | 55.1 |   | $ | (42.4 | ) |

 

The decrease in expenses of $7.2 million for the threemonths ended June 30, 2009 compared to the same period in 2008 wasprimarily attributable to decreases in compensation and benefits of $4.6million, impairment of intangible assets and goodwill of $1.0 million anddepreciation and amortization of $1.0 million. The decrease in expenses of $42.4 million for the six months ended June 30,2009 compared to the same period in 2008 was primarily attributable todecreases in impairment of intangible assets and goodwill of $28.9 million,compensation and benefits of $10.4 million and depreciation and amortization of$2.0 million.

 

The $4.6 million and $10.4 million decrease incompensation and benefits for the three and six months ended June 30,2009, respectively, as compared to the same periods in 2008, was primarily theresult of the implementation of two cost savings initiatives and to a lesserextent a reduction in our projected 2009 incentive compensation for existingemployees. On March 1, 2008, in response to the adverse credit markets, weimplemented an initial cost saving initiative and reduced our headcount by 13employees, or 10% of our then current workforce, across a broad range offunctions. In November 2008, in response to the continued deterioration inmarket conditions, we implemented a second cost saving initiative and reducedour headcount by 24 employees, or approximately 26% of our then currentworkforce, and reduced bonus compensation. The compensation payable to those 24employees accounted for approximately 37% of our annual compensation expense in2008. The headcount reductions were largely related to the fixed incomearbitrage trading business and the associated back-office infrastructure. Webelieve these cost savings initiatives will continue to improve our financialresults without adversely impacting our ability to operate our business in aprudent manner. As of June 30, 2009, we had 67 employees, as compared to103 employees as of June 30, 2008.

 

During the three and six months ended June 30,2009, we recorded $0.1 million of impairment charges related to the intangibleasset associated with the management contract for Knollwood CDO II Ltd. as aresult of the decline in expected future management fee cash flows from thisCDO.  During the three and six monthsended June 30, 2008, we recorded impairment charges on our intangibleassets of $1.1 million and $9.0 million, respectively.  During the three months ended June 30,2008, the impairment charges were comprised of $0.1 million related to anadjustment to purchase accounting that resulted in an additional impairment tothe intangible asset associated with the management contract for our smallestinvestment fund, which subsequently liquidated, and $1.0 million related to themanagement contract for Western Springs CDO. During the six months ended June 30, 2008, the remaining $7.9million of impairment charges were comprised of $4.6 million related to theintangible asset associated with the management contract for our smallestinvestment fund, and $3.3 million related to the management contract forColtrane CLO PLC, or Coltrane CLO, which triggered a market value based eventof default and was subsequently liquidated.

 

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During the sixmonths ended June 30, 2008, we also recorded a $20.0 million impairment ongoodwill.  The significant decline in our overall market value during thefirst quarter of 2008 was a triggering event for an analysis of possiblegoodwill impairment. Although the estimated cash flows generated were generallyexpected to be consistent with the estimated cash flows at the time of theMerger, the market multiple for the companies that we considered comparable haddecreased. This decline in market multiples largely contributed to the$20.0 million of goodwill impairment.

 

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

 

Other income and gain (loss) for the InvestmentManagement segment primarily consisted of the realized and unrealized lossesrelated to our investments in preferred shares of CDOs that are managed by DCM.During the three months ended June 30, 2009 and 2008, we recognizedunrealized losses of zero and $0.9 million, respectively, and, during thesix months ended June 30, 2009 and 2008, we recognized unrealized lossesof $0.2 million and $3.0 million, respectively, in net gain (loss) oninvestments at fair value in the condensed consolidated statements ofoperations related to these investments.  As of June 30, 2009, ourone remaining investment in the preferred shares of a CDO we manage is valuedat zero.

 

***Income Tax Expense***

 

For the three and six months ended June 30, 2009,the Investment Management segment recorded income tax expense of $10,000 and$28,000 due to our subsidiary in London. For income tax purposes, impairmentsof intangibles and goodwill are not recognized but are amortized straight-lineover a 15-year life from the date we established a tax basis. There is a fullvaluation allowance on all of our deferred tax assets except for thoseassociated with our subsidiary in London.

 

**Principal Investing Segment**

 

***Revenues***

 

Our Principal Investing segment revenues represent thenet spread, or difference, between the interest income we earn on ourinvestment portfolio and the cost of our borrowings. We also recognize theimpact of our provision for loan losses on our Principal Investing segmentrevenues. The following table summarizes the Principal Investing segmentrevenues:

 
| ** **                                  | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                  | ** ** | **2009**                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**                  | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                  | ** ** | **(In millions)**                    | ** ** |
| **Principal  Investing Segment Revenues**   |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Interest income                             |       | $                                    | 14.1       |         | $          | 21.7                               |       | $            | (7.6       | ) | $ | 27.8 |   | $ | 82.7 |   | $ | (54.9 | ) |
| Interest expense                            |       | 4.4                                  |       | 10.9         |       | 6.5                                |       | 10.0         |       | 56.5 |   | 46.5 |   |
| Net interest income                         |       | 9.7                                  |       | 10.8         |       | (1.1                               | )          | 17.8         |       | 26.2 |   | (8.4 | ) |
| Provision for loan  losses                  |       | 9.1                                  |       | 2.3          |       | (6.8                               | )          | 11.2         |       | 4.5 |   | (6.7 | ) |
| Total Principal  Investing segment revenues |       | $                                    | 0.6        |         | $          | 8.5                                |       | $            | (7.9       | ) | $ | 6.6 |   | $ | 21.7 |   | $ | (15.1 | ) |

 

The following table summarizes our Principal Investingsegment interest income:

 
| ** **                                   | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **% of total interest income** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|--------------|------------|--------------------------------|------------|
| ** **                                   | ** ** | **2009**                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**              | ** ** | **Three months ended June 30,** | ** ** |
| ** **                                   | ** ** | **(In millions)**                    | ** ** | **2009**     | ** ** | **2008**                       | ** ** |
| **Real  Estate Investments:**                |       |                                 |       |         |       |                           |       |   |   |   |   |
| RMBS                                         |       | $                                    | 4.2        |         | $          | 6.4                            |       | $ | (2.2 | ) | 29.8 | % | 29.5 | % |
| Corporate loans and  securities:             |       |                                 |       |         |       |                           |       |   |   |   |   |
| Loans held in DFR MM  CLO                    |       | 6.2                                  |       | 6.9          |       | (0.7                           | )          | 44.0 | % | 31.9 | % |
| Loans held in Wachovia  Facility             |       | 0.6                                  |       | 2.8          |       | (2.2                           | )          | 4.2 | % | 12.9 | % |
| Other corporate  leveraged loans             |       | —                               |       | 0.4          |       | (0.4                           | )          | 0.0 | % | 1.8 | % |
| Assets held in Market  Square CLO            |       | 3.0                                  |       | 4.3          |       | (1.3                           | )          | 21.3 | % | 19.8 | % |
| Commercial real estate  loans and securities |       | —                               |       | 0.7          |       | (0.7                           | )          | 0.0 | % | 3.2 | % |
| Treasuries and short  term investments       |       | 0.1                                  |       | 0.2          |       | (0.1                           | )          | 0.7 | % | 0.9 | % |
| Equities and other  investments              |       | —                               |       | —       |       | —                         |       | 0.0 | % | 0.0 | % |
| **Total interest income**                    |       | $                                    | 14.1       |         | $          | 21.7                           |       | $ | (7.6 | ) | 100.0 | % | 100.0 | % |

 

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| ** **                                   | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** | **% of total interest income** | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|--------------|------------|--------------------------------|------------|
| ** **                                   | ** ** | **2009**                           | ** ** | **2008**     | ** ** | **2009 vs. 2008**              | ** ** | **Six months ended June 30,** | ** ** |
| ** **                                   | ** ** | **(In millions)**                  | ** ** | **2009**     | ** ** | **2008**                       | ** ** |
| **Real  Estate Investments:**                |       |                               |       |         |       |                           |       |   |   |   |   |
| RMBS                                         |       | $                                  | 8.7        |         | $          | 48.1                           |       | $ | (39.4 | ) | 31.3 | % | 58.2 | % |
| Corporate loans and  securities:             |       |                               |       |         |       |                           |       |   |   |   |   |
| Loans held in DFR MM  CLO                    |       | 12.0                               |       | 15.2         |       | (3.2                           | )          | 43.2 | % | 18.3 | % |
| Loans held in Wachovia  Facility             |       | 1.2                                |       | 6.2          |       | (5.0                           | )          | 4.3 | % | 7.5 | % |
| Other corporate  leveraged loans             |       | —                             |       | 0.8          |       | (0.8                           | )          | 0.0 | % | 1.0 | % |
| Assets held in Market  Square CLO            |       | 6.1                                |       | 9.5          |       | (3.4                           | )          | 21.9 | % | 11.5 | % |
| Commercial real estate  loans and securities |       | (0.1                               | )          | 1.8          |       | (1.9                           | )          | -0.4 | % | 2.2 | % |
| Treasuries and short  term investments       |       | 0.1                                |       | 1.1          |       | (1.0                           | )          | 0.4 | % | 1.3 | % |
| Equities and other  investments              |       | (0.2                               | )          | —       |       | (0.2                           | )          | -0.7 | % | 0.0 | % |
| **Total interest income**                    |       | $                                  | 27.8       |         | $          | 82.7                           |       | $ | (54.9 | ) | 100.0 | % | 100.0 | % |

 

The decrease in interest income of $7.6 million and$54.9 million for the three and six months ended June 30, 2009,respectively, as compared to the same periods in 2008 was attributableprimarily to the reduction of our RMBS and alternative assets portfolios and,to a lesser extent, to a lower interest rate environment. As of June 30,2009, our RMBS and alternative asset portfolios totaled $311.2 million and$301.7 million, respectively, as compared to $444.2 million and$653.2 million, respectively, at June 30, 2008.  RMBS interestincome decreased by $2.2 million and $39.4 million for the three and sixmonths ended June 30, 2009, respectively, as compared to the same periodsin 2008. This decline was primarily the result of the sale of RMBS with anamortized cost of $6.2 billion during the three months ended March 31,2008 combined with a lower interest rate environment.  The $5.4 million and $15.5 milliondecrease in alternative assets interest income for the three and six monthsended June 30, 2009, respectively, compared to the same periods in 2008,was primarily the result of lower investment balances and a lower interest rateenvironment during the three and six months ended June 30, 2009 ascompared to the same periods in 2008. Other corporate leveraged loans, loansheld in the Wachovia Facility and loans held in DFR MM CLO totaled$309.1 million as of June 30, 2009 as compared to $374.1 millionas of June 30, 2008.  Reductions in interest rates and the placementof certain loans on non-accrual status contributed to the reductions ininterest income on loans held in DFR MM CLO and commercial real estate loansand securities.  The decrease in interest income on loans held in theWachovia Facility of $2.2 million and $5.0 million for the three and sixmonths ended June 30, 2009, was the result of the sale of a substantialportion of the loans in the portfolio during 2008 and the first quarter of2009.

 

The following table summarizes our Principal Investingsegment interest expense:

 
| ** **                          | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                          | ** ** | **2009**                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**                  | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009 vs. 2008** | ** ** |
| ** **                          | ** ** | **(In millions)**                    | ** ** |
| Repurchase agreements               |       | $                                    | 0.6        |         | $          | 3.1                                |       | $            | (2.5       | ) | $ | 1.3 |   | $ | 34.4 |   | $ | (33.1 | ) |
| Hedging activity                    |       | —                               |       | 0.1          |       | (0.1                               | )          | 0.1          |       | 5.3 |   | (5.2 | ) |
| Long term debt:                     |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Recourse:                           |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Trust preferred  securities         |       | 1.3                                  |       | 1.9          |       | (0.6                               | )          | 2.7          |       | 4.0 |   | (1.3 | ) |
| Non-Recourse:                       |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Wachovia Facility                   |       | —                               |       | 0.4          |       | (0.4                               | )          | —       |       | 1.1 |   | (1.1 | ) |
| Market Square CLO                   |       | 1.1                                  |       | 2.4          |       | (1.3                               | )          | 2.7          |       | 5.7 |   | (3.0 | ) |
| DFR MM CLO                          |       | 1.0                                  |       | 2.2          |       | (1.2                               | )          | 2.5          |       | 5.1 |   | (2.6 | ) |
| Total long term debt                |       | 3.4                                  |       | 6.9          |       | (3.5                               | )          | 7.9          |       | 15.9 |   | (8.0 | ) |
| Amortization of debt  issuance cost |       | 0.4                                  |       | 0.8          |       | (0.4                               | )          | 0.8          |       | 0.9 |   | (0.1 | ) |
| Total interest expense              |       | $                                    | 4.4        |         | $          | 10.9                               |       | $            | (6.5       | ) | $ | 10.1 |   | $ | 56.5 |   | $ | (46.4 | ) |

 

The decrease in interest expense of $6.5 millionand $46.4 million for the three and six months ended June 30, 2009,respectively, compared to the three and six months ended June 30, 2008,was primarily the result of significantly reduced repurchase agreement balances,decreased interest rates and decreased long term debt balances.

 

During the first quarter of 2008, we significantlyreduced our RMBS portfolio through sales, which in turn resulted in therepayment of the outstanding repurchase agreements used to finance that RMBSand the termination of the associated interest rate swaps used to hedge ourinterest rate risk on those repurchase agreements. The decrease in the averageoutstanding repurchase agreement balance and swaps outstanding for the threeand six months ended June 30, 2009, combined with a lower interest rateenvironment during the three and six months ended June 30, 2009, ascompared to the three and six months ended June 30, 2008, contributed to adecrease in interest expense of $2.6 million and $38.3, respectively.

 

The interest expense related to long term debtdecreased by $3.9 million and $8.1 million for the three and six monthsended June 30, 2009, respectively, as compared to the same periods in2008. This decrease was primarily driven by lower interest rates on our longterm debt, which provided a decrease of $3.1 million and $6.9 million for thethree and six months ended June 30, 2009,

 

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respectively,as compared to the same period in 2008.  In addition, from June 30,2008 to June 30, 2009, we decreased the outstanding balance in theWachovia Facility from $53.4 million to $0.8 million through sales andpaydowns on the portfolio. This resulted in a reduction to our interest expenseof $0.4 million and $1.1 million for the three and six months ended June 30,2009, respectively, as compared to the same periods in 2008.

 

Absent other influences, we expect interest income andinterest expense to continue to decline due, in part, to our deconsolidation ofMarket Square CLO.

 

***Provision for Loan Losses***

 

The following table summarizes our Principal Investingsegment provision for loan losses:

 
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                       | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(In millions)**                    | ** ** |
| Loans held in DFR MM  CLO        |       | $                                    | 8.8        |                               | $          | — |   | $ | 9.6 |   | $ | — |   |
| Other corporate  leveraged loans |       | —                               |       | —                             |       | — |   | 2.2 |   |
| Commercial real estate  loans    |       | 0.3                                  |       | 2.3                                |       | 1.6 |   | 2.3 |   |
| Total provision for  loan losses |       | $                                    | 9.1        |                               | $          | 2.3 |   | $ | 11.2 |   | $ | 4.5 |   |

 

During the three and six months ended June 30,2009, we recognized provisions for loan losses of $9.1 million and $11.2million, respectively. During the three months ended June 30, 2009, werecorded provisions for loan losses of $8.8 million related to two loans heldin DFR MM CLO with total outstanding principal of $10.1 million and$0.3 million in additional provisions related to two commercial realestate loans still being held for investment with total outstanding principalof $6.0 million.  In addition, during thethree months ended March 31, 2009, we recorded additional provisions forloan losses of $0.8 million related to two loans held in the DFR MM CLO withtotal outstanding principal of $17.7 million and $1.3 million related tothree commercial real estate loans still being held for investment with totaloutstanding principal of $10.1 million.

 

During the three and six months ended June 30,2008, we recorded an increase to the provision for loan losses of$2.3 million and $4.5 million, respectively. During the three monthsended June 30, 2008, we determined that a provision for loan loss of$1.3 million was required on a commercial real estate loan held forinvestment with a total principal balance of $5.3 million. Subsequently,$1.8 million of the total principal balance was sold, and the remainingprincipal balance was transferred to loans held for sale. The $1.3 millionaddition to the provision for loan losses was transferred to valuationallowance for loans held for sale and included in loans held for sale on thecondensed consolidated balance sheet as of June 30, 2008. Additionally, werecognized an increase to the provision for loan losses of $0.6 millionfor a commercial real estate loan held for investment with a principal balanceof $1.0 million, which was sold during the three months ended June 30,2008. As a result of the sale, the residual amount of the loan was charged-off.During the three months ended June 30, 2008, we further determined that a$0.4 million provision for loan loss was required on a commercial realestate loan held for investment with a total principal balance of$3.1 million.

 

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***Expenses***

 

The following table summarizes Principal Investingsegment expenses for the periods presented:

 
| ** **                                   | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                   | ** ** | **2009**                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**                  | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                   | ** ** | **(In millions)**                    | ** ** |
| ** **                                   | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                         | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Management fee expense  to related party (1) |       | $                                    | 1.7        |         | $          | 4.4                                |       | $            | (2.7       | ) | $ | 3.2 |   | $ | 8.4 |   | $ | (5.2 | ) |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Audit and audit-related  fees                |       | 0.3                                  |       | 0.2          |       | 0.1                                |       | 0.4          |       | 0.9 |   | (0.5 | ) |
| Legal fees                                   |       | 0.3                                  |       | 1.6          |       | (1.3                               | )          | 0.7          |       | 1.7 |   | (1.0 | ) |
| Other professional fees                      |       | 0.1                                  |       | 0.2          |       | (0.1                               | )          | 0.2          |       | 0.5 |   | (0.3 | ) |
| Total professional  services                 |       | 0.7                                  |       | 2.0          |       | (1.3                               | )          | 1.3          |       | 3.1 |   | (1.8 | ) |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Insurance expense                            |       | 0.7                                  |       | 0.6          |       | 0.1                                |       | 1.4          |       | 1.2 |   | 0.2 |   |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Board of directors fees                      |       | 0.7                                  |       | 0.9          |       | (0.2                               | )          | 1.0          |       | 1.1 |   | (0.1 | ) |
| Banking and other  administrative fees       |       | 0.2                                  |       | 0.1          |       | 0.1                                |       | 0.3          |       | 0.4 |   | (0.1 | ) |
| Software and data feeds                      |       | —                               |       | —       |       | —                             |       | —       |       | 0.1 |   | (0.1 | ) |
| Other general and  administrative fees       |       | 0.1                                  |       | 0.1          |       | —                             |       | 0.1          |       | 0.1 |   | — |   |
| DPLC stucturing and  organizational expenses |       | 3.2                                  |       | —       |       | 3.2                                |       | 3.2          |       | — |   | 3.2 |   |
| Total general and  administrative expenses   |       | 4.2                                  |       | 1.1          |       | 3.1                                |       | 4.6          |       | 1.7 |   | 2.9 |   |
|                                         |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Total Principal  Investing segment expenses  |       | $                                    | 7.3        |         | $          | 8.1                                |       | $            | (0.8       | ) | $ | 10.5 |   | $ | 14.4 |   | $ | (3.9 | ) |

 

----

(1)           Management fee expense of$1.4 million and $4.4 million for the three and six months ended June 30,2009, respectively, and $2.9 million and $8.4 million for the three and sixmonths ended June 30, 2008, respectively, is charged in conjunction withour management agreement with DCM, which is eliminated in consolidation.

 

The decrease in expenses of $0.8 million for the threemonths ended June 30, 2009, compared to the same period in 2008, wasattributable to decreases in management fee expense to related party andprofessional services of $2.7 million and $1.3 million, respectively, partiallyoffset by increases in general and administrative expenses and insuranceexpense of $3.1 million and $0.1 million, respectively.  Management feeexpense to related party is eliminated upon consolidation and is based upon acost plus margin basis for investment advisory, management and operationalservices. The decrease in total professional services of $1.3 million wasprimarily the result of decreased legal fees.  The $3.1 million increasein general and administrative expenses was primarily driven by $3.2 million inone-time organizational and structuring fees from the formation of DPLC.  These fees were borne by DPLC.  The $0.1 million increase in insuranceexpense reflects an increase in insurance premiums over the prior periodpresented.

 

The decrease in expenses of $3.9 million for the sixmonths ended June 30, 2009, compared to the same period in 2008, wasattributable to decreases in management fee expense to related party andprofessional services of $5.2 million and $1.8 million, respectively, partiallyoffset by increases in general and administrative expenses and insuranceexpense of $2.9 million and $0.2 million, respectively.  The decrease intotal professional services of $1.8 million was primarily the result of a $1.0million decrease in legal fees and a $0.5 million decrease audit andaudit-related fees based on a reduction in estimated fees for services during2009.  The $2.9 million increase in general and administrative expenseswas primarily driven by $3.2 million in one-time organizational and structuringfees from the formation of DPLC.  Thesefees were borne by DPLC.  The $0.2million increase in insurance expense reflects an increase in insurancepremiums over the prior period presented.

 

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

 

The following table summarizes our Principal Investingsegment other income and (loss) gain for the periods presented:

 
| ** **                                                        | ** ** | **Three months ended June 30,** | ** ** | **Variance** | ** ** | **Six months ended June 30,** | ** ** | **Variance** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------------------------------|------------|--------------|------------|
| ** **                                                        | ** ** | **2009**                             | ** ** | **2008**     | ** ** | **2009 vs. 2008**                  | ** ** | **2009**     | ** ** | **2008** | ** ** | **2009 vs. 2008** | ** ** |
| ** **                                                        | ** ** | **(In millions)**                    | ** ** |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Other-than-temporary  impairment on available-for-sale securities |       | $                                    | —     |         | $          | (3.9                               | )          | $            | 3.9        |   | $ | — |   | $ | (3.9 | ) | $ | 3.9 |   |
| Net loss on  available-for-sale securities                        |       | —                               |       | (3.9         | )          | 3.9                                |       | —       |       | (3.9 | ) | 3.9 |   |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net realized gain (loss)  on investments at fair value            |       | (0.3                                 | )          | (0.1         | )          | (0.2                               | )          | (0.3         | )          | (169.2 | ) | 168.9 |   |
| Net unrealized gain  (loss) on investments at fair value          |       | 1.5                                  |       | (0.8         | )          | 2.3                                |       | 6.8          |       | (30.3 | ) | 37.1 |   |
| Net gain (loss) on  investments at fair value                     |       | 1.2                                  |       | (0.9         | )          | 2.1                                |       | 6.5          |       | (199.5 | ) | 206.0 |   |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net realized gain (loss)  on loans                                |       | (1.9                                 | )          | (7.7         | )          | 5.8                                |       | (7.1         | )          | (12.6 | ) | 5.5 |   |
| Net unrealized gain  (loss) on loans                              |       | 26.8                                 |       | 13.2         |       | 13.6                               |       | 37.8         |       | (8.4 | ) | 46.2 |   |
| Net gain (loss) on loans                                          |       | 24.9                                 |       | 5.5          |       | 19.4                               |       | 30.7         |       | (21.0 | ) | 51.7 |   |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net realized loss on  interest rate swaps                         |       | (9.9                                 | )          | (4.8         | )          | (5.1                               | )          | (9.4         | )          | (272.1 | ) | 262.7 |   |
| Net realized loss on  credit default swaps                        |       | —                               |       | (0.3         | )          | 0.3                                |       | (0.5         | )          | (2.4 | ) | 1.9 |   |
| Net realized loss on  total return swaps                          |       | —                               |       | —       |       | —                             |       | —       |       | (0.7 | ) | 0.7 |   |
| Net realized loss on  interest rate floors and caps               |       | —                               |       | —       |       | —                             |       | —       |       | (1.6 | ) | 1.6 |   |
| Net unrealized gain on  interest rate swaps                       |       | 12.8                                 |       | 9.6          |       | 3.2                                |       | 12.1         |       | 57.6 |   | (45.5 | ) |
| Net unrealized gain on  credit default swaps                      |       | —                               |       | 0.5          |       | (0.5                               | )          | 0.4          |       | 0.5 |   | (0.1 | ) |
| Net unrealized gain on  total return swaps                        |       | —                               |       | 0.8          |       | (0.8                               | )          | —       |       | 0.3 |   | (0.3 | ) |
| Net unrealized gain on  interest rate floors and caps             |       | —                               |       | —       |       | —                             |       | —       |       | 1.1 |   | (1.1 | ) |
| Net unrealized gain  (loss) on warrants                           |       | —                               |       | 0.3          |       | (0.3                               | )          | (0.1         | )          | 0.2 |   | (0.3 | ) |
| Net gain (loss) on  derivatives                                   |       | 2.9                                  |       | 6.1          |       | (3.2                               | )          | 2.5          |       | (217.1 | ) | 219.6 |   |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Dividend income                                                   |       | 0.1                                  |       | 0.1          |       | —                             |       | 0.1          |       | 0.2 |   | (0.1 | ) |
| Dividend income and  other net gain                               |       | 0.1                                  |       | 0.1          |       | —                             |       | 0.1          |       | 0.2 |   | (0.1 | ) |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net gain on the  deconsolidation of Market Square CLO             |       | 29.6                                 |       | —       |       | 29.6                               |       | 29.6         |       | — |   | 29.6 |   |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Net other income and  gain (loss)                                 |       | $                                    | 58.7       |         | $          | 6.9                                |       | $            | 51.8       |   | $ | 69.4 |   | $ | (441.3 | ) | $ | 510.7 |   |
|                                                              |       |                                 |       |         |       |                               |       |         |       |   |   |   |   |
| Total realized gain  (loss)                                       |       | $                                    | 17.6       |         | $          | (12.8                              | )          | $            | 30.4       |   | $ | 12.4 |   | $ | (458.4 | ) | $ | 470.8 |   |
| Total unrealized gain                                             |       | $                                    | 41.1       |         | $          | 19.7                               |       | $            | 21.4       |   | $ | 57.0 |   | $ | 17.1 |   | $ | 39.9 |   |

 

Net other income and gain (loss) improved by $51.8 millionand $510.7 million for the three and six months ended June 30, 2009,respectively, compared to the same periods for 2008. The improvement during thethree months ended June 30, 2009, as compared to the same period in 2008,was primarily attributable to improvements on investments in loans,available-for-sale securities and investments at fair value of $19.4 million,$3.9 million and $2.1 million, respectively, and a net gain on thedeconsolidation of Market Square CLO of $29.6 million.  The improvement during the six months ended June 30,2009, as compared to the same period in 2008, was primarily attributable toimprovements in derivatives, investments at fair value, loans andavailable-for-sale securities of $219.6 million, $206.0 million, $51.7 millionand $3.9 million, respectively, and a net gain on the deconsolidation of MarketSquare CLO of $29.6 million.

 

During the three and six months ended June 30,2009, the net gains on investments at fair value were $1.2 million and $6.5million, respectively, primarily driven by valuation increases on our RMBSportfolio.  The decrease in net losses on investments at fair value andderivatives was primarily the result of the significant sales of our RMBSportfolio and associated reductions in our outstanding interest rate swapsduring the first quarter of 2008.  During the first quarter of 2008, ourRMBS portfolio experienced a significant decrease in value fueled by theemergent credit crisis. This reduced our ability to successfully finance andhedge our RMBS portfolio. We sold a substantial portion of our non-Agency RMBSand Agency RMBS to improve liquidity, which resulted in realized trading lossesof $169.2 million for the six months ended June 30, 2008.  Inconjunction with the sale of a substantial portion of our RMBS portfolio duringthe three months ended March 31, 2008, we terminated 188 interest rateswaps with a notional amount of $6.2 billion, which resulted in net losseson interest rate swaps during the three months ended March 31, 2008 of$219.3 million.

 

Prior to these sales, as of January 1, 2008, inconjunction with the adoption of SFAS No. 159, *The Fair Value Option for Financial Assets andLiabilities*, or SFAS No. 159, we de-designated$3.8 billion (notional) of interest rate swaps previously designated as ahedge with a net negative fair value of $85.9 million at de-designation,including accrued interest.  As of the adoption date, the othercomprehensive loss related to the de-designation of interest rate hedges was$69.9 million. To the extent that the forecasted rolls on repurchaseagreement transactions continued as anticipated, we would have amortized thisloss and the $27.3 million in other comprehensive loss related topreviously de-designated swaps from other comprehensive loss into interestexpense over the remaining original hedge period, and all future changes infair value of the interest rate swaps would be reflected in the condensedconsolidated

 

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statementsof operations. However, due to the significant RMBS sales activity andcorresponding repurchase agreement repayment during the three months ended March 31,2008, forecasted rolls on the repaid repurchase agreements did not continue asanticipated. As a result, a loss of $91.7 million (including$69.6 million of accelerated amortization on interest rate swaps) wasrecognized during the three months ended March 31, 2008 in the condensedconsolidated statements of operations in net loss on derivatives, and acorresponding cumulative net loss relating to newly and previouslyde-designated and terminated interest rate swaps in other comprehensive losswas removed.

 

The improvement in net gain (loss) on loans during thethree and six months ended June 30, 2009 was primarily the result ofstronger market performance, which in turn increased the valuation of our heldfor sale portfolio within Market Square CLO by $30.8 million and $45.2 million,respectively.  Unrealized gains on loansheld for sale include recoveries up to original cost or value on the date theloan was transferred from loans held for investment to loans held forsale.  The increase in valuation on our Market Square CLO loan portfoliowas partially offset by decreased performance on loans held for sale in ourstructured and syndicated loan portfolio which drove down valuations on theseloans. In addition, we realized net losses on sales of loans of $1.9 millionand $7.1 million during the three and six months ended June 30, 2009,respectively, primarily as a result of the sale of loans held within theWachovia Facility with a par value of $31.5 million for $10.8 million, net ofinterest of $0.2 million, during the three months ended March 31, 2009.

 

Although substantially allof the $24.9 million and $30.7 million of net gain on loans for the three andsix months ended June 30, 2009, respectively, was related to loans held in MarketSquare CLO, our future results will not reflect changes to the values of loansheld in Market Square CLO as a result of its deconsolidation.

 

***Income Tax Expense***

 

For the three and six months ended June 30, 2009,the Principal Investing segment recorded income tax expense of $150,000 and$150,000, respectively, as a result of differences in the calculation ofalternative minimum taxable income versus regular taxable income.

 

**Off-Balance Sheet Arrangements**

 

In September 2005, August 2006 and October 2006,we formed Deerfield Capital Trust I, Deerfield Capital Trust II and DeerfieldCapital Trust III, or the Trusts, which are VIEs. Through our wholly-ownedsubsidiary, DC LLC, we own 100% of the common shares of the Trusts, whichissued, in the aggregate, $120.0 million of preferred shares to unaffiliatedinvestors. DC LLC issued junior subordinated debt securities to the Trusts inthe aggregate of $123.7 million, which are guaranteed by us. The rights ofcommon shares of the Trusts are subordinate to the rights of the preferredshares only in the event of a default. Otherwise, the common stockholders’economic and voting rights rank pari passu with the preferred stockholders. Werecord the investment in the Trusts’ common shares as other investments at costand record dividend income upon declaration by the Trust. The juniorsubordinated debt securities are recorded as long term debt, and debt issuancecosts are deferred in prepaid and other assets in the consolidated balancesheet. Interest on the debt securities and amortization of debt issuance costsare recorded in the consolidated statements of operations as interest expense.

 

As of June 30, 2009, we did not maintain anyother relationships with unconsolidated entities or financial partnerships,such as entities often referred to as structured finance, special purpose orVIEs, established for the purpose of facilitating off-balance sheetarrangements or other contractually narrow or limited purposes. Further, as of June 30,2009, we had not guaranteed any obligations of unconsolidated entities or enteredinto any commitment or intent to provide additional funding to any suchentities, except for the Trusts.

 

**Liquidity and Capital Resources**

 

We held cash and cash equivalents of$41.8 million as of June 30, 2009.

 

Our operating activities used cash of $10.9 millionfor the three months ended June 30, 2009, primarily through the following:

 

Net inflows and non-cash adjustments of $80.1 million,consisting of the following:

 

·                            Net income attributable to DFR. —$64.4 million

·                            Provision for loan losses —$11.2 million

·                            Depreciation and amortization— $3.3 million

·                            Net change in operating assets andliabilities — $0.5 million

·                            Share-based compensation —$0.3 million

·                            Impairment of intangible assets— $0.1 million

·                            Non-cash rental expense —$0.1 million

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

·                            Deferred tax benefit —$0.1 million

 

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Net outflows and non-cash adjustments totaled$91.0 million, consisting of the following:

 

·                            Net gain on loans —$30.7 million

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

·                            Net changes in undesignated derivatives —$12.8 million

·                            Net purchases of investments at fairvalue — $7.4 million

·                            Net gain on investments at fairvalue — $6.3 million

·                            Net loss attributable to noncontrollinginterest — $3.0 million

·                            Net purchases of loans held forsale — $0.9 million

·                            Net premium and discount amortization oninvestments, loans and debt issuance — $0.4 million

 

Our investing activities provided cash of $46.5million for the six months ended June 30, 2009, primarily from the changein restricted cash and cash equivalents of $44.0 million, principal paymentsand proceeds from the sale of investments at fair value previously classifiedas available-for-sale of $43.3 million, principal payments and proceeds fromthe sale of loans of $26.2 million and proceeds from the sale of loanspreviously classified as held for investment of $12.0 million, partially offsetby the origination and purchase of loans held for investment of$79.0 million.

 

Our financing activities used cash of $26.6 millionfor the six months ended June 30, 2009, primarily for payments onrepurchase agreements of $31.3 million, payments made on the Wachovia Facilityof $13.2 million, payments made on other long term debt of $2.1 millionand debt issuance costs of $0.1 million, partially offset by contributionsof noncontrolling interests of $20.1 million.

 

***Leverage***

 

The sale of a substantial portion of our RMBSportfolio has decreased our reliance on short term debt, in the form ofrepurchase agreements, used to finance that portfolio. Our RMBS holdings were$311.2 million, and our repurchase agreement liabilities were$294.5 million as of June 30, 2009. As discussed in more detail inthe following section “Liquidity and Sources of Funds,” our remaining long termdebt of $427.5 million consists of $231.8 million of non-recourse debt,$72.0 million of Series A and Series B Notes, due in 2012, and$123.7 million of trust preferred securities with $51.6 million and$72.1 million due in 2035 and 2036, respectively.

 

Although we continue to closely monitor our leverage,the changes in our business resulting from the Merger in 2007 and thetermination of our REIT status on September 30, 2008 (retroactive to January 1,2008) impacted how we expect to use and manage leverage going forward. Theacquisition of Deerfield, and our subsequent focus on our Investment Managementsegment, significantly reduces our need for leverage and equity to support ouroperations because of the generation of cash flows in the form of contractualinvestment advisory fees. Additionally, the termination of our REIT statusprovides us with more flexibility to allocate capital to assets other thanRMBS, although, in the near term, we expect to continue to hold our RMBSportfolio.

 

**Liquidity and Sources of Funds**

 

We believe that our current cash and cash equivalents,unencumbered liquid assets and net equity in our financed RMBS portfolio, alongwith cash flows from operations, among other things, are adequate to meetanticipated long term (greater than one year) liquidity requirements.  Unencumbered RMBS and unrestricted cash andcash equivalents aggregated $45.1 million at June 30, 2009. Inaddition, net equity in our financed RMBS portfolio (including associatedinterest rate swaps), excluding the unencumbered RMBS included above, totaled$16.6 million at quarter end. In total, we had unrestricted cash and cashequivalents, unencumbered RMBS and net equity in the financed RMBS portfolio of$61.7 million as of June 30, 2009. As of June 30, 2009, the fairvalue of our Agency RMBS and non-Agency RMBS portfolios were$308.0 million and $3.1 million, respectively. Our largest repurchaseagreement counterparty has required that we maintain a minimum of$20.0 million of cash in their custody in order to maintain our currentrepurchase agreement margin percentages on our Agency RMBS. If we fail tosatisfy this requirement, the counterparty will have the right to immediatelyincrease the margin percentages under our repurchase agreements and may exerciseother remedies.

 

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

 

We attempt to maintain our leverage at a level thatensures that our cash and cash equivalents will be sufficient to satisfy ourliquidity requirements. However, if we are not successful, we may be requiredto sell additional RMBS or Corporate Loans and may be unable to do so onfavorable terms or at all. Sales of additional RMBS or Corporate Loans atprices lower than their carrying value would result in further realized lossesand reduced income. For further discussions concerning the availability ofrepurchase agreement financing, which we use to finance our RMBS portfolio, see*“Trends — Liquidity”* above. We mayincrease our capital resources by consummating offerings of securities orissuing new debt, possibly including preferred stock, common stock, commercialpaper, 

 

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medium-termnotes, CDOs, collateralized mortgage obligations and other borrowings. Theability to execute these strategies will depend on, among other things, marketconditions for capital raises and for the investment of any proceeds.

 

The lease on our corporate headquarters requires us tomaintain a letter of credit, which was renewed in May 2008 and requires usto maintain $2.3 million of cash on deposit, with annual reductions of$0.3 million, with the letter of credit provider in a restricted account.

 

As we focus on growing our Investment Managementsegment, we expect to utilize our cash and liquidity to invest in newinvestment products.  We also may use our cash in connection with theacquisition of CDO management contracts or other Investment Management opportunities.We expect our CLO subordinated investment advisory fees to continue to bedeferred in the near term.  However, over time and with improved marketconditions, we expect the CLOs to regain compliance with theirovercollateralization tests, and, subject to the satisfaction of certain otherconditions, we would expect to recoup at least a portion and potentiallysubstantially all of the deferred subordinated management fees and to receivefuture subordinated management fees on a current basis.

 

The economic impact of our investment in DFR MM CLO isdetermined by the cash flows distributed to us by DFR MM CLO on our investmentin $50.0 million of preferred shares, subject to diversion of cash flows awayfrom us as provided in accordance with the indenture for DFR MM CLO, and ourinvestment in $19.0 million of debt of DFR MM CLO.  For the three and six months ended June 30,2009 the net loss of $3.5 million and net gain of $0.8 million, respectively,recorded under GAAP for DFR MM CLO was not indicative of the economic impact tous of cash flow distributions from DFR MM CLO of $4.8 million and $5.0 million,respectively.  Cash flows from ourinvestment in preferred shares of DFR MM CLO began to be diverted during thesecond quarter of 2009 in accordance with the DFR MM CLO indenture; however,cash flows are still being received on our investment in DFR MM CLO debt.

 

***Investment Management Segment***

 

The following is a summary of our recourse InvestmentManagement segment borrowings as of June 30, 2009:

 
| ** **                                      | ** ** | **Series A and**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **Series B Notes** | ** ** |
| Outstanding balance (in  thousands)             |       | $                       | 72,042     | (1) |
| Weighted average  borrowing rate                |       | 6.21                    | %          |
| Weighted-average  remaining maturity (in years) |       | 3.50                    |       |
|                                                 |            |                         |            |  |

 

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(1)  Principal outstanding of $72.0 millionis presented net of a $1.9 million discount.

 

***Principal Investing Segment***

 

The following is a summary of our Principal Investingsegment borrowings as of June 30, 2009:

 
| ** **                                      | ** ** | **Recourse**   | ** ** | **Non-Recourse** | ** ** | ** **     | ** ** |
|-------------------------------------------------|------------|----------------|------------|------------------|------------|----------------|------------|
| ** **                                      | ** ** | ** **     | ** ** | **Trust**        | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Repurchase** | ** ** | **Preferred**    | ** ** | ** **     | ** ** | **Wachovia** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Agreements** | ** ** | **Securities**   | ** ** | **DFR MM CLO** | ** ** | **Facility** | ** ** | **Total** | ** ** |
| Outstanding balance (in  thousands)             |       | $              | 294,470    |             | $          | 123,717        |       | $ | 231,000 |    (2) | $ | 771 |   | $ | 649,958 |   |
| Weighted average  borrowing rate                |       | 0.69           | %          | 3.81             | %          | 1.80           | %(3)       | 2.81 | % | 1.68 | % |
| Weighted-average  remaining maturity (in years) |       | 0.01           |       | 26.94            | (1)        | 10.06          |       | — | (4) | 8.71 |   |
|                                                 |            |                |            |                  |            |                |            |  |  |  |  |  |  |  |  |  |

 

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| (1) | $51.6 million of the Trust Preferred Securities are callable by  us after October 30, 2010, and $72.1 million are callable by us  after October 30, 2011.            |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | The term financing is callable on July 20,  2010 and quarterly thereafter.                                                                                                          |
| (3) | Excludes $19.0 million of DFR MM CLO debt that is owned by us and  eliminated upon consolidation. Had this debt been included, the  weighted-average borrowing rate would be 2.05%. |
| (4) | The Wachovia Facility was fully repaid subsequent  to June 30, 2009.                                                                                                                |

 

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*Recourse Debt*

 

Recourse debt refers to debt that is a generalobligation of ours. None of our long term debt is subject to potential margincalls for additional pledges of our cash or assets.

 

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

 

*Repurchase Agreements*

 

As of June 30, 2009, proceeds from repurchaseagreements totaling $294.5 million, with a weighted-average currentborrowing rate of 0.69%, were used to finance the acquisition of RMBS. Weexpect to continue borrowing funds in the form of repurchase agreements. As of June 30,2009, we had outstanding repurchase agreement balances with two financialinstitutions. Our repurchase agreement liabilities are significantlyconcentrated with one counterparty that provides financing totaling 84.0% ofthe $294.5 million of repurchase agreement liabilities as of June 30,2009. Increases in interest rates could reduce the value of our RMBS, whichcould limit our borrowing ability or cause our lenders to initiate additionalmargin calls. An increase in the percentage deduction of fair value of RMBScollateral that we receive in cash at the inception of the repurchaseagreement, which we sometimes refer to as a haircut, imposed by ourcounterparties would limit our borrowing capacity. Amounts due upon maturity ofour repurchase agreements will be funded primarily through the rollover orre-issuance of repurchase agreements and monthly principal and interestpayments received on our RMBS.

 

The following table presents certain informationregarding the amount at risk related to our repurchase agreements:

 
| ** **                                | ** ** | ** **             | ** ** | **Weighted-Average**       | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | ** **             | ** ** | **Maturity of Repurchase** | ** ** |
| ** **                                | ** ** | **Amount at Risk (1)** | ** ** | **Agreements**             | ** ** |
| ** **                                | ** ** | **(In thousands)**     | ** ** | **(In days)**              | ** ** |
| **Repurchase  Agreement Counterparties:** |       |                   |       |                       |       |
| Deutsche Bank  Securities Inc.            |       | 5,461                  |       | 14                         |       |
| Fortis Securities LLC                     |       | 9,890                  |       | 2                          |       |
| Total                                     |       | $                      | 15,351     |                       | 4          |   |
|                                           |            |                        |            |                            |            |  |

 

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(1)                                  Equal to thefair value of securities pledged minus repurchase agreement liabilities andrelated accrued interest payable.

 

We are currently in violation of substantially all ofour International Swap Dealers Association, or ISDA, agreements with ourinterest rate swap counterparties. Each of these ISDA agreements contains anequity decline trigger that we breached during the first quarter of 2008. Thisviolation generally gives the counterparties the right to terminate the ISDAagreements and the related interest rate swaps. We have notified our active counterpartiesof the breach, and none of those counterparties has expressed an intention toterminate the ISDA agreements. To date, the violations of our ISDA agreementshave not had a material adverse effect on our operations.

 

*Non-Recourse Debt*

 

Non-recourse debt refers to debt with recourse only tospecific assets pledged as collateral to the lenders, such as warehousefacilities and the debt issued by CDOs that are consolidated by us as VIEs. Thecreditors of the non-recourse debt have no recourse to our other assets. Noneof the long term debt is subject to potential margin calls for additionalpledges of our cash or assets. The carrying value of the collateral of theentities which the non-recourse debt holders have recourse for the repayment ofoutstanding debt are $1.5 million and $288.2 million for the Wachovia Facilityand DFR MM CLO, respectively.

 

*Wachovia Facility.  *On May 8, 2009, we entered into asecond amended and restated forbearance agreement related to the WachoviaFacility extending the period through which no action will be taken in respectof any prior noncompliance with the covenant requiring us to maintainstockholders’ equity of at least $240.0 million as well as certain othercovenants under the Wachovia Facility through the earlier of July 7, 2009and the date of any breach of the forbearance agreement by us. TheWachovia Facility was fully repaid and all of our obligations thereunder weresatisfied subsequent to June 30, 2009.

 

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***Distribution Policy***

 

We are no longer subject to the distributionrequirements applicable to REITs. The covenants contained in our indebtednesscurrently prohibit us from declaring dividends or distributions on our commonstock, and therefore, we do not expect to make dividend distributions in theforeseeable future.

 

***Inflation***

 

Virtually all of our assets and liabilities areinterest rate sensitive. As a result, interest rates and other factorsinfluence our performance more than inflation. Our financial statements areprepared in accordance with GAAP, and our distributions are determined by ourBoard based primarily on cash flow considerations; in each case, our activitiesand balance sheet are measured with reference to historical cost or fair valuewithout considering inflation.

 

***Seasonality***

 

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

 

**Recent Developments**

 

On July 31, 2009, weentered into the three supplemental indentures, or the Supplemental Indentures,with the holders of our trust preferred securities issued by each of DeerfieldCapital Trust I, Deerfield Capital Trust II and Deerfield Capital Trust III, orcollectively the Trust Preferred Securities. The Supplemental Indentures amend the consolidated net worth covenants,or the Net Worth Covenants, contained in the indentures governing the TrustPreferred Securities to (i) permanently decrease the net worth required bythe Net Worth Covenants from $175 million to $50 million and (ii) providethat the initial measurement date for compliance with the Net Worth Covenantswill be September 30, 2012.  Inaddition, the Supplemental Indentures contain provisions prohibiting us from (i) incurringadditional indebtedness for the life of the Trust Preferred Securities, exceptfor indebtedness permitted to be incurred in accordance with provisions thatare substantially similar to the provisions of the agreements governing the Series Aand Series B Notes, and (ii) declaring additional dividends ordistributions on our capital stock for the life of the Trust PreferredSecurities, except as permitted in accordance with provisions that aresubstantially similar to the provisions of the agreements governing the Series Aand Series B Notes.  TheSupplemental Indentures also provide the representative of the holders of theTrust Preferred Securities with certain inspection rights.  The Supplemental Indentures supersede thetemporary waiver of the Net Worth Covenants obtained from the holders of theTrust Preferred Securities in November 2008.  We paid the holders of the Trust PreferredSecurities a fee of $250,000 on July 31, 2009 and committed to pay suchholders an additional fee of $250,000 on or before July 31, 2010 inconnection with the Supplemental Indentures.

 

The Wachovia Facility wasfully repaid and all our obligations thereunder were satisfied subsequent toJune 30, 2009.

 

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

 

As of June 30, 2009, the primary component of ourmarket risk was interest rate and spread risk, as described below. While we donot seek to avoid risk completely, we actively manage interest rate risk andregularly assess whether earnings in the portfolio include appropriatecompensation for the inherent market risks to which it is exposed. In light ofthese risks, we regularly consider our capital levels and currently are focusedon redeploying capital from Principal Investing activities to growing ourInvestment Management segment.

 

**Interest Rate Risk**

 

We are subject to interest rate risk primarily inconnection with our investments in hybrid adjustable-rate and fixed-rate RMBSand our debt obligations related to those investments, which are generallyrepurchase agreements of short duration that periodically reset at currentmarket rates. We seek to manage this risk through utilization of derivativecontracts, primarily interest rate swap agreements.

 

**Effect on Net Interest Income**

 

We fund our investments in RMBS primarily with shortterm borrowings under repurchase agreements. During periods of rising interestrates, short term borrowing costs tend to increase while the income earned onhybrid adjustable-rate (during the fixed-rate period of such securities) andfixed-rate RMBS may remain substantially unchanged. This results in a narrowingof the net interest spread between the related assets and borrowings and mayeven result in losses.

 

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In order to mitigate our interest rate exposure, wehave two interest rate swap transactions outstanding as of June 30, 2009.The following table summarizes the expiration dates of these contracts andtheir notional amounts:

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

 

Our hedging strategies are partly based on assumedlevels of prepayments of our RMBS. If prepayments are slower or faster thanassumed, the life of the RMBS will be longer or shorter, which changes the netimpact of our hedging activity and may cause unexpected gains or losses on suchtransactions. Hedging strategies involving the use of derivative instrumentsare highly complex and may produce volatile returns.

 

**Extension Risk**

 

The majority of our RMBS portfolio consists of hybridadjustable-rate RMBS, which have interest rates that are fixed for the firstseveral years of the loan (typically three, five, seven or 10 years) and,thereafter, reset periodically on the same basis as adjustable-rate RMBS. Wecompute the projected weighted-average life of our RMBS based on assumptionsregarding the rate at which the borrowers will prepay the underlying mortgages.In general, when a fixed-rate or hybrid adjustable-rate residentialmortgage-backed security is funded by a short term borrowing, we may, but arenot required to, enter into an interest rate swap agreement or other hedginginstrument that effectively fixes a portion of our borrowing costs for a periodclose to the anticipated weighted-average life of the fixed-rate portion of therelated RMBS. This strategy is designed to protect a portion of our portfoliofrom increased funding costs due to rising interest rates because the borrowingcosts are not fixed for the duration of the fixed-rate period of the relatedresidential mortgage-backed security.

 

However, if prepayment rates decrease in a risinginterest rate environment, the weighted average life of the fixed-rate portionof the related RMBS could extend beyond the term of the swap agreement or otherhedging instrument. This could have a negative impact on our results ofoperations, as borrowing costs would no longer be effectively fixed after thematurity of the hedging instrument, while the income earned on the remaininghybrid adjustable-rate RMBS would remain fixed for a period of time. Thissituation may also cause the market value of our hybrid adjustable-rate RMBS todecline, with little or no offsetting gain from the related hedgingtransactions. We may be forced to sell assets to maintain adequate liquidity,which could cause us to incur losses, and we may be unable to sell assets onfavorable terms or at all.

 

**Hybrid Adjustable-Rate RMBS Interest Rate Cap Risk**

 

We also invest in hybrid adjustable-rate RMBS whichare based on mortgages that are typically subject to periodic and lifetimeinterest rate caps and floors, which limit the amount by which the security’sinterest rate may change during any given period. However, our borrowing costspursuant to our repurchase agreements will not be subject to similarrestrictions. Therefore, in a period of increasing interest rates, interestrate costs on our borrowings could increase without limitation by caps, whilethe interest-rate yields on our hybrid adjustable-rate RMBS could be limited bycaps. These factors could lower our net interest income or cause a net lossduring periods of rising interest rates, which would negatively impact ourfinancial condition, cash flows and results of operations.

 

**Interest Rate Mismatch Risk**

 

We intend to fund a substantial portion of ourpurchases of RMBS with borrowings that, after the effect of hedging, haveinterest rates based on indices and repricing terms similar to, but of somewhatshorter maturities than, the interest rate indices and repricing terms of theRMBS. Thus, we anticipate that in most cases the interest rate indices andrepricing terms of our mortgage assets and our funding sources will not beidentical, thereby creating an interest rate mismatch between assets andliabilities. Therefore, our cost of funds would likely rise or fall morequickly than would our earnings rate on assets. During periods of changinginterest rates, such interest rate mismatches could negatively impact ourfinancial condition, cash flows and results of operations. To mitigate interestrate mismatches, we may utilize hedging strategies discussed above.

 

Our analysis of portfolio risks is based on management’sexperience, estimates, quantitative analysis and assumptions. These analysesrely on models, which utilize estimates of fair value and interest ratesensitivity. Actual economic conditions or implementation of investmentdecisions by our management may produce results that differ significantly fromthe estimates and assumptions used in our models and the projected resultsreflected herein.

 

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**Prepayment Risk**

 

Prepayments are the full or partial repayment ofprincipal prior to contractual due dates of a mortgage loan and often occur dueto refinancing activity. Prepayment rates for existing RMBS generally increasewhen prevailing interest rates fall below the market rate existing when theunderlying mortgages were originated. In addition, prepayment rates onadjustable-rate and hybrid adjustable-rate RMBS generally increase when thespread between long-term and short-term interest rates declines or becomesnegative. Prepayments of RMBS could impact our results of operations in severalways. Some adjustable-rate mortgages underlying our adjustable-rate RMBS maybear initial teaser interest rates that are lower than their fully-indexedrates, which refers to the applicable index rates plus a spread. In the eventthat such an adjustable-rate mortgage is prepaid prior to or soon after thetime of adjustment to a fully-indexed rate, the holder of the relatedresidential mortgage-backed security would have held such security while it wasless profitable and lost the opportunity to receive interest at thefully-indexed rate over the expected life of the adjustable-rate residentialmortgage-backed security. Additionally, we currently own RMBS that werepurchased at a premium. The prepayment of such RMBS at a rate faster thananticipated would result in a write-off of any remaining unamortized premiumand a corresponding reduction of our net interest income by such amount.

 

**Effect on Fair Value**

 

Another component of interest rate risk is the effectchanges in interest rates will have on the fair value of our assets. We facethe risk that the fair value of our assets will increase or decrease atdifferent rates than that of our liabilities, including our hedginginstruments.

 

We primarily assess our interest rate risk byestimating the duration of our assets and the duration of our liabilities.Duration essentially measures the market price volatility of financialinstruments as a function of interest rates changes. We calculate durationusing various third party financial models and empirical data. Different modelsand methodologies can produce different duration numbers for the samesecurities.

 

The following sensitivity analysis table shows theimpact on the estimated fair value of our RMBS interest rate-sensitiveinvestments and interest rate swaps as of June 30, 2009, assuming ratesinstantaneously fall 100 basis points and rise 100 basis points. Thebelow table excludes the securities held in DFR MM CLO because theseinvestments are impacted by cash flows and the terms of their respectiveindentures, rather than fair values.

 
| ** **                         | ** ** | **Interest Rates**         | ** ** | ** **    | ** ** | **Interest Rates** | ** ** |
|------------------------------------|------------|----------------------------|------------|---------------|------------|--------------------|------------|
| ** **                         | ** ** | **Fall 100**               | ** ** | ** **    | ** ** | **Rise 100**       | ** ** |
| ** **                         | ** ** | **Basis Points**           | ** ** | **Unchanged** | ** ** | **Basis Points**   | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| **RMBS**                           |       |                       |       |          |       |               |       |
| Fair value                         |       | $                          | 316,192    |          | $          | 311,154            |       | $ | 304,422 |   |
| Change in fair value               |       | $                          | 5,038      |          |       |               | $          | (6,732 | ) |
| Change as a percent of  fair value |       | 1.62                       | %          |          |       | (-2.16             | )%         |
| **Interest  Rate Swaps**           |       |                       |       |          |       |               |       |
| Fair value                         |       | $                          | (947       | )             | $          | (863               | )          | $ | (707 | ) |
| Change in fair value               |       | $                          | (84        | )             |       |               | $          | 156 |   |
| Change as a percent of  fair value |       | 9.73                       | %          |          |       | 18.08              | %          |
| **Net  Portfolio Impact**          |       | $                          | 4,954      |          |       |               | $          | (6,576 | ) |

 

----

n/m — not meaningful

 

The impact of changing interest rates on fair valuecan change significantly when interest rates change beyond 100 basispoints from current levels. Therefore, the volatility in the fair value of ourassets could increase significantly when interest rate changes exceed100 basis points. In addition, other factors impact the fair value of ourinterest rate-sensitive investments and hedging instruments, such as the shapeof the yield curve, market expectations as to future interest rate changes andother market conditions. Accordingly, in the event of changes in actualinterest rates, the change in the fair value of our assets would likely differfrom that shown above, and such difference might be material and adverse to ourstockholders.

 

As of June 30, 2009, substantially allinvestments in our alternative investments portfolio (non-RMBS) are instrumentswith variable interest rates that are indexed to LIBOR. Because the variablerates on these instruments are short term in nature, we are not exposed tomaterial changes in fair value as a result of changes in interest rates.

 

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**Risk Management**

 

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

 

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

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

**Evaluation of Effectiveness of Disclosure Controls andProcedures**

 

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

 

**Changes in Internal Control Over Financial Reporting**

 

There have been no changes in our internal controlover financial reporting during the three months ended June 30, 2009 thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Inherent Limitations on Effectiveness of Controls**

 

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

 

**PART II. OTHER INFORMATION**

 

**ITEM 1A. RISK FACTORS**

 

In addition to the risk factors disclosed in “*Part I — Item 1A. Risk Factors*” ofour Annual Report, set forth in this section are additional risk factors webelieve are applicable to our business.

 

***Pegasus may notinvest the full amount of its capital commitments into DPLC.***

 

Pegasus has committed to invest $75.0 million inDPLC.  However, that capital commitment is subject to numerous conditions,any or all of which may be outside of our control and may not be satisfied. In the event that Pegasus does not invest the full amount of its $75.0 millioncapital commitment, our revenues from DPLC, both in the form of management feesand incentive allocations and in the form of return on our investment in DPLC, arelikely to be significantly lower than expected, which may adversely affect ourfinancial condition and results of operations.  Furthermore, we havecommitted $15.0 million in DPLC, and we may not invest all of such amount ifPegasus does not invest the full amount of its capital commitment.

 

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***DPLC may notperform as anticipated, which may affect future investment advisory fees and/orthe loss of some or all of our investment.***

 

We expect to derive revenue from DPLC principally fromthree sources (i) management fees based on the net asset value of theinvestment portfolio, (ii) incentive allocations based on the performanceof DPLC and (iii) investment income from our investment in DPLC, which wemay not receive until DPLC is liquidated according to its terms.  Ifeconomic and market conditions are unfavorable, or if we are unsuccessful inselecting appropriate investments for DPLC’s portfolio, DPLC may not performwell.  In the event that DPLC does not perform as well as we expect, ourrevenues from DPLC may be significantly lower than expected, and we could losesome or all of our direct investment in the DPLC, each of which may adverselyaffect our financial condition and the value of our common stock. Furthermore,in the event DPLC is not successful, it could be significantly less likely thatwe will be able to successfully launch new investment products and implement thisaspect of our business strategy.

 

***Ownershiplimitations in our charter may restrict change of control or businesscombination opportunities in which our stockholders might receive a premium fortheir shares.***

 

On May 20, 2009,following stockholder approval, we amended our charter to restrict certainacquisitions and dispositions of our securities in order to preserve thebenefit of our NOLs, NCLs and certain other tax attributes for taxpurposes.  As amended, our chartergenerally restricts the ability of a person or entity or group fromaccumulating 5% or more of our common stock. The ownership limitations in our charter could have the effect ofimpeding or discouraging an acquisition of common stock, tender offer or othertransaction, even if such a transaction may be favorable to the interests ofsome or all of our stockholders.  Thismight prevent our common stockholders from realizing an opportunity to sell allor a portion of their shares of our stock at higher than market prices.  In addition, the ownership limitationcontained in our charter may impede the assumption of control by a holder of alarge block of common stock and the removal of incumbent directors andmanagement, even if such removal may be beneficial to all of our stockholders.  The charter restriction could also negativelyaffect the liquidity of our stock and otherwise decrease the market price ofour common stock.

 

**Item 4. Submission of Matters to aVote of Security Holders**

 

We held our AnnualMeeting on May 19, 2009.  Thefollowing Class I directors were elected by our stockholders as follows:

 
| **Nominee for Director** | ** ** | **For**   | ** ** | **Withheld** | ** ** |
|--------------------------|------------|-----------|------------|--------------|------------|
| Peter  H. Rothschild     |       | 4,577,245 |       | 1,421,161    |       |
| Robert  E. Fischer       |       | 5,322,114 |       | 676,295      |       |
| Peter  W. May            |       | 5,352,223 |       | 646,186      |       |

 

Each of the above-named Class Idirectors will be up for election again at our annual meeting expected to beheld in 2011.  Our Class IIdirector, Stuart Oran, will be up for election at our next annual meetingexpected to be held later in the 2009 calendar year, and our Class IIIdirectors, Jonathan W. Trutter and Robert B. Machinist will be up for electionat our annual meeting expected to be held in 2010.

 

The other matters votedupon at the annual meeting are as follows:

 

**Approval of an amendment to ourcharter to restrict certain acquisitions and dispositions of our securities inorder to preserve the benefit of our NOLs, NCLs and certain other taxattributes for tax purposes and to remove references to our operation as a REITas one of the purposes of our company:**

 
| **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 3,781,051 |       | 522,722     |       | 27,987      |       |

 

1,666,648 brokernon-votes arose in connection with the proposal to amend our charter.

 

**Ratification of the appointmentof Deloitte & Touche LLP as our independent registered publicaccounting firm for the fiscal year ending December 31, 2009:**

 
| **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 5,871,487 |       | 112,217     |       | 14,704      |       |

 

There were no additionalmatters voted upon at the annual meeting.

 

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**ITEM 5. OTHER INFORMATION**

 

The information set forth under “*Part I — Item 2.  Management’s Discussionand Analysis of Financial Condition and Results of Operations*—*Recent Developments*” of this quarterlyreport on Form 10-Q is incorporated by reference into this Part II —Item 5.

 

**ITEM 6. EXHIBITS AND FINANCIALSTATEMENT SCHEDULES**

** **
| **Exhibit   Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|---------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.1                       |       | Articles of Amendment  and Restatement of Deerfield Capital Corp., as amended and supplemented.                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2                       |       | Bylaws of Deerfield  Capital Corp. (incorporated by reference to Exhibit 3.2 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  June 30, 2008, filed with the SEC on August 11, 2008).                                                                                                                                                                                                                                                                                                                                |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.1                       |       | Warrant, dated  April 9, 2009, issued by Deerfield Capital Corp. to Pegasus Deerfield  (AIV), LLC (incorporated by reference to Exhibit 4.1 to the Company’s  Current Report on Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                                                                                                                                                    |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2                       |       | Warrant, dated  April 9, 2009, issued by Deerfield Capital Corp. to Pegasus Deerfield  (AIV), LLC (incorporated by reference to Exhibit 4.2 to the Company’s  Current Report on Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                                                                                                                                                    |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1                      |       | Registration Rights  Agreement, dated April 9, 2009, between Deerfield Capital Corp. and  Pegasus Deerfield (AIV), LLC (incorporated by reference to Exhibit 10.1  to the Company’s Current Report on Form 8-K filed with the SEC on  April 15, 2009).                                                                                                                                                                                                                                                                                             |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.2                      |       | Letter Agreement, dated  April 9, 2009, by and among Pegasus Deerfield (AIV), LLC, PGS  Management, LLC, Deerfield Pegasus Loan Capital LP, DPLC General Partner LLC,  Deerfield Capital Corp. and Deerfield Capital Management LLC (incorporated by  reference to Exhibit 10.2 to the Company’s Current Report on  Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.3                      |       | Letter Agreement, dated  April 9, 2009, by and among Pegasus Deerfield (AIV), LLC, PGS  Management, LLC, Deerfield Pegasus Loan Capital LP, DPLC General Partner LLC,  Deerfield Capital Corp. and Deerfield Capital Management LLC (incorporated by  reference to Exhibit 10.3 to the Company’s Current Report on  Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.4                      |       | Letter Agreement, dated  April 9, 2009, by and among Pegasus Deerfield (AIV), LLC, Deerfield  Capital Corp. and Deerfield Capital Management LLC (incorporated by reference  to Exhibit 10.4 to the Company’s Current Report on Form 8-K filed  with the SEC on April 15, 2009).                                                                                                                                                                                                                                                                   |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.5                      |       | Letter Agreement, dated  April 9, 2009, between Deerfield Capital Management LLC and Jonathan  Trutter (incorporated by reference to Exhibit 10.5 to the Company’s  Current Report on Form 8-K filed with the SEC on April 15, 2009).                                                                                                                                                                                                                                                                                                              |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.6                      |       | Second Amended and  Restated Forbearance Agreement, dated as of May 8, 2009 by and among  DWFC, LLC and Deerfield TRS (Bahamas) Ltd., as borrowers, Deerfield Capital  LLC, as originator and servicer, Wachovia Bank, National Association, as  swingline purchaser and institutional purchaser, and Wachovia Capital  Markets, LLC, as administrative agent (incorporated by reference to Exhibit 10.1  to the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended March 31, 2009, filed with the SEC on May 11, 2009). |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.7                      |       | Letter Agreement, dated  May 11, 2009, between Deerfield Capital Management LLC and Francis P.  Straub III (incorporated by reference to Exhibit 10.2 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  March 31, 2009, filed with the SEC on May 11, 2009).                                                                                                                                                                                                                                                    |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.8                      |       | Letter Agreement, dated  May 11, 2009, between Deerfield Capital Management LLC and Robert A.  Contreras (incorporated by reference to Exhibit 10.3 to the Company’s  Quarterly Report on Form 10-Q for the quarterly period ended  March 31, 2009, filed with the SEC on May 11, 2009).                                                                                                                                                                                                                                                      |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.9                      |       | Amendment No. 1,  dated as of May 11, 2009, to the Employment Agreement by and between  Deerfield Capital Management LLC and Jonathan W. Trutter, dated as of  June 26, 2004 (incorporated by reference to Exhibit 10.4 to the  Company’s Quarterly Report on Form 10-Q for the quarterly period ended  March 31, 2009, filed with the SEC on May 11, 2009).                                                                                                                                                                        |

 

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| 10.10  |   | Letter Agreement, dated  May 11, 2009, by and between Deerfield Capital Management LLC and  Jonathan W. Trutter (incorporated by reference to Exhibit 10.5 to the  Company’s Quarterly Report on Form 10-Q for the quarterly period ended  March 31, 2009, filed with the SEC on May 11, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                               |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.11  |   | Form of Indemnification  Agreement (incorporated by reference to Exhibit 10.51 to the Company’s  Annual Report on Form 10-K for the fiscal year ended December 31,  2008, filed with the SEC on March 16, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.12  |   | Deerfield Capital Corp.  First Amended and Restated Stock Incentive Plan, as amended (incorporated by  reference to Exhibit 10.2 to the Company’s Current Report on  Form 8-K filed with the SEC on June 11, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.13  |   | Form of  Performance Share Award Agreement (incorporated by reference to  Exhibit 10.3 to the Company’s Current Report on Form 8-K filed with  the SEC on June 11, 2009).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.14  |   | Third Supplemental  Indenture, dated as of July 31, 2009, to and under the Junior  Subordinated Indenture, dated as of September 29, 2005, by and among  Deerfield Capital LLC and The Bank of New York Mellon Trust Company, National  Association (as successor to JPMorgan Chase Bank, National Association), as  trustee, and with respect to certain provisions, each of The Bank of New York  Mellon Trust Company, National Association, in its capacity as property  trustee, Deerfield Capital Trust I, Taberna Preferred Funding III, Ltd. and  Taberna Preferred Funding V, Ltd. (incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with  the SEC on August 5, 2009).   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.15  |   | Third Supplemental  Indenture, dated as of July 31, 2009, to and under the Junior  Subordinated Indenture, dated as of August 2, 2006, by and among  Deerfield Capital LLC and The Bank of New York Mellon Trust Company, National  Association (as successor to JPMorgan Chase Bank, National Association), as  trustee, and with respect to certain provisions, each of The Bank of New York  Mellon Trust Company, National Association, in its capacity as property  trustee, Deerfield Capital Trust II and Taberna Preferred Funding VII Ltd.  (incorporated by reference to Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed with the SEC on August 5, 2009).                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.16  |   | Third Supplemental  Indenture, dated as of July 31, 2009, to and under the Junior  Subordinated Indenture, dated as of October 27, 2006, by and among  Deerfield Capital LLC and The Bank of New York Mellon Trust Company, National  Association (as successor to JPMorgan Chase Bank, National Association), as  trustee, and with respect to certain provisions, each of The Bank of New York  Mellon Trust Company, National Association, in its capacity as property  trustee, Deerfield Capital Trust III, Taberna Preferred Funding VIII, Ltd.  and Taberna Preferred Funding IX, Ltd. (incorporated by reference to  Exhibit 10.3 to the Company’s Current Report on Form 8-K filed with  the SEC on August 5, 2009). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1   |   | Certification of  Principal Executive Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2   |   | Certification of  Principal Financial Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 32.1   |   | Certification of  Principal Executive Officer and Principal Financial Officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                        | DEERFIELD  CAPITAL CORP.                                   |
|-----------------------------|------------------------------------------------------------|
|                        | (Registrant)                                               |
|                        |                                                       |
|                        |                                                       |
| Date:  August 10, 2009 | By: /s/ JONATHAN  W. TRUTTER                               |
|                        | Jonathan W.  Trutter, Chief Executive Officer and Director |
|                        | (Principal  Executive Officer)                             |
|                        |                                                       |
| Date:  August 10, 2009 | By: /s/ FRANCIS  P. STRAUB III                             |
|                        | Francis P.  Straub III, Senior Vice President,             |
|                        | Chief Financial  Officer and Treasurer                     |
|                        | (Principal  Financial and Accounting Officer)              |

 

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