The statements in this discussion regarding the industry outlook and our expectations regarding the future performance of our business and the other non-historical statements in this discussion are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in this quarterly report on Form 10-Q on page 3 under the title "Special Note Regarding Forward Looking Statements" and our Annual Report on Form 10-K filed on February 29, 2008, as amended, in "Part I - Item 1A. Risk Factors." You should read the following discussion together with our condensed consolidated financial statements and notes thereto included in "Part I - Item 1. Financial Statements" of this Form 10-Q. Unless otherwise noted or the context otherwise requires, we refer to Deerfield Capital Corp. as "DFR," to DFR and its subsidiaries as "we," "us," "our," or "our company," to Deerfield & Company LLC, one of our indirect wholly-owned subsidiaries, as "Deerfield," and to Deerfield Capital Management LLC, our former external manager and another of our indirect wholly-owned subsidiaries, as "DCM." We refer to our acquisition of Deerfield pursuant to a merger agreement dated as of December 17, 2007 among us, DFR Merger Company, LLC (our wholly-owned subsidiary that was merged into Deerfield), Deerfield and Triarc Companies, Inc., or Triarc (as sellers' representative), by which DFR Merger Company, LLC was merged with and into Deerfield on December 21, 2007, as the "Merger." General
DFR is a Maryland corporation with a principal investing portfolio of approximately $2.1 billion as of June 30, 2008, comprised of fixed income investments, including residential mortgage backed securities, or RMBS, government securities and corporate debt. In addition, through our subsidiary, DCM, we manage approximately $13.0 billion of client assets ($596.1 million of which is also included in our investment portfolio) as of July 1, 2008, including government securities, corporate debt, RMBS and asset-backed securities, or ABS.
Overview
As of June 30, 2008, our Agency RMBS (as defined below) and AAA-rated non-Agency RMBS portfolios were $415.3 million and $28.9 million, respectively. This represents an approximately 93.0% reduction in our RMBS holdings since December 31, 2007. See "First Quarter Overview" below for a discussion of the significant sales of our RMBS portfolio during the three months ended March 31, 2008. We have experienced a 5.0% reduction in our RMBS holdings since March 31, 2008, primarily as a result of the receipt of principal paydowns.
As of June 30, 2008, our book value was $3.37 per share, and leverage was 9.6 times equity. Our reduced leverage, down from 12.3 times equity as of June 30, 2007, has resulted in improved stability in our liquidity position. Unencumbered RMBS and unrestricted cash and cash equivalents aggregated approximately $57.4 million at June 30, 2008. In addition, net equity in the financed RMBS portfolio (including associated interest rate swaps), excluding the unencumbered RMBS included above, totaled approximately $28.3 million at June 30, 2008. In total, we had cash and cash equivalents, unencumbered liquid securities and net equity in financed liquid securities of approximately $85.7 million as of June 30, 2008. We believe our current cash and cash equivalents, unencumbered liquid securities and net equity in financed liquid securities along with financing sources and cash flows from operations are adequate to meet anticipated long term (greater than one year) liquidity requirements.
We are focused on optimizing the Investment Management segment of our business by launching new investment products that will diversify our revenue streams while highlighting our core competencies of credit analysis and asset management. We expect to make co-investments in certain of these new investment products. We believe that the growth of fee based income through the management of alternative investment products will provide the most attractive risk-adjusted return on capital. We are also focused on our previously announced strategy of acquiring existing CDO management contracts. On July 21, 2008, we announced that we acquired the management contract for Robeco CDO II Limited from Robeco Investment Management, Inc. We continue to explore the possibility of acquiring additional management contracts from other CDO managers.
First Quarter Overview
During the first three months of 2008, we were adversely impacted by the continuing deterioration of global credit markets. The most pronounced impact was on our AAA-rated non-Agency RMBS portfolio. This portfolio experienced a significant decrease in value during the first three months of 2008 fueled by the ongoing liquidity crisis. This negative environment affected our ability to successfully finance and hedge our RMBS assets in several ways. First, as financing conditions worsened and the value of our AAA-rate non-Agency RMBS portfolio declined, we sold a significant portion of our AAA-rate non-Agency RMBS and Agency RMBS to improve our liquidity.

Second, repurchase agreement counterparties in some cases ceased financing non-Agency collateral (including AAA-rated collateral such as ours) and, in other cases, significantly increased the equity, or "haircut," required to finance such collateral. The reduction of available counterparties further restricted our ability to obtain financing on favorable terms.
Finally, we have a long standing practice of hedging a substantial portion of the interest rate risk that we incur in connection with financing the RMBS portfolio. This hedging is generally accomplished through interest rate swaps under which we agree to pay a fixed interest rate in return for receiving a floating interest rate. As the credit environment worsened in early 2008, it created a flight to U.S. Treasury securities and prompted further Federal Reserve rate cuts and interest rates decreased sharply. This, in turn, required us to post additional collateral to support declines in our interest rate swap portfolio. While Agency RMBS demonstrated offsetting gains providing releases of certain margin, AAA-rated non-Agency RMBS experienced significant price declines which, coupled with losses on our interest rate swap portfolio, exacerbated the strain on our liquidity.
The combined impact of these developments resulted in the acceleration of our strategy to decrease investment in AAA-rated non-Agency RMBS and to seek to liquidate other assets to significantly reduce leverage in our balance sheet in an effort to support liquidity needs. Specifically, the following actions were taken during the three months ended March 31, 2008:
• Agency RMBS with an amortized cost of $4.6 billion were sold at a net realized gain of $24.4 million.

• AAA-rated non-Agency RMBS with an amortized cost of $1.6 billion were sold at a net realized loss of $193.5 million.

• The net notional amount of interest rate swaps used to hedge the RMBS portfolio was reduced by $6.2 billion. Net losses in this portfolio for the three months ended March 31, 2008 totaled $219.3 million.

Our Business
Our business is managed in two operating segments: Investment Management and Principal Investing. Our Investment Management segment involves managing a variety of investment products including private investment funds, collateralized debt obligations, or CDOs, and separately managed accounts. Our Principal Investing segment is comprised primarily of Agency RMBS, AAA-rated non-Agency RMBS, government securities and Corporate Loans (as defined below).
Agency-issued RMBS are backed by mortgage loans and are guaranteed as to principal and interest by federally chartered entities such as the Federal National Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage Corporation, or Freddie Mac, and, in the case of the Government National Mortgage Association, or Ginnie Mae, the U.S. government. We refer to these entities as "Agencies" and to RMBS guaranteed or issued by the Agencies as "Agency RMBS." Our Agency RMBS portfolio currently consists of Fannie Mae and Freddie Mac securities. We refer to our investments in senior secured loans (first lien and second lien term loans), senior subordinated debt facilities and other junior securities, typically in middle market companies across a range of industries, as "Corporate Loans."
Investment Management Segment
DCM manages investment accounts for various types of clients, including CDOs and a structured loan fund, a private investment fund and separately managed accounts (separate, non-pooled accounts established by clients). Except for the separately managed accounts, these clients are collective investment vehicles that pool the capital contributions of multiple investors, which are typically financial institutions, such as insurance companies, employee benefits plans and "funds of funds" (investment funds that in turn allocate their assets to a variety of other investment funds). Our teams that manage these accounts are supported by various other groups within DCM, such as risk management, systems, accounting, operations and legal. DCM enters into an investment management agreement with each client, pursuant to which the client grants DCM discretion to purchase and sell securities and other financial instruments without the client's prior authorization.
The various investment strategies that DCM uses to manage client accounts are developed internally by DCM and include fundamental credit research (such as for the CDOs) and arbitrage trading techniques (such as for the investment fund). Arbitrage trading generally involves seeking to generate trading profits from changes in the price relationships between related financial instruments rather than from "directional" price movements in particular instruments. Arbitrage trading also typically involves the use of substantial leverage, through borrowing of funds, to increase the size of the market position being taken and therefore the potential return on the investment.
Our primary source of revenue from our Investment Management segment is the investment advisory fees paid by the accounts we manage. These fees consist of management fees based on the account's assets and performance fees based on the profits we generate for the account, or in the case of CDOs, the achievement of performance targets set forth in any related agreements.

AUM
   The following table summarizes the assets under management, or AUM, for each
of the Investment Management segment product categories as of July 1, 2008:

                                           Number of          AUM as of
                                            Accounts       July 1, 2008 (1)
                                                            (In thousands)
         CDOs (2)
         Bank loans (3)                            15     $        5,151,278
         Asset-backed securities                   13              6,336,532
         Investment grade credit                    2                620,883

         Total CDOs                                               12,108,693
         Investment Fund (4)
         Fixed income arbitrage                     1                436,156

         Separately managed accounts (5)            6                431,480

         Total AUM (6)                                    $       12,976,329

(1) AUM numbers are reported as of July 1, 2008, rather than as of June 30, 2008, to be inclusive of investment fund contributions, if any, effective on the first of the month.
(2) 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, 2008. Our CDOs/Bank loans AUM includes AUM related to our structured loan fund.
(3) The AUM for our Euro-denominated CDO has been converted into U.S. dollars using the spot rate of exchange on June 30, 2008.
(4) The Number of Accounts for the Investment Fund does not include feeder funds, which are funds that invest all or substantially all of their assets into a trading fund which we manage, although some of our management fees are paid pursuant to contracts with those feeder funds.
(5) 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 levered AUM number.
(6) Included in Total AUM are $295.3 million and $300.8 million related to Market Square
CLO and DFR MM CLO, respectively, which amounts are also included in the total reported for the Principal Investing segment. DCM manages these CDOs but is not contractually entitled to receive any management fees for so long as 100% of the equity is held by DC LLC or an affiliate thereof. All other amounts included in the Principal Investing portfolio are excluded from Total AUM.

Principal Investing Segment
Our income from our Principal Investing segment is generated primarily from the net spread, or difference, between the interest income we earn on our investment portfolio and the cost of our borrowings net of hedging activities, as well as the recognized gains and losses on our investment portfolio, including provision for loan losses, if any. Our net interest income will vary based upon, among other things, the difference between the interest rates earned on our interest-earning investments and the borrowing costs of the liabilities used to finance those investments. We use a substantial amount of leverage to seek to enhance our returns, which can also magnify losses. The cost of borrowings to finance our investments comprises a significant portion of our operating expenses.

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

                                                           June 30, 2008
                                                     Carrying          % of Total
              Principal Investments                   Value           Investments
                                                  (In thousands)
   Real Estate Investments:
   RMBS (1)                                      $        444,185             21.1 %
   Commercial real estate loans and securities             17,212              0.8 %

                                                          461,397             21.9 %


   Government Investments:
   U.S. Treasury bills                                    999,954             47.5 %


   Corporate Investments:
   Corporate leverage loans:
   Loans held in DFR MM CLO                               259,577             12.3 %
   Loans held in Wachovia Facility                         89,627              4.2 %
   Other corporate leveraged loans (2)                     24,879              1.2 %
   Assets held in Market Square CLO (3)                   263,037             12.5 %
   Equity securities                                        5,472              0.3 %
   Other investments                                        1,293              0.1 %

                                                          643,885             30.6 %


   Total Investments                                    2,105,236            100.0 %

   Allowance for loan losses                               (7,883 )

   Net Investments                               $      2,097,353

(1) RMBS are either Agency RMBS or AAA-rated non-Agency RMBS.
(2) Other corporate leveraged loans excludes credit default and total return swaps.
(3) Includes syndicated bank loans of $257.9 million, high yield corporate bonds of $3.3 million and ABS of $1.8 million as of June 30, 2008.

Trends
The following trends may also affect our business:
Liquidity. We depend on the capital markets to finance our investments in RMBS. We enter into repurchase agreements to provide short term financing for our RMBS portfolio. Commercial and investment banks have historically provided sufficient liquidity to finance our mortgage portfolio. Recent market events, however, have caused such firms to change their credit standards and generally reduce the loan amounts available to borrowers, resulting in a decrease in overall market liquidity. This has reduced our access to repurchase financing, particularly with respect to the AAA-rated non-Agency portion of our RMBS portfolio. This reduction in liquidity reduced the market valuations of our AAA-rated non-Agency RMBS, which resulted in our need to post additional margin and, ultimately, to sell a significant portion of our RMBS portfolio at a time when we would not otherwise have chosen to do so. The market dislocation has put significant downward pressure in the value of RMBS across the credit spectrum, resulting in significant losses, which has also had a significant negative effect on our liquidity.
Although we do not have direct exposure to the sub-prime mortgage sector, the current default trends in that sector and the resulting weakness in the broader mortgage market could adversely affect our lenders, causing one or more of them to be unwilling or unable to provide us with additional or continuing financing. This could increase our financing costs and further reduce our liquidity. The failure of one or more major market participants could reduce the marketability of all fixed income securities, including Agency RMBS, which could reduce the value of the securities in our portfolio, thus reducing our net book value. If our lenders are unwilling or unable to provide us with additional financing, we could be forced to sell a large portion of our securities at an inopportune time or on unfavorable terms. However, because the vast majority of our current RMBS portfolio consists of Agency RMBS, we believe that we are better positioned to convert our investment securities to cash or to negotiate an extended financing term should our lenders reduce the amount of the liquidity available to us.

Corporate credit performance. Earlier periods had demonstrated reasonably stable corporate credit performance, as evidenced by the relatively low corporate default rates. More recently, however, corporate default rates have begun to increase as the economy has begun to show signs of weakening. A further weakening of the U.S. economy would likely have a negative impact on corporate credit performance, which could result in an increase in corporate default rates. Such an increase would likely reduce the returns associated with certain of our investments, particularly the corporate leveraged loans held in both our Principal Investing segment portfolio and in certain of the vehicles managed within our Investment Management segment. Furthermore, such an increase in default rates would likely increase our allowance for loan losses on loans held for investment and increase our valuation allowance on loans held for sale. Additionally, an increase in default rates would likely generate realized losses in our portfolios. These events could result in significant losses and a reduction in our book value. Increases in defaults could also cause us to hit certain structural triggers in the CDOs that we own and manage. These CDOs generally contain certain structural provisions, including, but not limited to, over collateralization requirements and/or market value triggers that are meant to protect investors from deterioration in the credit quality of the underlying collateral pool.
Credit spreads. Over the past several years, the credit markets experienced tightening credit spreads (specifically, spreads between U.S. Treasury securities and other securities that are identical in all respects except for ratings) mainly due to the strong demand for lending opportunities. Over the second half of 2007 and the first half of 2008, however, there was significant widening of credit spreads across all of the credit markets. A continued widening could reduce our book value but could also have the positive effect of increasing net interest income on future investment opportunities. However, we would need to have additional capital available, either through debt financings or equity offerings, to take advantage of these investment opportunities. We are currently unable to take significant advantage of the increased yields available on investments due to a lack of available capital.
CDO financing and management. The reduction in liquidity and widening of credit spreads have resulted in significant downward pressure on the market values of assets typically held in and financed by CDOs. These decreased market values, along with increased default rates on ABS and significant rating agency downgrades of the collateral underlying certain of our CDOs, have made it more likely that our CDOs may trigger certain of their structural protections or events of default, either of which would reduce our management fees and our AUM.
We anticipate that, given current market conditions, it will be significantly more difficult to create new CDOs in the near term than it has been in the past. Tighter lending standards imposed by financial institutions could also result in a diminished ability to finance some security positions in CDOs and other funds on favorable terms or at all. To the extent that we are successful in creating new CDOs, the management fees we earn from managing those CDOs may be at a significantly lower rate than what we averaged previously. This may affect our ability to sustain our historical AUM and revenue growth.
During 2008, the CDO management market experienced some consolidation, evidenced by CDO management contracts being transferred to or acquired by larger, more established CDO managers. We expect this trend to continue in the near term and are looking to take advantage of this trend by acquiring CDO management contracts. For example, on July 21, 2008, we announced that we acquired the management contract for Robeco CDO II Limited from Robeco Investment Management, Inc.
Interest rate environment. From September 18, 2007 to June 30, 2008, the Federal Reserve decreased the Fed Funds rate on seven occasions by an aggregate of 325 basis points, from 5.25% to 2.00%. The Fed Funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. These decreases caused a drop in London interbank offered rate, or LIBOR, rates as well as a comparable decrease in our short term borrowing costs. Due to our interest rate hedging program, the changes in our borrowing costs were largely offset by our hedges, and our effective cost of funding remained relatively stable. Greater volatility in market interest rates will place a higher degree of reliance on the effectiveness of our interest rate hedging strategies including in the other funds we manage. Additionally, the fair value changes in the Agency RMBS portfolio associated with shifts in term interest rates were generally offset by our portfolio of swap hedges of varying maturities. Because we own hybrid adjustable mortgages which contain caps on the interest rate, a significant rise in rates after the initial fixed rate period would also decrease net interest income if the financing rate is higher than the capped rate.
Shape of the yield curve. During the first half of 2008, the yield curve continued to steepen, with the yield on the three-month U.S. Treasury bill decreasing by 151 basis points, while the yield on the five-year U.S. Treasury note decreased by only 11 basis points. It is difficult to predict the future shape of the yield curve. If the yield curve continues to steepen, we would likely experience increases in our net interest income on our RMBS, as the financing of our RMBS is usually shorter in term than the fixed rate period of our RMBS, which is heavily weighted towards hybrid adjustable rate RMBS. Similarly, if the curve inverts, our net interest income would likely decrease. We expect our hedging program to offset some of the impact of changes in the shape of the yield curve, but, since we do not hedge 100% of our interest rate exposure, the impact from the hedges will not fully offset the impact to net interest income.

Valuation of investments. Recent events in the financial markets have resulted in the offer for sale of a significant amount of investment assets, increasingly under distressed circumstances, with limited financing available to potential buyers. This increase in investment assets for sale, together with investors' diminished confidence in being able to assess the credit quality of credit-sensitive investments, has caused significant price volatility in previously stable asset classes. As a result, the pricing process for certain investment classes has become more uncertain and subjective, and prices obtained through such process may not necessarily represent what we would receive in an actual sale of a given investment.
Prepayment rates. Prepayment rates generally increase when interest rates fall and decrease when they rise, but the precise impact of interest rate changes on prepayment rates is difficult to predict. Prepayment rates also may be affected by other factors, including conditions in the housing and financial markets, conditions in the mortgage origination industry, general economic conditions and the relative interest rates on adjustable-rate and fixed-rate mortgage loans. Because interest rates have declined, we would expect to see an increase in the prepayment rates associated with our RMBS portfolio. If this occurred, our current portfolio, which is heavily weighted towards hybrid adjustable-rate mortgages, could experience decreases in its net interest income due to reinvestment opportunities being in a lower rate environment. In addition, a significant increase in prepayment rates could reduce our liquidity, as we would expect to experience an increase in margin calls from repurchase counterparties associated with the decline in the market value of the RMBS securing the repurchase financings.
Investor demand. We believe that institutions, high net worth individuals and other investors are increasing their allocations of capital to the alternative investment sector. Such allocations and the related demand, however, depend partly on the strength of the economy and the returns available from other investments relative to returns from alternative investments. These returns depend on the interest rate and credit spread markets. As interest rates rise or credit spreads widen, returns available on other investments tend to increase, which could slow capital flow to, or increase capital withdrawal from, the alternative investment sector. In recent years, we have experienced relatively steady and historically low interest rates and tight credit spreads, which has generally been favorable to our Investment Management segment. However, recent market developments have caused credit spreads to significantly widen. Increased volatility and widening of credit spreads triggered by the higher delinquency and default rates in the subprime mortgage markets, which is negatively impacting our management and related fees from CDOs as well as the fair value of our CDO investments, recently has, and could continue to, depress investor demand and negatively impact the performance and profitability of our Investment Management segment. . . .