During the three months ended September 30, 2008, the credit environment continued to worsen, and we experienced additional declines in our overall market capitalization. In addition to declines in values for assets held in the Principal Investing segment, our Investment Management segment was also negatively impacted by the global credit crisis which has reduced investment advisory fees and net income. As a result, we performed an analysis for possible goodwill impairment and determined that, as of September 30, 2008, the remaining goodwill balance related to the Merger of $78.2 million was impaired. We also recorded $32.1 million in impairment charges related to intangible assets during the three months ended September 30, 2008, consisting of $30.6 million on intangible assets related to the management contract for our remaining investment fund, which exhibited poor performance during the quarter resulting in significant notice of redemptions by investors and is expected to be liquidated no later than November 30, 2008, and $1.5 million of intangible assets related to the management contracts associated with two market value collateralized loan obligations, or CLOs, which are now liquidated or pending liquidation. As a result of these impairment charges related to our goodwill and intangible assets and the effect that such charges had on our ability to comply with the net worth covenant contained in the agreements governing our trust preferred securities, we entered into a letter agreement on November 7, 2008 that provided a waiver of any prior noncompliance with the minimum net worth covenant and waived any future noncompliance with such covenant through April 1, 2010. See Recent Developments for a complete discussion of the letter agreement.
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 intend 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. Additionally, we continue to explore strategic opportunities in order to maximize value for our stockholders.
On July 17, 2008, we acquired the management contract for Robeco CDO II Limited, or Robeco CDO, a CDO previously managed by Robeco Investment Management, Inc. Robeco CDO is collateralized primarily by high-yield corporate bonds. This acquisition was in line with our previously announced strategy to acquire CDO management contracts from asset managers, and we are continuing to explore the possibility of acquiring additional management contracts in a similar fashion.
We effected a 1-for-10 reverse stock split of our common stock after the close of business on October 16, 2008. Share and per share amounts reflected throughout this quarterly report on Form 10-Q have been retroactively restated to reflect the reverse stock split.
Significant RMBS Portfolio Activity
During the first nine months of 2008, we were adversely impacted by the continuing deterioration of global credit markets. The most pronounced impact was on our non-Agency RMBS portfolio. This portfolio experienced a significant decrease in value during the first three months of 2008 fueled by the credit 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 non-Agency RMBS portfolio declined, we sold a significant portion of our non-Agency RMBS and Agency RMBS to improve our liquidity.
Second, repurchase agreement counterparties in some cases ceased financing non-Agency collateral (including 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, 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 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.

• 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 earning investment advisory fees for managing a variety of investment products including CDOs, a private investment fund and separately managed accounts. Our Principal Investing segment is comprised primarily of Agency RMBS, non-Agency RMBS 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. As a result of adverse conditions in the mortgage market, both Fannie Mae and Freddie Mac have experienced significant financial difficulties. On September 7, 2008, the Federal Housing Finance Agency, or FHFA, placed Fannie Mae and Freddie Mac into conservatorship, which is a statutory process pursuant to which the FHFA will operate Fannie Mae and Freddie Mac as conservator in an effort to stabilize these entities. See "Part II - Item 1A. Risk Factors" for additional information concerning the Fannie Mae and Freddie Mac conservatorship. We refer to these entities as "Agencies" and to RMBS guaranteed or issued by the Agencies as "Agency RMBS." Our Agency RMBS portfolio consists of Fannie Mae and Freddie Mac securities. Our non-Agency RMBS portfolio consists primarily of securities that are currently rated between AA and AAA by the major rating agencies, although we do hold one B-rated security that, as of September 30, 2008, constituted 10% of our $20.2 million non-Agency RMBS portfolio. 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.
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 October 1, 2008:

                                          Number of            AUM as of
                                           Accounts       October 1, 2008 (1)
                                                            (In thousands)
        CDOs (2)
        CLOs (3)                                  14     $           4,738,850
        Asset-backed securities                   12                 5,780,808
        Corporate bonds                            3                   797,139

        Total CDOs                                29                11,316,797

        Investment Fund (4)
        Fixed income arbitrage                     1                   330,959

        Separately managed accounts (5)            6                   267,295

        Total AUM (6)                                    $          11,915,051

(1) AUM numbers are reported as of October 1, 2008, rather than as of September 30, 2008.

(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 October 1, 2008. Our CDOs/CLOs
AUM includes AUM
related to our
structured loan
fund.

(3) The AUM for our Euro-denominated CLO has been converted into U.S. dollars using the spot rate of exchange on September 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. This Investment Fund is expected to be liquidated no later than November 30, 2008.

(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 $294.1 million and $300.9 million related to Market Square CLO Ltd., or Market Square CLO, and DFR Middle Market CLO Ltd., or 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 Deerfield Capital LLC, or DC LLC, or an affiliate thereof. All other amounts included in the Principal Investing portfolio are excluded from Total AUM.

Principal Investing Segment
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 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:

                                                        September 30, 2008
                                                     Carrying          % of Total
   Principal Investments                              Value           Investments
                                                  (In thousands)
   RMBS                                          $        414,502             39.5 %
   Corporate leveraged loans:
   Loans held in DFR MM CLO                               256,818             24.5 %
   Loans held in Wachovia Facility                         77,676              7.4 %
   Other corporate leveraged loans (1)                     32,259              3.1 %
   Assets held in Market Square CLO (2)                   250,082             23.8 %
   Commercial real estate loans and securities             12,371              1.2 %
   Equity securities                                        4,764              0.5 %

   Total Investments                                    1,048,472            100.0 %

   Allowance for loan losses                              (21,596 )

   Net Investments                               $      1,026,876

(1) Other corporate leveraged loans excludes credit default swaps and total return swaps.

(2) Includes syndicated bank loans of $245.0 million, high yield corporate bonds of $2.9 million and ABS of $2.2 million as of September 30, 2008.

Trends
The following trends may also affect our business:
Credit market dislocation. The third quarter of 2008 was extremely volatile and presented many challenges. During the quarter, global financial markets came under increased stress as problems in the U.S. residential mortgage market spread to the broader economy and the global financial sector. In addition, fears of a global recession increased and were exacerbated by further declines in the housing and credit markets in the U.S. and Europe, which heightened concerns over the creditworthiness of some financial institutions. As a result, most sectors of the financial markets experienced declines over the quarter, including international equity and credit markets, driven, in part, by deleveraging and difficulty pricing risk in the market that has been affecting investors all over the world.
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 and continuing 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 non-Agency portion of our RMBS portfolio. This reduction in liquidity reduced the market valuations of our 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 on 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 borrowing term should our lenders reduce the amount of the financing 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 continued to weaken. A further weakening of the U.S. economy would likely have an even more pronounced 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, overcollateralization 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 mainly due to the strong demand for lending opportunities. Over the second half of 2007 and the first nine months of 2008, however, there was significant widening of credit spreads across all of the credit markets. This widening was most pronounced in the third quarter of 2008. This widening has resulted in a decline in the fair value for most of our investments and in the securities we manage, which has resulted in a decline in our book value and a reduction in our AUM. 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 capital available 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. Declines in market prices of bank loans in the third quarter of 2008 have caused certain market value CLOs managed by DCM to trip their market value triggers. See "Results of Operations - Investment Management 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 term than it has been in the past. Conditions in the credit markets have led to banks charging higher fees to warehouse collateral for the CDOs prior to their closing and potential investors demanding significantly increased interest rates on CDO liabilities. 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 grow our AUM and revenue.
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.

Interest rate environment. From September 18, 2007 to September 30, 2008, the Federal Reserve decreased the Federal Funds, or Fed Funds, rate on seven occasions by an aggregate of 325 basis points, from 5.25% to 2.00%. Since September 30, the Federal Reserve lowered the rate twice more, from 2.00% to 1.00% as of October 31, 2008. The Fed Funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. While these decreases generally caused a drop in the London interbank offered rate, or LIBOR, during the third quarter LIBOR temporarily spiked higher, due to general weakness in the international bank system, which causes banks to raise the rates under which they were willing to lend to one another. 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 nine months of 2008, the yield curve continued to steepen, with the yield on the three-month U.S. Treasury bill decreasing by 233 basis points, while the yield on the five-year U.S. Treasury note decreased by only 46 basis points. It is difficult to predict the future . . .