UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

FORM 10-Q

(Mark One)

þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended September 30, 2007

OR

o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the transition period from                     to

Commission File Number: 000-31828

LUMINENT MORTGAGE CAPITAL, INC.

(Exact name of registrant as specified in its charter)

Maryland (State or other jurisdiction of incorporation or organization)		06-1694835 (I.R.S. Employer Identification No.)
101 California Street, Suite 1350, San Francisco, California (Address of principal executive offices)		94111 (Zip Code)

(415) 217-4500
(Registrant’s telephone number, including area code)

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

     Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o.

     Indicate by check mark whether registrant is a large accelerated filer, an accelerated filer, or a non- accelerated filer. See definition of “accelerated filer and large accelerated filer” as defined in Rule 12b-2 of the Exchange Act. (Check one)

Large accelerated filer o      Accelerated filer þ      Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o. No þ.

     The number of shares of common stock outstanding on December 24, 2007 was 43,172,839.

 

 

INDEX

		PAGE
CAUTIONARY NOTE			ii
PART I            FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS			1
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			26
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			47
ITEM 4. CONTROLS AND PROCEDURES			51
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS			52
ITEM 1A. RISK FACTORS			52
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			55
ITEM 3. DEFAULTS UPON SENIOR SECURITIES			55
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS			55
ITEM 5. OTHER INFORMATION			55
ITEM 6. EXHIBITS			55
SIGNATURES			56
EXHIBIT INDEX			57
CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

     This Form 10-Q contains or incorporates by reference certain forward-looking statements under the Private Securities Litigation Reform Act of 1995. Forward-looking statements convey our current expectations or forecasts of future events. All statements contained in this Form 10-Q other than statements of historical fact are forward-looking statements. Words such as “anticipates,” “estimates,” “expects,” “projects,” “intends,” “plans,” “believes” and words and terms of similar substance used in connection with any discussion of future operating or financial performance identify forward-looking statements.

     We claim the protection of the safe harbor for forward-looking statements provided in the Private Securities Litigation Reform Act of 1995. These statements may be made directly in this Form 10-Q and they may also be incorporated by reference in this Form 10-Q to other documents we file with the SEC. We base our forward-looking statements upon the current beliefs and expectations of our management and they are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are difficult to predict and generally beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the anticipated results discussed in these forward-looking statements. These forward-looking statements include, among other things, statements about:

	•		our ability to meet margin calls on our repurchase agreement financing that may be required due to further declines in the value of the mortgage-backed securities collateralizing the agreements;
	•		our ability to obtain or renew sufficient funding to maintain our leverage strategies and support our liquidity position;
	•		the continued creditworthiness of the holders of mortgages underlying our mortgage-related assets;
	•		our ability to purchase sufficient mortgages for our securitization business;
	•		the effect of the flattening of, or other changes in, the yield curve on our investment strategies;
	•		changes in interest rates and mortgage prepayment rates;
	•		the possible effect of negative amortization of mortgages on our financial condition and REIT qualification;
	•		the possible impact of our failure to regain or maintain exemptions under the 1940 Act;
	•		potential impacts of our leveraging policies on our net income and cash available for distribution;
	•		the power of our board of directors to change our operating policies and strategies without stockholder approval;
	•		the effects of interest rate caps and or proposed federal legislation on our adjustable-rate and hybrid adjustable-rate loans and mortgage-backed securities;
	•		the degree to which our hedging strategies may or may not protect us from interest rate volatility;
	•		our ability to invest up to 10% of our investment portfolio in residuals, leveraged mortgage derivative securities and shares of other REITs as well as other investments;
	•		our current inability to make cash distributions to our stockholders because of our liquidity concerns; and
	•		the other factors described in this Form 10-Q, including those under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors” and “Quantitative and Qualitative Disclosures about Market Risk.”

     We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q or the date of any document incorporated by reference in this Form 10-Q. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. Except to the extent required by applicable law or regulation, we undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events.

PART I

FINANCIAL INFORMATION

     Item 1. Financial Statements.

INDEX TO FINANCIAL STATEMENTS

Condensed Consolidated Financial Statements of Luminent Mortgage Capital, Inc.:
Condensed Consolidated Balance Sheets at September 30, 2007 (unaudited) and December 31, 2006			2
Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2007 and September 30, 2006			3
Condensed Consolidated Statement of Stockholders’ Equity (unaudited) for the nine months ended September 30, 2007			4
Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2007 and September 30, 2006			5
Notes to the Condensed Consolidated Financial Statements (unaudited)			7

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 30,				December 31,
		2007				2006
(in thousands, except share and per share amounts)		(Unaudited)
Assets:
Cash and cash equivalents		$	8,285			$	5,902
Restricted cash			8,396				7,498
Loans held-for-investment, net of allowance for loan losses of $21,282 at September 30, 2007 and $5,020 at December 31, 2006			4,369,019				5,591,717
Mortgage-backed securities, at fair value			—				141,556
Mortgage-backed securities pledged as collateral, at fair value			907,005				2,789,382
Debt securities, at fair value			1,006				—
Equity securities, at fair value			413				1,098
Interest receivable			24,023				36,736
Principal receivable			1,771				1,029
Derivatives, at fair value			201				13,021
Other assets			52,318				25,856
Total assets		$	5,372,437			$	8,613,795
Liabilities:
Mortgage-backed notes		$	4,030,643			$	3,917,677
Repurchase agreements			792,231				2,707,915
Warehouse lending facilities			—				752,777
Commercial paper			—				637,677
Collateralized debt obligations			294,529				—
Junior subordinated notes			92,788				92,788
Convertible senior notes			90,000				—
Derivatives, at fair value			2,623				—
Revolving line of credit			43,256				—
Cash distributions payable			13,857				14,343
Accrued interest expense			14,231				12,094
Warrant liability, at fair value			68,910				—
Accounts payable and accrued expenses			19,854				6,969
Total liabilities			5,462,922				8,142,240
Stockholders’ Equity:
Preferred stock, par value $0.001:
10,000,000 shares authorized; no shares issued and outstanding at September 30, 2007 and December 31, 2006			—				—
Common stock, par value $0.001:
100,000,000 shares authorized; 43,172,839 and 47,808,510 shares issued and outstanding at September 30, 2007 and December 31, 2006, respectively			43				48
Additional paid-in capital			548,459				583,492
Accumulated other comprehensive income			2,560				3,842
Accumulated distributions in excess of accumulated earnings			(641,547	)			(115,827	)
Total stockholders’ equity (deficit)			(90,485	)			471,555
Total liabilities and stockholders’ equity (deficit)		$	5,372,437			$	8,613,795

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

		For the Three Months Ended								For the Nine Months Ended
		September 30,								September 30,
(in thousands, except share and per share amounts)		2007				2006				2007				2006
Net interest income:
Interest income:
Mortgage loan and securitization portfolio		$	86,869			$	65,658			$	281,527			$	133,667
Spread portfolio			21,850				18,947				84,001				69,757
Credit sensitive bond portfolio			25,268				10,493				60,495				28,176
Total interest income			133,987				95,098				426,023				231,600
Interest expense			112,392				73,149				349,819				172,633
Net interest income			21,595				21,949				76,204				58,967
Other income (expenses):
Gains (losses) on derivative instruments, net			6,524				(11,689	)			42,406				4,087
Gains (losses) on sales of mortgage-backed securities, net			(137,959	)			167				(153,409	)			990
Losses on sales of loans held-for-investment			(46,477	)			—				(46,477	)			—
Impairment losses on mortgage-backed securities			(268,877	)			—				(287,622	)			(2,179	)
Mortgage-backed securities, trading change in fair value			(18,209	)			—				(18,200	)			—
Warrants, change in fair value			(46,569	)			—				(46,569	)			—
Other expense			(49	)			—				(156	)			(608	)
Total other income (expenses)			(511,616	)			(11,522	)			(510,027	)			2,290
Operating Expenses:
Servicing expense			5,389				3,526				18,104				7,546
Provision for loan losses			10,247				1,779				18,434				3,304
Salaries and benefits			8,363				2,934				14,998				7,375
Professional services			3,171				1,088				5,012				2,181
Management compensation expense to related party			—				6,048				—				7,712
Other general and administrative expenses			1,690				1,242				5,366				3,334
Total operating expenses			28,860				16,617				61,914				31,452
Income (loss) before income taxes			(518,881	)			(6,190	)			(495,737	)			29,805
Income taxes			1,755				405				1,709				1,057
Net income (loss)		$	(520,636	)		$	(6,595	)		$	(497,446	)		$	28,748
Net income (loss) per share — basic		$	(12.17	)		$	(0.17	)		$	(11.07	)		$	0.74
Net income (loss) per share — diluted		$	(12.17	)		$	(0.17	)		$	(11.07	)		$	0.74
Weighted-average number of shares outstanding — basic			42,790,740				38,695,800				44,943,803				38,937,454
Weighted-average number of shares outstanding — diluted			42,790,740				38,695,800				44,943,803				39,066,406
Dividends per share		$	—			$	0.30			$	0.62			$	0.55

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)

(Unaudited)

																		Accumulated
														Accumulated				Distributions
		Common Stock								Additional				Other				in Excess of
						Par				Paid-in				Comprehensive				Accumulated				Comprehensive
(in thousands)		Shares				Value				Capital				Income/(Loss)				Earnings				Income/(Loss)				Total
Balance, January 1, 2007			47,809			$	48			$	583,492			$	3,842			$	(115,827	)						$	471,555
Net income (loss)																			(497,446	)		$	(497,446	)			(497,446	)
Securities available-for-sale, fair value adjustment															(105	)							(105	)			(105	)
Amortization of derivative gains															(1,177	)							(1,177	)			(1,177	)
Comprehensive income (loss)																						$	(498,728	)
Repurchases and retirement of common stock			(4,905	)			(5	)			(41,290	)															(41,295	)
Distributions to stockholders																			(28,274	)							(28,274	)
Issuance and amortization of restricted common stock			269								6,257																6,257
Balance, September 30, 2007			43,173			$	43			$	548,459			$	2,560			$	(641,547	)						$	(90,485	)

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

		For the Nine Months Ended September 30,
(in thousands)		2007				2006
Cash flows from operating activities:
Net income (loss)		$	(497,446	)		$	28,748
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Amortization of premium/(discount) on loans held-for-investment and mortgage-backed securities and depreciation			20,652				(941	)
Impairment losses on securities			287,622				2,179
Provision for loan losses			18,434				3,304
Realized loss on real estate owned			491				—
Negative amortization of loans held-for-investment			(86,531	)			(35,004	)
Share-based compensation			6,257				2,594
Net realized and unrealized (gains) losses on derivative instruments			7,156				(3,459	)
Net losses on mortgage backed securities held as trading			18,200				—
Net change in the fair value of warrants			46,569				—
Net (gain) losses on sales of mortgage-backed-securities available-for-sale			153,409				(990	)
Net losses on the sales of loans held-for-investment			46,477				—
Changes in operating assets and liabilities:
(Increase) decrease in interest receivable, net of purchased interest			(16,048	)			73
(Increase) decrease in other assets			2,452				(2,042	)
Increase in accounts payable and other liabilities			12,304				890
Increase (decrease) in accrued interest expense			2,742				(13,183	)
Increase in management compensation payable, incentive compensation payable and other related-party payable			—				4,949
Net cash provided by (used in) operating activities			22,740				(12,882	)
Cash flows from investing activities:
Purchases of mortgage-backed securities			(821,436	)			(1,849,595	)
Proceeds from sales of mortgage-backed securities			1,863,969				3,750,554
Principal payments of mortgage-backed securities			376,188				364,781
Purchases of loans held-for-investment, net			(1,679,991	)			(3,949,480	)
Principal payments of loans held-for-investment			1,295,362				272,476
Proceeds from the sale of loans held-for-investment			957,150				—
Purchases of derivative instruments			(32,979	)			(2,792	)
Proceeds from derivative instruments			40,184				3,484
Purchase of debt securities			(1,271	)			—
Net change in restricted cash			(8,437	)			671
Other			(129	)			—
Net cash provided by (used in) investing activities			1,988,610				(1,409,901	)
Cash flows from financing activities:
Proceeds from issuance of common stock			—				11,747
Repurchases of common stock			(41,295	)			(15,832	)
Capitalized financing costs			(2,355	)			—
Borrowings under repurchase agreements			31,313,807				27,681,403
Principal payments on repurchase agreements			(33,021,207	)			(29,080,973	)
Borrowings under warehouse lending facilities			2,069,957				3,806,251
Paydown of warehouse lending facilities			(2,822,551	)			(3,806,251	)
Borrowings under commercial paper facility			3,849,451				—
Paydown of commercial paper facility			(4,487,127	)			—
Distributions to stockholders			(28,760	)			(11,014	)
Proceeds from issuance of mortgage-backed notes			1,763,061				3,062,397
Principal payments on mortgage-backed notes			(1,025,663	)			(214,187	)
Proceeds from issuance of collateralized debt obligations			291,027				—
Principal payments on collateralized debt obligations			(568	)			—
Principal payments on margin debt			—				(3,548	)
Proceeds from issuance of convertible senior notes			90,000				—
Proceeds from revolving line of credit			43,256				—
Net cash provided by (used in) financing activities			(2,008,967	)			1,429,993
Net increase in cash and cash equivalents			2,383				7,210
Cash and cash equivalents, beginning of the period			5,902				11,466
Cash and cash equivalents, end of the period		$	8,285			$	18,676

LUMINENT MORTGAGE CAPITAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

(Unaudited)

		For the Nine Months Ended September 30,
(in thousands)		2007				2006
Supplemental disclosure of cash flow information:
Interest paid		$	365,523			$	186,786
Taxes paid			4,665				994
Non-cash investing and financing activities:
Issuance of warrants		$	22,343			$	—
Transfer of loans held-for-investment to real estate owned			22,605				—
Proceeds from the sale of mortgage-backed securities			(18,982	)			—
Repayments of repurchase agreements			18,982				—
Acquisition of mortgage-backed securities available-for-sale through collateralized debt obligations			(3,986	)			—
(Increase) decrease in principal receivable			(742	)			12,478
Increase (decrease) in cash distributions payable to stockholders			(486	)			11,006
Principal payments of mortgage-backed securities available-for-sale			183				—
Paydown of warehouse lending facilities			(183	)			—
Increase in unsettled security purchases			—				3,000

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—OVERVIEW

          Luminent Mortgage Capital Inc., or the Company, was organized as a Maryland corporation on April 25, 2003. The Company commenced operations on June 11, 2003. The Company’s common stock began trading on the New York Stock Exchange, or NYSE, under the trading symbol LUM on December 19, 2003.

          The Company is a real estate investment trust, or REIT, which, together with its subsidiaries, invests in two core mortgage investment strategies. Under its Residential Mortgage Credit strategy, the Company invests in mortgage loans purchased from selected high-quality providers within certain established criteria as well as subordinated mortgage-backed securities and other asset-backed securities that have credit ratings below AAA. Under its Spread strategy, the Company invests primarily in U.S. agency and other highly-rated single-family, adjustable-rate and hybrid adjustable-rate mortgage-backed securities. The Company also generates fee income by managing portfolios of mortgage-backed securities for other institutions.

          The information furnished in these unaudited condensed consolidated interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations for the interim periods do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with the Company’s Form 10-K for the year ended December 31, 2006.

     Business Conditions and Going Concern

          The Company’s consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. As the Company announced on August 6, 2007, the mortgage industry and the financing methods the industry has historically relied upon deteriorated significantly and in an unprecedented fashion. Effectively, the secondary market for mortgage-backed securities seized-up, and as a result, the Company simultaneously experienced a significant increase in margin calls from its repurchase agreement counterparties, or repurchase agreement lenders, and a decrease in the amount of financing its lenders would provide on a given amount of collateral. Prices for even the highest quality AAA-rated bonds dropped precipitously. These events resulted in a rapid and significant loss of liquidity over a short period of time and caused substantial doubt about the Company’s ability to continue as a going concern for a reasonable period of time.

          The Company has implemented a financial strategy to restore investor confidence and will continue its initiatives in this regard. The Company has taken the following steps that are intended to assure its customers and investors, that it can fulfill its commitments in the ordinary course of business:

          On September 26, 2007, the Company entered into a definitive credit agreement with Arco Capital Corporation Ltd., or Arco, that provides for a revolving credit facility in the amount of the lesser of up to $60.0 million or 85% of eligible asset values as defined in the agreement. Interest on the outstanding balance is set at one-month LIBOR plus a margin of between 4.00% and 4.50%, depending on the amount outstanding. As of September 30, 2007, the Company had $43.3 million outstanding on this line of credit. Arco also arranged for repurchase agreement financing, at an interest rate of one-month LIBOR plus a margin of 4.00%. The Company had $74.0 million outstanding on this repurchase agreement facility as of September 30, 2007. See Note 5 for further information on the terms of these credit facilities.

          On December 7, 2007, the Company entered into another amendment to its amended and restated credit agreement with Arco in order to provide for increases in repurchase agreement financings from a subsidiary of Arco. The amendment to the credit agreement increased to $190.0 million the cap on total outstanding amounts of such

purchase agreements and credit agreement borrowings. See Note 14 to the consolidated financial statements for further information on the amended agreement.

			As of September 30, 2007, progress in the stabilization of the Company’s lending facilities includes the following achievements.
	•		The Company has completed the sale of approximately $1.9 billion of mortgage-backed securities to repay lenders and meet required margin calls.
	•		The Company has completed the sale or refinancing of assets financed by its asset-backed commercial program, and it no longer has any outstanding commercial paper liabilities under the asset-backed commercial paper program.
	•		The Company has sold approximately $1.0 billion of loans and has repaid all of its warehouse lines of credit that were used to finance whole loan purchases. One warehouse line for $1.0 billion was terminated prior to September 30, 2007, one warehouse line for $500.0 million expired in October 2007, and no balances are currently outstanding on the remaining warehouse line totaling $1.0 billion. See Note 5 for additional information on the warehouse facilities.
	•		The Company has stabilized approximately $781.5 million of repurchase agreement financing with six repurchase agreement lenders by meeting all required margin calls.
	•		The Company is working with an additional repurchase agreement lender, HSBC, to resolve a dispute on the fair value of the underlying collateral for that agreement to settle an additional $32.2 million of repurchase agreement financing.

          The Company has taken additional measures to improve its liquidity position that include the implementation of operating expense reductions including a personnel reduction, the closure of its San Francisco, CA corporate office on December 31, 2007 and the establishment of its corporate headquarters in Philadelphia, PA, where the majority of its workforce is currently located.

          The Company is currently focused on maintaining the progress made to date in stabilizing its investment portfolio in the short-term, and then returning to profitability. These efforts are likely to include additional sales of securities in order to provide additional liquidity and exploring long-term financing alternatives to replace existing short-term financing. In addition, the Company is considering alternatives for the resolution of its issues related to its status as a REIT. See Note 11 for further information on issues concerning the Company’s REIT status. There can be no assurance that further market disruption will not occur or that the Company will be able to successfully execute its business or liquidity plans discussed herein.

NOTE 2 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

          Note 2 to the consolidated financial statements to the Company’s 2006 Form 10-K describes the Company’s significant accounting policies. There have been no significant changes to these policies during 2007 with the exception of the required adoption of SFAS No. 155, Accounting for Certain Hybrid Financial Instruments — an Amendment of FASB Statement No. 133 and 140. See the description of recent accounting pronouncements below.

          Recent Accounting Pronouncements

          In June 2007, the American Institute of Certified Public Accountants, or AICPA, issued Statement of Position, or SOP, 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting for Parent Companies and Equity Method Investors for Investments in Investment Companies. This SOP provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide Investment Companies, or the Guide. Entities that are within the scope of the Guide are required, among other things, to carry their investments at fair value, with changes in fair value included in earnings. In November 2007, the AICPA issued a proposed SOP 07-1a. This proposed SOP if implemented would delay indefinitely the implementation of SOP 07-1 until implementation issues or modifications to SOP

07-1 can be considered. The SOP 07-1a is expected to become effective in January 2008 for financials statements beginning in years after December 15, 2007.

          In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This Statement allows entities to make an election to record financial assets and liabilities, with limited exceptions, at fair value on the balance sheet, with changes in fair value recorded in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company elected not to adopt the Statement early as permitted and is still evaluating the impact of this Statement on its consolidated financial statements.

          In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement defines fair value in GAAP and expands requirements for disclosure about fair value estimates. SFAS 157 does not require any new fair value measurements. The Company is required to adopt SFAS 157 for financial statements issued for fiscal years beginning after November 15, 2007. The statement will have no material impact on the Company’s consolidated financial statements other than the requirement to include expanded disclosure.

          In February 2006, the FASB issued SFAS No. 155. This Statement provides entities with relief from having to separately determine the fair value of an embedded derivative that would otherwise be required to be bifurcated from its host contract in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The Statement allows an entity to make an irrevocable election to measure such a hybrid financial instrument at fair value in its entirety, with changes in fair value recognized in earnings. Once the fair value election has been made, that hybrid financial instrument may not be designated as a hedging instrument pursuant to SFAS No. 133. The Statement is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. In January 2007, the FASB released Statement 133 Implementation Issue No. B40, Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets (B40). B40 provides a narrow scope exception for certain securitized interests from the tests required under SFAS No. 133. The Company reviewed all securities that were purchased subsequent to January 1, 2007 and identified certain hybrid securities which require bifurcation. The Company has elected to carry these securities at fair value as trading securities, although these securities were not acquired for resale. The Company will recognize changes in the fair value of these securities in other income.

          In June 2006, the FASB issued Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 became effective for fiscal years beginning after December 15, 2006. The Company’s adoption of this interpretation did not have a material impact on its consolidated financial statements.

NOTE 3—SECURITIES

          The Company held $28.6 million of hybrid securities that are classified as trading. For the three and nine months ended September 30, 2007, the Company recognized decreases in fair value of $18.2 million in its consolidated statement of operations.

          The Company had $3 thousand of unrealized gains and no unrealized losses on available-for-sale securities at September 30, 2007. The following table summarizes the Company’s unrealized gains and losses on securities classified as available-for-sale, which are carried at fair value as of December 31, 2006.

Unrealized Gains and Losses on Available-for-Sale Securities
(in thousands)

						Gross				Gross
		Amortized				Unrealized				Unrealized
		Cost				Gains				Losses				Fair Value
December 31, 2006
Mortgage-backed securities, available-for-sale		$	2,930,878			$	7,549			$	(7,489	)		$	2,930,938

          At September 30, 2007 and December 31, 2006, mortgage-backed securities had a weighted-average amortized cost, excluding residual interests, of 75.7% and 99.0% of face amount, respectively.

          The following table shows the Company’s available-for-sale mortgage-backed securities’ fair value and gross unrealized losses on temporarily impaired securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006. The Company had no unrealized losses on available-for-sale securities at September 30, 2007.

Holding Period of Gross Unrealized Losses on Available-for-Sale Securities
(in thousands)

		Less than 12 Months								12 Months or More								Total
						Gross								Gross								Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
December 31, 2006
Agency-backed mortgage-backed securities		$	8,850			$	(66	)		$	—			$	—			$	8,850			$	(66	)
Non-agency-backed mortgage-backed securities			971,034				(3,058	)			138,210				(4,365	)			1,109,244				(7,423	)
Total temporarily impaired mortgage-backed securities		$	979,884			$	(3,124	)		$	138,210			$	(4,365	)		$	1,118,094			$	(7,489	)

          The temporary impairment of securities at December 31, 2006 resulted from the fair value of the mortgage-backed securities falling below their amortized cost basis and was solely attributable to changes in interest rates. At December 31, 2006, none of the securities held had been downgraded by a credit rating agency since their purchase and the Company had the ability and intent to hold these securities for a period of time that is sufficient to recover all unrealized losses. As such, the Company does not believe any of these securities were other-than-temporarily impaired at December 31, 2006.

          The Company evaluates available-for-sale securities for other-than-temporary impairment on a quarterly basis, and more frequently when conditions warrant such evaluation. Impairment losses of $268.9 million and $287.6 million for the three and nine months ended September 30, 2007, respectively, were primarily due to assumption changes on certain mortgage-backed securities for increased loss expectations and increases in the discount rates used to calculate the fair value of mortgage-backed securities on our Residential Mortgage Credit portfolio. As discussed in Note 1, due to current business conditions, the Company cannot say with certainty that it has the ability to hold these securities until recovery of the impairment loss and therefore has recorded the impairment through its statement of operations.

          Impairment losses for the three and nine months ended September 30, 2006 were zero and $2.2 million, respectively, related to Spread securities that the Company did not intend to hold until their maturity.

          The Company accounts for certain of the mortgage-backed securities in its Residential Mortgage Credit portfolio in accordance with the Emerging Issues Task Force, or EITF 99-20, Recognition of interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. Under EITF 99-20, the Company evaluates whether there is other-than-temporary impairment by discounting projected cash flows using credit, prepayment and other assumptions compared to prior period projections. If the discounted projected cash flows have decreased due to a change in the credit, prepayment and other assumptions, then the mortgage-backed security must be written down to fair value if the fair value is below the amortized cost basis. If there have been no changes to the Company’s assumptions and the change in value is solely due to interest rate changes, the Company does not recognize an impairment of a mortgage-backed security in its consolidated statements of operations. It is difficult to predict the timing or magnitude of these other-than-temporary impairments and impairment losses could be substantial.

          During the three months ended September 30, 2007, the Company had realized losses of $138.5 million and gains of $0.6 million on the sales of mortgage-backed securities. During the nine months ended September 30, 2007, the Company had realized losses of $154.0 million and gains of $0.6 million on the sales of mortgage-backed securities. The Company sold securities in the third quarter of 2007 to repay repurchase agreement financing and in order to satisfy margin calls on the financing of these securities. Securities sold prior to the third quarter of 2007 were selected for sale due to their rising level of delinquencies in the underlying loan collateral which was noted in the first quarter of 2007, as well as to reduce the Company’s exposure to certain mortgage-backed asset issuers. During the three months ended September 30, 2006, the Company had realized gains of $0.3 million and realized losses of $1.0 million on the sale of mortgage-backed securities and for the nine months ended September 30, 2006, the Company had realized gains of $10.0 million and realized losses of $9.0 million on the sale of mortgage-backed securities. The Company sold securities during the first nine months of 2006 in order to reposition the portfolio.

          The weighted-average lives of the mortgage-backed securities as of September 30, 2007 in the table below are based upon data provided through subscription-based financial information services, assuming constant prepayment rates to the balloon or reset date for each security. The prepayment model considers current yield, forward yield, steepness of the yield curve, current mortgage rates, mortgage rates of the outstanding loans, loan age, margin and volatility. Actual maturities of the Company’s mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal, and are generally shorter than their stated maturities.

Weighted-Average Life of Mortgage-Backed Securities
(dollars in thousands)

										Weighted-
										Average
Weighted-Average Life		Fair Value				Amortized Cost				Coupon
Less than one year		$	49,828			$	50,383				7.05	%
Greater than one year and less than five years			814,094				814,091				6.42
Greater than five years			43,083				60,793				7.00
Total		$	907,005			$	925,267				6.49	%

NOTE 4—LOANS HELD-FOR-INVESTMENT

          The following table summarizes the Company’s residential mortgage loans classified as held-for-investment, which are carried at amortized cost, net of allowance for loan losses.

Components of Residential Mortgage Loans Held-for-Investment
(in thousands)

		September 30,				December 31,
		2007				2006
Principal		$	4,287,143			$	5,472,325
Unamortized premium			103,158				124,412
Amortized cost			4,390,301				5,596,737
Allowance for loan losses			(21,282	)			(5,020	)
Total residential mortgage loans, net of allowance for loan losses		$	4,369,019			$	5,591,717

          At September 30, 2007 and December 31, 2006, residential mortgage loans had a weighted-average amortized cost of 102.4% and 102.3% of face amount, respectively.

Geographic Concentrations of Loans Held-for-Investment

Top five geographic concentrations (% exposure):		September 30, 2007				December 31, 2006
California			52.7	%			57.4	%
Florida			11.9	%			8.6	%
Arizona			4.3	%			4.1	%
Virginia			3.8	%			3.7	%
Nevada			3.5	%			3.4	%

          In the third quarter of 2007, the Company sold some of its interests in its securitization trusts that were established to permanently finance its residential mortgage loans. These sales triggered a reconsideration event in accordance with FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, or FIN 46. As a result, the Company’s Luminent Mortgage Trust 2007-2 or 2007-2, securitization no longer qualified for consolidation in the Company’s consolidated financial statements. Residential mortgage loans in the amount of $636.7 million were removed from the Company’s balance sheet along with the related debt of $620.8 million. The Company recorded $12.8 million in losses on the deconsolidation of this securitization. The Company continues to hold mortgage-backed securities with a fair value of $10.0 million at September 30, 2007 related to the 2007-2 trust. These assets are included in the Company’s mortgage-backed securities portfolio as of September 30, 2007. All other securitizations other than the 2007-2 securitization continue to qualify for consolidation as of September 30, 2007.

Allowance for Loan Losses
(in thousands)

		For the Three Months Ended								For the Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2007				2006				2007				2006
Balance, beginning of period		$	12,297			$	1,525			$	5,020			$	—
Provision for loan losses			10,247				1,779				18,434				3,304
Charge-offs			(1,262	)			(15	)			(2,172	)			(15	)
Balance, end of period		$	21,282			$	3,289			$	21,282			$	3,289

          On a quarterly basis, the Company evaluates the adequacy of its allowance for loan losses and records a provision for loan losses based on this analysis for loans that are estimated to have defaulted. At September 30, 2007

and December 31, 2006, $135.4 million and $33.9 million, respectively, of residential mortgage loans were 90 days or more past due all of which were on non-accrual status. Interest reversed for loans in non-accrual status at September 30, 2007 and December 31, 2006 was $4.7 million and $1.0 million, respectively.

          At September 30, 2007 and December 31, 2006, the Company had $20.3 million and $3.6 million of real estate owned that is included in other assets on its consolidated balance sheet.

NOTE 5—BORROWINGS

          The Company leverages its portfolio of mortgage-backed securities and loans held-for-investment through the use of various financing arrangements. The following table presents summarized information with respect to the Company’s borrowings.

Borrowings
(dollars in thousands)

						Weighted-
		Borrowings				Average				Fair Value of				Final Stated
		Outstanding				Interest Rate				Collateral(4)				Maturities (6)
September 30, 2007
Mortgage-backed notes (1) (2)		$	4,014,145				5.37	%		$	3,992,911				2046
Repurchase agreements (3)			813,681				6.21				954,046				2007
Collateralized debt obligations (1)			295,432				6.37				245,696				2047
Junior subordinated notes			92,788				8.73				none				2035
Convertible senior notes			90,000				8.38				none				2027
Revolving line of credit			43,256				9.13				none				2012
Total		$	5,349,302				5.69	%		$	5,092,921
December 31, 2006
Mortgage-backed notes (1) (2)		$	3,914,932				5.60	%		$	3,919,354				2046
Repurchase agreements			2,707,915				5.45				2,909,895				2008
Commercial paper facility			639,871				5.36				643,823				2007
Warehouse lending facilities			752,777				5.80				794,420				(5	)
Junior subordinated notes			92,788				8.58				none				2035
Total		$	8,108,283				5.58	%		$	8,267,492

          At September 30, 2007 and December 31, 2006, the Company had unamortized capitalized financing costs of $18.9 million and $15.9 million, respectively, related to the Company’s borrowings, which were deferred at the issuance date of the related borrowing and are being amortized using the effective yield method over the estimated life of the borrowing.

     Mortgage-backed notes

          The Company has issued non-recourse mortgage-backed notes to provide permanent financing for its loans held-for-investment. The mortgage-backed notes are issued through securitization trusts which are comprised of various classes of securities that bear interest at various spreads to the one-month London Interbank Offered Rate, or LIBOR. The borrowing rates of the mortgage-backed notes reset monthly except for $0.2 billion of the notes which, like the underlying loan collateral, are fixed for a period of three to five years and then become variable based on the

average rates of the underlying loans which will adjust based on LIBOR. Loans held-for-investment collateralize the mortgage-backed notes. On a consolidated basis, the securitizations are accounted for as financings in accordance with SFAS No. 140 and qualify for consolidation with the Company’s balance sheet in accordance with FIN 46, therefore the assets and liabilities of the securitization entities are consolidated on the Company’s consolidated balance sheet. See Note 4 for information on the deconsolidation of the Luminent Mortgage Trust 2007-2.

     Repurchase Agreements

          The Company has entered into repurchase agreements with seven third-party financial institutions to finance the purchase of certain of its mortgage-backed securities. The repurchase agreements are short-term borrowings that bear interest rates that have historically moved in close relationship to the three-month LIBOR.

Repurchase Agreement Maturities
(in thousands)

		September 30, 2007				December 31, 2006
Overnight 1 day or less		$	252,235			$	—
Between 2 and 30 days			389,037				2,070,939
Between 31 and 90 days			172,409				201,976
Between 91 and 636 days			—				435,000
Total		$	813,681			$	2,707,915

          In August 2007, the Company entered into repurchase agreement financing that was arranged by Arco. In exchange for the repurchase agreement financing, the Company issued warrants that are accounted for as a debt discount that will be amortized over the life of the related financing. The Company’s repurchase agreement financing at September 30, 2007 included $74.0 million of financing provided by Arco with unamortized debt discount of $21.5 million. See Note 14 for additional information on the Arco financing.

     Warehouse Lending Facilities

          Mortgage Loan Financing. The Company maintains warehouse lending facilities that are structured as repurchase agreements. These facilities are the Company’s primary source of funding for acquiring mortgage loans. These warehouse lending facilities are short-term borrowings that are secured by the loans and bear interest based on LIBOR. In general, the warehouse lending facilities provide financing for loans for a maximum of 120 days. Proceeds from the issuance of mortgage-backed notes are used to pay down the outstanding balance of warehouse lending facilities.

          Asset-backed Securities Financing. The Company maintained a warehouse lending facility with Greenwich Capital Financial Products, Inc. that was used to purchase mortgage-backed securities rated below AAA until the Company financed the securities permanently through collateralized debt obligations, or CDOs. This short-term warehouse lending facility was secured by asset-backed securities, bearing interest based on LIBOR. The facility was terminated in March 2007 concurrently with the permanent financing of the asset-backed securities by the CDOs.

Warehouse Lending Facilities
(in millions)

		At September 30, 2007												At December 31, 2006
										Weighted-												Weighted-
		Borrowing				Borrowings				Average				Borrowing				Borrowings				Average
Counterparty		Capacity				Outstanding				Interest Rate				Capacity				Outstanding				Interest Rate
Mortgage loan financing:
Greenwich Capital Financial Products, Inc.		$	1,000.0			$	—				—			$	1,000.0			$	455.2				5.80	%
Barclays Bank plc			—				—				—				1,000.0				290.1				5.78
Bear Stearns Mortgage Capital Corp.			500.0				—				—				500.0				7.5				5.77
Asset-backed securities financing:
Greenwich Capital Financial Products, Inc.			—				—				—				500.0				—				—
Total		$	1,500.0			$	—				—			$	3,000.0			$	752.8				5.80	%

          At September 30, 2007, the Company was not in compliance with certain debt covenants related to its warehouse lending facilities. There were no borrowings on these facilities and the Company currently has no intentions to use the facilities. The Bear Stearns Mortgage Capital Corp facility expired on October 7, 2007.

     Commercial Paper Facility

          In August 2006, the Company established a $1.0 billion commercial paper facility, Luminent Star Funding I, to fund its mortgage-backed securities portfolio. Luminent Star Funding I was a single-seller commercial paper program that provided a financing alternative to repurchase agreement financing. It issued asset-backed secured liquidity notes that were rated by Standard & Poor’s and Moody’s. In August 2007, the commercial paper counterparty did not renew the Company’s commercial paper funding. The Company has liquidated all assets financed with commercial paper and, as of September 30, 2007, the facility was closed.

     Collateralized Debt Obligations

           In March 2007, the Company issued $400.0 million of collateralized debt obligations, or CDOs, from Charles Fort CDO I, Ltd., a qualified REIT subsidiary of the Company. The CDOs are floating-rate pass-through non-recourse certificates that were initially collateralized at closing by $289.1 million of the Company’s mortgage-backed securities and $59.1 million of mortgage-backed securities that the Company retained from prior whole loan securitizations as well as an uninvested cash balance that was used to purchase additional securities subsequent to the CDO closing. As of September 30, 2007, third-party investors held $294.5 million of certificates net of unamortized debt discounts and the Company retained $103.8 million of certificates including $27.0 million of subordinated certificates, which provide credit support to the certificates issued to third-party investors. The interest rates on the certificates reset quarterly and are indexed to three-month LIBOR. The Company accounted for this securitization transaction as a financing of the mortgage-backed securities in accordance with SFAS No. 140 and therefore the assets and liabilities of the securitization entities are included on the Company’s consolidated balance sheet.

          As of September 30, 2007, certain securities with a fair value of $10.9 million that collateralize the CDO were deemed to be in default by way of ratings downgrades. These securities have to date continued to make principal and interest payments as required by their individual structures. Because these securities are deemed to be in default the principal payment structure of the CDO has converted from a pro-rata principal payment structure to a sequential principal payment structure where principal payments are paid to the highest rated bonds first and then will be made sequentially to each class of bond from highest to lowest. In addition, all interest payments collected by the trust on the securities that are deemed to be in default are made as principal payments on a sequential pay basis.

     Junior Subordinated Notes

           Junior subordinated notes consist of 30-year notes issued in March and December 2005 to Diana Statutory Trust I, or DST I, and Diana Statutory Trust II, or DST II, respectively, unconsolidated affiliates of the Company

formed to issue $2.8 million of the trusts’ common securities to the Company and to place $90.0 million of preferred securities privately with unrelated third-party investors. The Company pays interest to the trusts quarterly. In August 2007, the Company became contractually prohibited from making payments of interest because of defaults on its senior securities. These defaults were subsequently cured and all interest due on the junior subordinated notes was paid in October 2007. The trusts remit dividends pro rata to the common and preferred trust securities based on the same terms as the junior subordinated notes.

          The DST I notes in the amount of $51.6 million bear interest at a fixed rate of 8.16% per annum through March 30, 2010 and, thereafter, at a variable rate equal to three-month LIBOR plus 3.75% per annum through maturity. The DST I notes and trust securities mature in March 2035 and are redeemable on any interest payment date at the option of the Company in whole, but not in part, on or after March 30, 2010 at the redemption rate of 100% plus accrued and unpaid interest. Prior to March 30, 2010, upon the occurrence of a special event relating to certain federal income tax or investment Company events, the Company may redeem the DST I notes in whole, but not in part, at the redemption rate of 107.5% plus accrued and unpaid interest.

          The DST II notes in the amount of $41.2 million bear interest at a variable rate equal to three-month LIBOR plus 3.75% per annum through maturity. The DST II notes and trust securities mature in December 2035, the Company may redeem the DST I notes at any interest payment date in whole, but not in part, at the redemption rate of 100% plus accrued and unpaid interest.

     Convertible Senior Notes

          In June 2007, the Company completed a private offering of $90.0 million of convertible senior notes that are due in 2027, or the Notes, with a coupon of 8.125%.

          Prior to June 1, 2026, upon the occurrence of specified events, the Notes are convertible at the option of the holder at an initial conversion rate of 89.4114 shares of the Company’s common stock per $1,000 principal amount of Notes. The initial conversion price of $11.18 represented a 22.5% premium to the closing price of $9.13 per share of the Company’s common stock on May 30, 2007. On or after June 1, 2026, the Notes are convertible at any time prior to maturity at the option of the holder. Upon conversion of Notes by a holder, the holder will receive cash up to the principal amount of such Notes and, with respect to the remainder, if any, of the conversion value in excess of such principal amount, at the option of the Company in cash or in shares of the Company’s common stock. The initial conversion rate is subject to adjustment in certain circumstances.

          Prior to June 5, 2012, the Notes are not redeemable at the Company’s option, except to preserve the Company’s status as a REIT. On or after June 5, 2012, the Company may redeem all or a portion of the Notes at a redemption price equal to the principal amount plus accrued and unpaid interest, including additional interest, if any.

          Note holders may require the Company to repurchase all or a portion of the Notes at a purchase price equal to the principal amount plus accrued and unpaid interest (including additional interest), if any, on the Notes on June 1, 2012, June 1, 2017, June 1, 2022 or upon the occurrence of certain change in control transactions prior to June 5, 2012.

          In August 2007, due to cross defaults on certain of the Company’s repurchase agreement financing arrangements, the Company had an event of default on the Notes which made them immediately due and payable. Subsequent to September 30, 2007, the Company was informed by the trustee of the Notes that the Company had remedied the conditions that gave rise to the event of default under the agreement.

          As of September 30, 2007, the Company is paying a 0.25% interest rate penalty on the Notes due to its inability to file a registration statement with the Securities and Exchange Commission to register the securities associated with the convertible debt as required by the agreement. The Company intends to register the securities when it becomes current on its quarterly reporting requirement.

     Revolving Line of Credit

          On September 26, 2007, the Company entered into a definitive credit agreement with Arco that provides for a revolving credit facility in the amount of the lesser of $60.0 million or 85% of eligible asset values as defined in the definitive credit agreement. The line of credit matures on September 26, 2012 and undrawn portions of the facility can be cancelled at the Company’s option. The line of credit bears interest at LIBOR plus 4.00% to 4.50% depending on the outstanding balance. A commitment fee of 0.50% is payable quarterly on the daily average amount of the unused line of credit. The facility will be repaid from net proceeds in excess $250,000 from the sale, transfer or disposition of any property or asset of the Company or from 75% of the Company’s annual excess cash amount as defined in the agreement. The line of credit is secured by all of the assets of the Company that are not subject to a previous security interest. As of September 30, 2007, the Company was not in compliance with certain covenants required by this agreement; however, Arco has continued to allow the Company to draw on the lines of credit and has increased the amount of financing available to the Company. See Note 14 for additional information on the Arco credit facility.

NOTE 6—CAPITAL STOCK AND EARNINGS PER SHARE

          At September 30, 2007 and December 31, 2006, the Company’s charter authorized the issuance of 100,000,000 shares of common stock, par value $0.001 per share, and 10,000,000 shares of preferred stock, par value $0.001 per share. At September 30, 2007 and December 31, 2006, the Company had 43,172,839 and 47,808,510 outstanding shares of common stock, respectively, and no outstanding shares of preferred stock.

          Beginning on August 14, 2007, the Company entered into a series of agreements with Arco that provided it with repurchase agreement financing and a liquidity line of credit. In exchange for the repurchase agreement financing Arco received warrants to purchase up to 51,000,000 shares of the Company’s common stock representing 49% of the voting interest in the Company and 51% of the economic interest in the Company on a fully diluted basis. The warrant holders have the right to elect to receive nonvoting shares for any warrant exercised. The warrants are exercisable until September 30, 2012 at an exercise price of $0.18 per share subject to anti-dilution adjustments to maintain the economic ownership percentage of the Company attributable to the warrants at 51% on a fully-diluted basis. In addition, one of the agreements required that the Company’s board of directors include four directors whom must be satisfactory to Arco. The value of the warrants was recorded as a liability on the Company’s balance sheet with an offsetting balance as a debt discount. The debt discount will be amortized as additional interest expense over the term of the related debt. Changes in fair value of the warrants are recorded as a component of other income.

          The initial value of the warrants of $22.3 million was recorded as a liability with an offsetting amount recorded as debt discount on the related repurchase agreement financing. The debt discount will be amortized as additional interest expense over the weighted-average life of the repurchase agreement financing. The remaining weighted-average life of the repurchase agreement financing at September 30, 2007 was approximately 2.9 years. The change in fair value of the warrants between the issuance date and September 30, 2007 of $46.6 million was also recorded as a liability and was recorded as expense in consolidated statement of operations for the period ended September 30, 2007.

          The Company estimates the fair value of the warrants using the Black-Sholes Pricing Model. Values ascribed to the warrants as of the issuance date of August 14, 2007 and the balance sheet date of September 30, 2007 was as follows:

Warrants Pricing Assumptions

		August 14,				September 30,
		2007				2007
Risk-free interest rate			4.35	%			4.23	%
Expected life in years			5.04				4.92
Expected volatility (1)			30.0	%			30.0	%
Dividend yield (2)			0.0	%			0.0	%

          On November 7, 2005, the Company announced a share repurchase program to repurchase up to 2,000,000 shares of its common stock at prevailing prices through open market transactions subject to the provisions of SEC Rule 10b-18 and in privately negotiated transactions. On February 9, 2006, the Company announced an additional share repurchase program for an incremental 3,000,000 shares. On May 7, 2007, the Company announced an additional share repurchase program to acquire up to an additional 5,000,000 shares of common stock. For the nine months ended September 30, 2007, the Company repurchased 4,904,765 shares at a weighted-average price per share of $8.39, including 1,986,000 shares purchased from $18.1 million of the proceeds from the offering of the Notes in June 2007. The Company has repurchased 7,629,215 shares since the inception of the share repurchase program and has the remaining authority to acquire up to 2,370,785 more common shares. Currently, due to the Company’s liquidity concerns, the Company has no plans to repurchase shares of its common stock on the open market.

          The Company calculates basic net income or loss per share by dividing net income or loss for the period by the weighted-average shares of its common stock outstanding for that period. Diluted net income per share takes into account the effect of dilutive instruments, such as stock options and unvested restricted common stock and convertible notes, but uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted-average number of shares outstanding. Stock options and unvested restricted common stock instruments are not taken into account in the case of a net loss as they would be anti-dilutive.

Reconciliation of Basic and Diluted Earnings Per Share

		For the Three Months Ended								For the Three Months Ended
		September 30, 2007								September 30, 2006
		Basic				Diluted				Basic				Diluted
Net income (loss) (in thousands)		$	(520,636	)		$	(520,636	)		$	(6,595	)		$	(6,595	)
Weighted-average number of common shares outstanding			42,790,740				42,790,740				38,695,800				38,695,800
Additional shares due to assumed conversion of dilutive instruments			—				—				—				—
Adjusted weighted-average number of common shares outstanding			42,790,740				42,790,740				38,695,800				38,695,800
Net income (loss) per share		$	(12.17	)		$	(12.17	)		$	(0.17	)		$	(0.17	)

		For the Nine Months								For the Nine Months
		Ended September 30, 2007								Ended September 30, 2006
		Basic				Diluted				Basic				Diluted
Net income (loss) (in thousands)		$	(497,446	)		$	(497,446	)		$	28,748			$	28,748
Weighted-average number of common shares outstanding			44,943,803				44,943,803				38,937,454				38,937,454
Additional shares due to assumed conversion of dilutive instruments			—				—				—				128,952
Adjusted weighted-average number of common shares outstanding			44,943,803				44,943,803				38,937,454				39,066,406
Net income (loss) per share		$	(11.07	)		$	(11.07	)		$	0.74			$	0.74

          The Company has 55,000 shares in stock options and 8,047,026 shares in instruments related to convertible debt which are not included in the above calculation due to their anti-dilutive effect. In addition, the Company has warrants outstanding to redeem 51,000,000 shares related to its financing agreements with Arco that are unexercised and anti-dilutive at September 30, 2007.

NOTE 7—2003 STOCK INCENTIVE PLANS

          Effective June 4, 2003, the Company adopted a 2003 Stock Incentive Plan and a 2003 Outside Advisors Stock Incentive Plan. The plans provide for the grant of a variety of long-term incentive awards to employees and officers of the Company or individual consultants or advisors who render or have rendered bona fide services as an additional means to attract, motivate, retain and reward eligible persons. These plans as amended authorize the award of up to 2,000,000 shares of the Company’s common stock at the discretion of the compensation committee of the board of directors of which 1,850,000 shares comprise the 2003 Stock Incentive Plan and 150,000 shares comprise the 2003 Outside Advisors Stock Incentive Plan. The compensation committee determines the exercise price and the vesting requirement of each grant as well as the maximum term of each grant. The Company uses

historical data to estimate stock option exercises and employee termination in its calculations of stock-based employee compensation expense and expected terms.

Common Stock Available for Grant

						2003 Outside
		2003 Stock				Advisors Stock
		Incentive Plan				Incentive Plan				Total
September 30, 2007
Shares reserved for issuance			1,850,000				150,000				2,000,000
Granted			(1,029,500	)			(20,760	)			(1,050,260	)
Forfeited			—				—				—
Expired			—				—				—
Total available for grant			820,500				129,240				949,740

Outstanding Stock Options

September 30, 2007
Stock options outstanding (shares)			55,000
Weighted-average exercise price		$	14.82
Weighted-average remaining life (years)			5.9

          At September 30, 2007, all outstanding stock options were fully vested and had no aggregate intrinsic value. No stock options were granted, exercised or forfeited during the nine months ended September 30, 2007.

Common Stock Awards

		Number of				Weighted-Average
		Common Shares				Issue Price
Outstanding, January 1, 2007			721,329			$	9.13
Issued			269,094				9.32
Forfeited			—				—
Outstanding, September 30, 2007			990,423			$	9.18

Non-vested Common Stock Awards

		Number of Common				Weighted-Average
		Shares				Grant-Date Fair Value
Nonvested, January 1, 2007			555,923			$	9.20
Granted			269,094				9.32
Vested			(804,257	)			9.25
Forfeited			—				—
Nonvested, September 30, 2007			20,760			$	8.67

          The fair value of common stock awards is determined on the grant date using the closing stock price on the NYSE that day.

          The Company had issued common stock awards to certain employees. These awards normally vest over a period of time but are subject to provisions that accelerate the vesting. The financing agreement with Arco described in Note 5 represented a change in control as defined in certain of the stock award agreements and, therefore, certain unvested awards vested on August 30, 2007. Total stock-based employee compensation expense related to common stock awards for the three and nine months ended September 30, 2007 was $4.8 million and $6.3 million, respectively. Expense related to the awards for the three and nine months ended September 30, 2006 was $0.3 million and $1.9 million, respectively. At September 30, 2007, stock-based employee compensation expense of $0.2 million related to nonvested common stock awards is expected to be recognized over a weighted-average period of 1.6 years.

NOTE 8—FAIR VALUE OF FINANCIAL INSTRUMENTS

          SFAS No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure of the fair value of financial instruments for which it is practicable to estimate that value. The fair value of short-term financial instruments such as cash and cash equivalents, restricted cash, interest receivable, principal receivable, repurchase agreements, commercial paper, warehouse lending facilities, revolving lines of credit, unsettled securities purchases and accrued interest expense approximates their carrying value on the consolidated balance sheet. The fair value of the Company’s investment securities is reported in Note 3. The fair value of the Company’s derivative instruments is reported in Note 10.

          The fair values of the Company’s remaining financial instruments that are not reported at fair value on the consolidated statement of financial position are reported below.

Fair Value of Financial Instruments
(in thousands)

		September 30, 2007								December 31, 2006
		Carrying								Carrying
		Value				Fair Value				Value				Fair Value
Loans held-for-investment		$	4,369,019			$	3,992,911			$	5,591,717			$	5,586,872
Mortgage-backed notes			4,030,643				3,781,117				3,917,677				3,919,353
CDOs			294,529				150,601				—				—
Convertible senior notes			90,000				67,500				—				—
Junior subordinated notes			92,788				91,738				92,788				91,325

NOTE 9—ACCUMULATED OTHER COMPREHENSIVE INCOME

Components of Accumulated Other Comprehensive Income
(in thousands)

		September 30,				December 31,
		2007				2006
Unrealized holding losses on securities available-for-sale		$	(441,028	)		$	(5,957	)
Reclassification adjustment for net losses (gains) on securities available-for-sale included in net income			153,409				(993	)
Impairment losses on securities			287,622				7,010
Net unrealized gain on securities available-for-sale			3				60
Net deferred realized and unrealized gains on cash flow hedges			2,557				3,734
Net unrealized losses (gains) on equity securities available-for-sale			—				48
Accumulated other comprehensive income		$	2,560			$	3,842

NOTE 10—DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

          The Company seeks to manage its interest rate risk and credit exposure and protect the Company’s liabilities against the effects of major interest rate changes. Such interest rate risk may arise from: (1) the issuance and forecasted rollover and repricing of short-term liabilities with fixed rate cash flows or from liabilities with a contractual variable rate based on LIBOR; (2) the issuance of long-term fixed rate or floating rate debt through securitization activities or other borrowings or (3) the change in value of loan purchase commitments. The Company also seeks to manage its credit risk exposure which may arise from the creditworthiness of the holders of the mortgages underlying its mortgage-related assets. The Company may use various combinations of derivative instruments or other risk-sharing arrangements to attempt to manage these risks.

Derivative Contracts
(in thousands)

		Estimated Fair Value
		September 30,				December 31,
		2007				2006
Eurodollar futures contracts sold short		$	—			$	149
Interest rate swap contracts			(4,149	)			4,383
Interest rate cap contracts			1,727				1,531
Credit default swaps			—				6,958

Realized and Unrealized Gains and Losses on Derivative Contracts
(in thousands)

		For the Three Months Ended								For the Nine Months Ended
		September 30,								September 30,
		2007				2006				2007				2006
Free standing derivatives:
Realized gains		$	34,673			$	477			$	50,133			$	4,417
Unrealized gains (losses)			(28,610	)			(11,994	)			(6,743	)			306
Purchase commitment derivatives:
Realized gains (losses)			43				(172	)			(984	)			(636	)
Unrealized gains (losses)			418				—				—				—