UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2007

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

For the transition period from                        to                       .

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.)
One Commerce Square, 21st Floor, 2005 Market Street, Philadelphia, PA (Address of principal executive offices)		19103 (Zip Code)

Registrant’s telephone number, including area code: (215) 564-5900
Securities registered pursuant to Section 12(b) of the Act:

Title of each class		Name of each exchange on which registered
Common Stock, par value $0.001 per share		New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

     Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.  Yes o     No þ

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

     Indicate by check mark whether the 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 requirements for the past 90 days.  Yes þ     No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in a definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

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

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

     State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $351,976,128

     The number of shares of our common stock outstanding on February 29, 2008 was 43,283,339.

DOCUMENTS INCORPORATED BY REFERENCE

     None

 

 

INDEX

				PAGE
		PREFACE			3
		PART I
ITEM 1.		BUSINESS			6
ITEM 1A.		RISK FACTORS			17
ITEM 1B.		UNRESOLVED STAFF COMMENTS			27
ITEM 2.		PROPERTIES			27
ITEM 3.		LEGAL PROCEEDINGS			28
ITEM 4.		SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS			28
		PART II
ITEM 5.		MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES			29
ITEM 6.		SELECTED FINANCIAL DATA			33
ITEM 7.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			34
ITEM 7A.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			58
ITEM 8.		FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA			62
ITEM 9.		CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE			95
ITEM 9A.		CONTROLS AND PROCEDURES			95
ITEM 9B.		OTHER INFORMATION			97
		PART III
ITEM 10.		DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE OF THE REGISTRANT			97
ITEM 11.		EXECUTIVE COMPENSATION			99
ITEM 12.		SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS			110
ITEM 13.		CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE			111
ITEM 14.		PRINCIPAL ACCOUNTANT FEES AND SERVICES			114
		PART IV
ITEM 15.		EXHIBITS AND FINANCIAL STATEMENT SCHEDULES			116
SIGNATURES
EXHIBIT INDEX
Consent of Independent Registered Public Accounting Firm
Consent of Independent Registered Public Accounting Firm
Certification of S. Trezevant Moore, Jr.
Certification of Karen Chang
Certification of S. Trezevant Moore, Jr., pursuant to Section 906
Certification of Karen Chang, pursuant to Section 906

PREFACE

          As a result of the turbulent conditions that have affected the market for mortgage-backed securities since last summer and our liquidity concerns, to date, we have not met the distribution requirements to maintain our qualification as a REIT for the fiscal year 2007. Given the changes to our current business strategy that includes offering fee-based services, including credit risk management, asset management advisory services and sub-manager services for investment funds, our board of directors has approved a restructuring that would result in our conversion from a Maryland corporation qualified as a REIT to a Delaware limited liability company that is a publicly traded partnership, or PTP. We believe the conversion could significantly enhance our flexibility for investment diversification and the offering of advisory services.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

          This Form 10-K contains 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-K other than statements of historical fact are forward-looking statements. Forward-looking statements include statements regarding our financial position, business strategy, budgets, projected costs, plans and objectives of management for future operations. The words “may continue,” “estimate,” “intend,” “project,” “believe,” “expect,” “plan,” “anticipate” and similar terms may identify forward-looking statements, but the absence of such words does not necessarily mean that a statement is not forward-looking. These forward-looking statements include, among other things, statements about:

	•		our ability to obtain the financing we will need to support our liquidity position and to remain in business;
	•		our inability to meet REIT dividend and distribution requirements;
	•		continued creditworthiness of the holders of mortgages underlying our mortgage-related assets;
	•		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;
	•		our ability to develop new fee-based asset management businesses successfully;
	•		the possible effect of negative amortization of mortgages on our financial condition;
	•		the possible impact of our failure to maintain exemptions under the 1940 Act;
	•		the possible impact of our failure to maintain our qualification as a REIT;
	•		the effect of the delisting of our common stock by the NYSE;
	•		potential impacts of our leveraging policies on our results of operations and cash available for distribution;
	•		the power of our board of directors to change our operating policies and strategies without stockholder approval;
	•		whether our board of directors will declare periodic distributions to our stockholders;
	•		effects of interest rate caps 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;
	•		volatility in the timing and amount of our cash distributions; and
	•		the other important factors described in this Form 10-K 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.”

          Any or all of our forward-looking statements in this Form 10-K, may turn out to be inaccurate and actual results could differ materially from those anticipated or implied by our forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and future trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. They may be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties.

          You should not rely unduly on those forward-looking statements, which speak only as of the date of this Form 10-K. Unless

required by the federal securities laws, we undertake no obligation to update publicly or revise any forward-looking statements to reflect new information or future events.

          This Form 10-K contains market data, industry statistics and other data that have been obtained or compiled from information made available by third parties. We have not independently verified any third party data.

PART I

ITEM 1.  BUSINESS

Our Company

Overview

          We were incorporated in Maryland in April 2003 to invest primarily in U.S. agency and other highly-rated, single-family, mortgage-backed securities. We began substantive operations in mid-June 2003 after completing a private placement of our common stock. In 2005, we expanded our mortgage investment strategy to include mortgage loan acquisition and securitization, as well as investments in mortgage-backed securities that have credit ratings of below AAA.

          Due to the downturn in 2007 in the United States, or U.S., mortgage markets, we have sold a significant portion of our mortgage-backed securities portfolio as well as mortgage loans due to our inability to meet our contractual obligations to meet margin calls under repurchase agreements or to find alternative profitable financing for these securities and loans. When the mortgage markets begin to stabilize, we plan to implement strategies which will return us to profitability. In all of our strategies, we seek to acquire or manage mortgage-related assets, and lever our credit and risk management competencies. First, we seek to invest our own capital in U.S. mortgages and mortgage-backed securities with carefully managed credit risk parameters. Second, we intend to seek selected opportunities in non-U.S. markets to purchase or manage real estate-related debt. Finally, we also intend to expand our product offerings and begin to provide fee-based asset management services, effectively providing our expertise to third parties interested in investing in real estate-related debt.

Assets

          Historically, we have invested in two core mortgage investment strategies. Under our residential mortgage credit strategy, we invested primarily in residential mortgage loans as well as subordinated mortgage-backed securities and other asset-backed securities that have credit ratings below AAA. Under our spread strategy, we invested in U.S. agency and other highly-rated single-family, adjustable-rate and hybrid adjustable-rate mortgage-backed securities with AAA credit ratings.

          Mortgage-backed securities have experienced significant declines in market values in the second half of 2007, and we have been forced to sell a significant portion of our investments in these securities at a loss due to our inability to meet required margin calls or finance them profitability. At December 31, 2007, AAA-rated securities and securities rated below AAA represented only 4.3% and 4.9% of our total assets, respectively. We securitized the loans and some of the mortgage-backed securities that we had purchased and retained the securitization tranches that we believe are the most valuable tranches. Our securitizations reduced our sensitivity to interest rates and helped match the income we earned on our mortgage assets with the cost of our related liabilities. The debt that we incurred in these securitizations is non-recourse to us; however, we pledged our mortgage loans and mortgage-backed securities as collateral for the securities we issued. As of December 31, 2007, mortgage loans represent 88.8% of total assets. Given current market conditions, we do not intend to make new investments in our residential mortgage credit or spread strategies in the near-term. We review our investment strategy regularly and will resume investing under our residential mortgage credit and spread strategies when we believe the market for mortgage-related securities has stabilized and opportunities arise.

          We have diversified our portfolio to limit undue geographic, product, originator, servicer and other types of concentrations. We employ rigorous due diligence and underwriting criteria to qualify whole loan assets for our portfolio in order to mitigate risk. This due diligence includes performing compliance sampling in states with predatory lending statutes, evaluation analysis and layered credit risk using software screening tools.

Borrowings

          We have historically financed the acquisition of our investments, including loans held-for-investment and securities available-for-sale, primarily through the use of collateralized borrowings in the form of secured financings, repurchase agreements, warehouse lending facilities, commercial paper and other secured and unsecured borrowings. We recognize interest expense on all borrowings on an accrual basis.

          Currently, our main sources of short-term financing are $526.6 million of repurchase agreements, including a $142.4 million repurchase agreement with related parties as of December 31, 2007. In addition, we have entered into a definitive credit agreement

with Arco Capital Corporation Ltd., or Arco, with total available financing of $190.0 million. As of March 12, 2008, we had moved $166.2 million of third-party repurchase agreement financing to this facility and the total outstanding was $182.1 million as of March 12, 2008. See Note 5 and Note 14 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for further information on our borrowings from Arco and its affiliates and our relationship with Arco.

          Our long-term financing includes a combination of the issuance of non-recourse mortgage-backed notes that provide financing for our whole loan portfolio and collateralized debt obligations, or CDOs, for the financing of certain mortgage-backed securities. At December 31, 2007, we had $3.9 billion of mortgage-backed notes with a weighted-average borrowing rate of 3.95% and $294.4 million of CDOs with a weighted-average borrowing rate of 5.55%. This long-term financing is non-recourse to us and is not subject to margin calls.

Hedging

          Typically, we engage in various hedging activities designed to match the terms of our assets and liabilities more closely. Hedging involves risk and typically involves costs, including transaction costs. The costs of hedging can increase as the periods covered by the hedging increase. During periods of rising and volatile interest rates, we may increase our hedging and, thus, increase our hedging costs during such periods. We generally intend to hedge as much of the interest rate risk as we determine is in the best interest of our stockholders, after considering the cost of such hedging transactions.

          We may also enter into credit default swaps to manage the credit risk associated with specific credit-sensitive mortgage-backed securities in our portfolio and general credit exposure related to our residential mortgage loans. A credit default swap is an agreement to purchase credit event protection based on a financial index or security in exchange for paying a fixed fee or premium at execution and over the term of the contract. As actual credit losses on the referenced bond or bonds are incurred, we will be reimbursed by the counterparties.

          Our policies do not contain specific requirements as to the percentage or amount of interest rate risk or credit risk that we hedge. Our hedging activities may not have the desired beneficial impact on our consolidated results of operations or financial condition. Moreover, no hedging activity can completely insulate us from the risks associated with changes in interest rates and prepayment rates and credit losses.

          Effective January 1, 2006, we discontinued the use of hedge accounting. As a result, beginning in the first quarter of 2006, all changes in value of derivative instruments that had previously been accounted for under hedge accounting are reflected in our consolidated statements of operations rather than primarily through accumulated other comprehensive income on our consolidated balance sheet. In general, rising interest rates increase, while declining interest rates decrease, the value of our derivative instruments. This change introduced some volatility into our results of operations, as the market value of our hedge positions changed. See Note 14 to our consolidated financial statements as of December 31, 2007 included elsewhere in this Form 10-K for additional information.

Business Strategy

Investment Strategy

          Through 2007, our domestic residential mortgage credit portfolio strategy was to invest primarily in residential mortgage loans underwritten to our specifications. During the summer of 2007, the capital markets, particularly non-Fannie Mae and non-Freddie Mac agency markets, seized up with a complete loss of liquidity in our core investment strategy, prime quality non-agency residential mortgage-backed securities, or RMBS. Although we believe that the market for private label primary quality non-agency RMBS will return, we are already working on alternative business strategies to take advantage of our credit and investment skills.

Management Services

          We believe our existing credit management infrastructure is readily adaptable for use by both us and third parties in two distinct channels.

Credit Risk Management

          We offer Credit Risk Management, or CRM, to holders of existing mortgage-backed securities or whole loan positions to provide forensic underwriting, loss mitigation, servicer oversight, contract enforcement and surveillance services. We currently

perform these functions in conjunction with managing our own loan and mortgage-backed securities portfolios and have the capacity to extend these services to third parties.

          We are in the process of finalizing a joint-venture arrangement with the creator of our operating platform and have developed a proprietary system for CRM services. The system has electronic links to third-party property valuation, credit and fraud tools via its fully integrated gateway. The joint-venture’s proprietary software is a dynamic system that optimizes process flows to enhance loan level surveillance, loss forecasting and repurchase activity. Our CRM capacity monitors prepayment penalties, early pay defaults, and mortgage insurance recoveries. The core feature of the system’s analytical tools center around servicer oversight and the ability to target loans with high expected loss. Loans are evaluated using our proprietary multi-dimensional program to identify candidate loans for forensic underwriting review. When a breach is discovered, we pursue full recovery through the enforcement of loan level representations and warranties in the underlying agreements.

          In addition, we can offer comprehensive management expertise to selected partners from loan acquisition through securitization in the following areas: product sourcing, contract negotiation, transaction management, loan level and counter-party due diligence, structuring and loan surveillance through the life of the transaction.

          We can reduce loss frequency for our clients though our contract enforcement capabilities. Our enforcement of representations and warranties made by the issuer in a transaction takes advantage of provisions that have always been present in mortgage-backed securities, but rarely examined and seldom enforced. Many investors do not have either the contractual or underwriting expertise to obtain redress. We can be the advocate for the investor using our existing infrastructure we have developed for ourselves. Initially, we expect a substantial proportion of losses we mitigate will be due to fraud in the origination process. Our ability to sort electronically by expected severity of loss and on-line fraud detection suites of software will allow us to focus on the loans with the greatest chance of recovery.

          We also expect to be able to reduce loss severity for our clients. Our software allows us to monitor all servicing comments, and mandate, if possible, the best course of action by the servicer using our experienced loss mitigation team. We can assist with compliance with servicing procedures mandated by the servicing agreements.

          We are also constructing a proprietary loss model which can forecast losses up to the succeeding 24 months. We expect this module to be useful to potential investors in mortgage-backed securities, opposed to existing holders of mortgage-backed securities, who will be attracted to our contract enforcement and surveillance offerings.

          For the near-term, we believe we can take advantage of our existing resources to absorb CRM business without significant increases in expenses as our own whole portfolio has decreased from $5.9 billion as of July 2007 to $4.2 billion as of December 31, 2007 primarily due to prepayments.

Asset Management

          We intend to seek asset management engagements, both in conjunction with partners or as a stand-alone assignments. Certain of our potential partners have extensive contacts with institutional investors including, but not limited to, foundations and other non-profit entities, state and municipal governmental entities, fund of funds, wealthy individuals and family offices, money managers, financial institutions and REITs. If we act as a sub-manager for any of these partners, we expect to receive approximately one-half of the fee payable to the manager.

          Therefore, as we gain experience as a sub-manager, we expect to seek the necessary approvals to act as an investment manager and then to obtain assignments as a primary asset manager. Our investment philosophy will be to generate the highest risk-adjusted return consistent with no or modest leverage, thus reducing liquidity issues. Currently, we see excellent opportunities in well-structured, well-protected AAA securities and seasoned non-investment grade jumbo loan securities. The actual choice of investment will vary as market conditions vary.

          Our CRM platform will give us a competitive advantage in asset management. We have an integrated system that tracks counterparties, including representations made, due diligence on ability to pay, credit and appraisal, servicing oversight, including loss mitigation from the earliest state of bankruptcy, master servicing of payments made by the mortgagor, data validation tools, quality control and contract enforcement; loss forecasting and REO management. We have a proprietary data base of actual

performance on almost two million loans as well as third-party cash flow forecasting models and tools licensed from the rating agencies.

Non-domestic Activities

          We intend to identify one Latin American and possibly one Eastern European country in which we can extend our credit underwriting skills and credit management infrastructure. We intend to invest in both loans and mortgage-backed securities created from loans within these jurisdictions.

          We have benefited from the addition of four new members to our board of directors who provide expertise in both domestic and international markets. We believe we can utilize the experience of these board members to develop new business opportunities in real estate management that will compliment the skills we have in managing our own investment portfolio.

          Although we believe the current market environment provides significant opportunities to us to develop these new services, which would be closely aligned with our current expertise, we can provide no assurance that we will be successful in our efforts to establish these new business activities.

Portfolio Activities

          The disruption in the RMBS market is profound. We expect that losses experienced by mortgage investors will continue in the near-term, extending the depression of the market for RMBS. We believe that after the first half of 2008, the impact of the so-called “subprime meltdown” will be largely known, although the actual defaults on mortgage loans and loss mitigation activities, which generate losses, may continue through 2009 and perhaps beyond.

          In light of these considerations, we expect that liquidity for well-underwritten prime, private label RMBS will begin to be available in the latter half of 2008, particularly as the securitization market has been virtually nonexistent since August 2007. We will then attempt to resume our residential mortgage loan purchases from high quality originators and our securitization activities as soon as we can make a prudent determination that we have a reasonable expectation of returns above our hurdle rates, conservative underwriting and a favorable risk/reward set of scenarios in our pricing.

          The originators perform the credit review of the borrower, the appraisal of the property and the quality control procedures. We generally only consider the purchase of loans when the borrowers have had their employment and assets verified, their credit checked and appraisals of the properties have been obtained. Generally, our whole loan target market includes prime borrowers with FICO scores that average more than 700, full documentation, owner-occupied property, moderate loan size and moderate loan-to-value ratio. We also seek to diversify geographic concentration to mitigate the impact of localized adverse market conditions. We, or a third party under our supervision, then perform an independent underwriting review of the underwriting and loan closing methodologies that the originators used in qualifying a borrower for a loan. We review all of the loans in a pool, selecting loans for extensive underwriting review based upon specific risk-based criteria such as property location, loan size, effective loan-to-value ratio, borrowers’ credit score and other criteria we believe to be important indicators of credit risk. Loans that meet our risk characteristics are reviewed for appraisal accuracy, reasonableness of income and indications of fraud, flipping or other undesirable characteristics. In addition, prior to the purchase of loans, we review the originator’s underwriting guidelines and exception policies and then also obtain representations and warranties from each originator to the effect that each loan is underwritten in accordance with its guidelines. An originator who breaches its representations and warranties may be obligated to repurchase the loan from us. As added security, we retain a third-party document custodian to insure the quality and accuracy of all individual mortgage loan legal documents and to hold the documents in safekeeping. As a result, the original loan collateral documents that are signed by the borrower, other than the original credit verification documents, are examined and held by the custodian.

          We do not service our residential mortgage loan portfolio. Whole loan mortgages we purchase are typically acquired on a servicing retained basis, which means the servicing is retained by the third-party servicer. In general, the servicers servicing our loans are highly-rated by the rating agencies. We also conduct a due diligence review of each servicer before executing a servicing agreement. Servicing procedures typically follow Fannie Mae guidelines but are specified in each servicing agreement. All of our servicing agreements meet standards for inclusion in highly-rated mortgage- or asset-backed securitizations. In 2006, we established a relationship with a servicer, Central Mortgage Co., who services certain of our residential mortgage loans in exchange for a fee. This relationship allows us to purchase residential mortgage loans with servicing released while maintaining our objective of operational efficiency.

          We acquire residential mortgage loans for our portfolio with the intention of securitizing them and retaining them in our portfolio. In order to facilitate the securitization or financing of our loans, we generally create subordinate certificates, which provide a specified amount of credit enhancement. We issue securities through securities underwriters and generally finance them through repurchase agreements. Our investment policy limits the amount we may retain of these below investment grade subordinate certificates to 10% of total assets, measured on a historical cost basis.

          Despite our intentions, however, we may not be successful in securitizing these mortgage loans. To meet our investment criteria, mortgage loans we acquire will generally conform to underwriting guidelines consistent with high quality mortgages. Applicable banking laws generally require that an appraisal be obtained in connection with the original issuance of mortgage loans by the lending institution.

          We do not originate mortgage loans or provide other types of financing to the owners of real estate, such as second liens. We do not purchase sub-prime mortgage loans. We require mortgage insurance on all loans with loan-to-value ratios in excess of 80% and, since July 2006, we have purchased supplemental mortgage insurance on current loan-to-value ratios of 75% or greater.

          An additional channel of our residential mortgage credit strategy has been investment in credit-sensitive residential mortgage-backed securities from securitizations where we did not contribute collateral. These mortgage-backed securities have credit ratings from AAA to not-rated, and are sometimes referred to as private label, i.e. not issued by a government-sponsored entity, residential mortgage-backed securities, or non-agency RMBS. We analyze basic parameters of non-agency RMBS (i.e., sector, rating and cash flow) and the available financing on the mortgage-backed securities and then perform a yield analysis to ascertain if the mortgage-backed securities meet our hurdle rates for return. If a security meets the applicable hurdle rate, we evaluate the loan credit characteristics and compare them to characteristics of comparable securitizations. Credit characteristics include, but are not limited to, loan balance distribution, geographic concentration, property type, occupancy, product type, periodic and lifetime cap, weighted-average loan-to-value ratio and weighted-average FICO score. Qualifying securities are then analyzed using base line expectations of expected prepayments and losses from given sectors, issuers and the current state of the fixed income market. We stress losses and prepayments simultaneously based on a credit risk-based model. We monitor securities in this portfolio for variance from expected prepayments, frequencies of default, actual losses and cash flow.

          Our spread strategy primarily consists of investments in AAA-rated single-family mortgage-backed securities. We have acquired these investments in the secondary market. We seek to acquire assets that will produce competitive returns after considering the amount and nature of the anticipated returns from the investments, our ability to pledge the investments for secured, collateralized borrowings and the costs associated with financing, managing, securitizing and reserving for these investments. We do not construct our overall investment portfolio in order to express a directional expectation for interest rates or mortgage prepayment rates. Future interest rates and mortgage prepayment rates are difficult to predict, and as a result, we seek to acquire mortgage-backed securities that we believe provides acceptable returns over a broad range of interest rate and prepayment scenarios. Due to current market conditions, we are not currently investing in our spread strategy.

          When evaluating new acquisitions for our portfolio, we analyze whether the purchase will permit us to continue to satisfy SEC requirements such that we are not deemed an investment company under the 1940 Act. We also assess the relative value of the mortgage-backed security and how well it fits into our existing portfolio of mortgage-backed securities. Many aspects of a mortgage-backed security or loan pool and the dynamic interaction of its characteristics with those of our portfolio can influence our valuation. The characteristics of each potential investment we analyze generally include, but are not limited to, origination year, originator, coupon, margin, periodic cap, lifetime cap, time-to-reset, loan-to-value, geographic dispersion and expectations as to price and prepayment. We do not assign a particular weight to any factor because the relative importance of the various factors varies depending upon the characteristics we seek for our portfolio and our borrowing cost structure.

Financing Strategy

          We historically financed the acquisition of our residential mortgage loans with a warehouse lending facility, in the form of repurchase agreements. We used these financing facilities while we were accumulating residential mortgage loans for securitization. We permanently finance our acquisitions of residential mortgage loans through the issuance of mortgage-backed notes.

          We finance the acquisition of our mortgage-backed securities with short-term borrowings and term loans with a term of less than one year and, to a lesser extent, equity capital. The amount of borrowing we employ depends on, among other factors, the amount of our equity capital. We use leverage to attempt to increase potential returns to our stockholders. Pursuant to our capital/liquidity and leverage policies described below, we seek to strike a balance between the under-utilization of leverage, which

reduced potential returns to our stockholders, and the over-utilization of leverage, which increases risk by reducing our ability to meet our obligations to creditors during adverse market conditions. Our policy on the use of leverage is designed to be effective under most economic scenarios but is not designed for the most extreme market conditions such as we have experienced in the second half of 2007. Please see “Risk Factors” for additional information on the risks of our liquidity and use of leverage. We are actively managing our repurchase agreement financing by increasing the use of affiliates to provide financing.

          We borrow at short-term rates using repurchase agreements. We seek to manage the adjustment periods actively and the selection of the interest rate indices of our borrowings against the adjustment periods and the selection of indices on our mortgage-backed securities in order to limit our liquidity and interest rate related risks. We generally seek to diversify our exposure by entering into repurchase agreements with multiple lenders. In addition, we only enter into repurchase agreements with institutions that we believe are financially sound and that meet credit standards approved by our board of directors.

Our Operating Policies and Programs

          Our board of directors has established the following five primary operating policies to implement our business strategies when we resume our purchase of mortgage-related assets:

	•		asset acquisition policies;
	•		capital/liquidity and leverage policies;
	•		credit risk management policy;
	•		asset/liability management policy; and
	•		prepayment risk management.

          Asset Acquisition Policy

          Our asset acquisition policy provides guidelines for acquiring investments in order to maintain compliance with our overall investment strategy. In particular, we acquire a portfolio of investments that can be grouped into specific categories. Each category and our respective investment guidelines are as follows:

	•		Category I—At least 75% of our total assets will be RMBS, residential real estate loans and short-term investments. Residential real estate loans will be “prime” credit quality loans, for example have FICO scores not less than 600, have a combined loan-to-value ratio not greater than 105% and be either in first or second lien position.
	•		Category II—At least 90% of our total assets will consist of Category I investments plus residential real estate loans not meeting one or more of the criteria in Category I.
	•		Category III—No more than 10% of our total assets will be of a type not meeting any of the above criteria. Among the types of assets generally assigned to this category are residuals, leveraged mortgage derivative securities, shares of REITs or other investments.

          We expect to acquire mortgage-related assets that we believe will provide consistent, long-term, attractive returns on capital invested, after considering, without limitation:

	•		the underwriter and servicer of the underlying loans;
	•		the coupon, price and yield of the assets;
	•		the amount and timing of the anticipated cash flow from the assets;
	•		our ability to pledge the assets to secure collateralized borrowings;

	•		the potential increase in our capital requirements determined by our capital and leverage policy resulting from the purchase and financing of the assets;
	•		the amount of the borrowings provided;
	•		the cost of financing, managing, reserving and hedging the assets, if applicable; and
	•		our other investment policies, as amended from time to time.

          Capital/Liquidity and Leverage Policies

          The objective of our leverage policy is to strike a balance between the under-utilization of leverage, which reduces potential returns to stockholders, and the over-utilization of leverage, which could reduce our ability to meet our obligations during adverse market conditions.

          We will manage the levels of the financing liabilities funding our portfolios based on recourse leverage, defined as recourse financing liabilities as a ratio of stockholders’ equity plus long-term debt. We will actively manage our capital efficiency through the types of borrowings, including the non-recourse mortgage-backed notes issued to finance our securitized loans held for investment, in order to manage our liquidity and interest rate related risks.

          Substantially all of our short-term borrowing agreements require us to deposit additional collateral in the event the market value of existing collateral declines, which may require us to sell assets to reduce our borrowings. We have designed our liquidity management policy to maintain an adequate capital base sufficient to provide required liquidity to respond to the effects under our borrowing arrangements of interest rate movements and changes in the market value of our mortgage-related assets. Our strategy is to use our affiliates as our repurchase agreement counterparties. However, if changing market conditions result in a reduction of equity capital below established thresholds, we report to our board of directors the causes of and the strategy to maintain or reduce the leverage.

          Credit Risk Management Policy

          We determine, at the time of purchase, whether or not a mortgage-related asset complies with our CRM policy guidelines, based upon the most recent information available to us. Such compliance is not expected to be affected by events subsequent to such purchase, such as changes in characterization, value or rating of any specific mortgage-related assets or economic conditions or events generally affecting any mortgage-related assets of the type we hold.

          We review the credit risk associated with each potential investment and may diversify our portfolio to avoid undue geographic, product, originator, servicer and other types of concentrations. By maintaining a large percentage of our assets in a diversified pool of high quality and highly-rated assets, many of which are credit-enhanced under limited circumstances as to payment of a limited amount of principal and interest by virtue of credit support in the underlying securities structures, we believe we can mitigate our exposure to losses from credit risk. We have significant credit enhancement that protects our investment in the assets we own at all rating levels. We employ rigorous due diligence and underwriting criteria to qualify whole loan assets for our portfolio in order to mitigate risk. This due diligence includes performing compliance sampling in states with predatory lending statutes, evaluation analysis and layered credit risk using software screening tools.

          Asset/Liability Management Policy

          Interest Rate Risk Management. We seek to manage our interest rate risk exposure to protect our portfolio of mortgage-related assets and related debt against the effects of major interest rate changes. We generally seek to manage our interest rate risk by:

	•		monitoring and adjusting, if necessary, the reset index and interest rates of our mortgage-related assets and our borrowings;
	•		attempting to structure our borrowing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;

	•		using derivatives, financial futures, swaps, options, caps, floors and forward sales to adjust the interest rate sensitivity of our mortgage-related assets and our borrowings; and
	•		actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods and gross reset margins of our mortgage-related assets and the interest rate indices and adjustment periods of our borrowings.

          As a result, we expect to be able to adjust the average maturity/adjustment period of our borrowings on an ongoing basis by changing the mix of maturities and interest rate adjustment periods as borrowings mature or are renewed. Through the use of these procedures, we attempt to reduce the risk of differences between interest rate adjustment periods of our adjustable-rate mortgage-related assets and our related borrowings.

          Prepayment Risk Management. We also seek to manage the effects of prepayment of mortgage loans underlying our securities. We expect to accomplish this objective by using a variety of techniques that include structuring a diversified portfolio with a variety of prepayment characteristics based on underlying coupon rate, type of loan, year of origination, loan-to-value, FICO score and property type, investing in certain mortgage security structures that have prepayment protections and purchasing mortgage-related assets at a premium and at a discount. We monitor prepayment risk through the periodic review of the impact of alternative prepayment scenarios on our revenues, net earnings, distributions, cash flow and net balance sheet market value.

Growth Strategy

          In addition to the assets we currently own, may seek to raise new capital in the future to invest as described above. Currently, we believe that there are ample opportunities to invest in well- structured, sound credit enhanced AAA-rated private label mortgage-backed securities at attractive yields with modest leverage and attractive yields. We also believe that equally attractive opportunities exist in purchasing non-investment grade mortgage-backed securities created from excellent quality, fixed-rate jumbo transactions. We would not currently seek to invest in BBB-rated securities.

Description of Mortgage-Related Assets

          Mortgage Loans

          Within the loan market, we have focused on acquiring prime quality, first lien Alt-A adjustable-rate mortgage loans. In the Alt-A market, borrowers choose the convenience of less than full documentation in exchange for a slightly higher mortgage rate. We require mortgage insurance on all loans with loan-to-value ratios in excess of 80%, and subsequent to July 2006, we purchased supplemental mortgage insurance down to a 75% loan-to-value ratio.

          We have also acquired mortgage loans that permit negative amortization. A negative amortization provision in a mortgage allows the borrower to defer payment of a portion or all of the monthly interest accrued on the mortgage and to add the deferred interest amount to the mortgage’s principal balance. As a result, during periods of negative amortization, the principal balances of negatively amortizing mortgages will increase and their weighted-average lives will extend. Our mortgage loans generally can experience negative amortization ranging from 110-125% of the original mortgage loan balance. As a result, given the relatively low average loan-to-value ratio of 71.8%, net of mortgage insurance, on our portfolio at December 31, 2007, we believe that our portfolio would still have a homeowners’ equity cushion even if all negatively-amortizing loans reached their maximum permitted amount of negative amortization.

          Mortgage-Backed Securities

          Our investments in mortgage-backed securities consist of pass-through certificates, which are securities representing interests in pools of mortgage loans secured by residential real property in which payments of both interest and principal on the securities are generally made monthly.

          Agency-backed securities include mortgage-backed securities whereby principal and interest may be guaranteed by the full faith and credit of the federal government, including securities backed by Ginnie Mae or by federally-chartered entities, including Fannie Mae or Freddie Mac. Mortgage-backed securities created by non-agency issuers, including commercial banks, savings and loan institutions, private mortgage insurance companies, mortgage bankers and other secondary market issuers, may be supported by various forms of insurance or guarantees.

          We may hold investments in several types of mortgage-backed securities, including adjustable-rate, hybrid-adjustable rate and fixed-rate mortgage-backed securities, as well as collateralized mortgage obligations, or CMOs. Adjustable-rate mortgage-backed securities have an interest rate that varies over time and usually resets based on market interest rates, although the adjustment of such an interest rate may be subject to certain limitations. Hybrid adjustable-rate mortgage-backed securities have a fixed-rate for the first few years—typically three, five, seven or ten years—and thereafter reset periodically like a traditional adjustable-rate mortgage-backed security. Fixed-rate mortgages are those where the borrower pays an interest rate that is constant throughout the term of the loan. CMOs are a type of mortgage-backed security in which interest and principal on a CMO are paid, in most cases, on a monthly basis.

          Other Investments

          We may acquire other investments that include equity and debt securities issued primarily by other mortgage-related finance companies, interests in mortgage-related collateralized bond obligations, other subordinated interests in pools of mortgage-related assets, commercial mortgage loans and securities, equity investments in REITs and residential mortgage loans other than high-credit quality mortgage loans. These investments are generally considered Category III investments under our asset acquisition policy and are limited to 10% of our total assets.

          We also intend to operate in a manner that will not subject us to regulation under the 1940 Act. Our board of directors has the authority to modify or waive our current operating policies and our strategies without prior notice and without stockholder approval.

Industry Trends

          Recently, the mortgage industry has been experiencing considerable strain from rising delinquencies and liquidity pressures and many mortgage lenders have failed. The increased scrutiny of the subprime lending market is one of the factors that have impacted general market conditions as well as perceptions of our business. Refer to “Overview” for additional information regarding our investment strategies, including a discussion of portfolio quality and liquidity.

Competition

          When we invest in mortgage-backed securities, mortgage loans and other investment assets, we compete with a variety of institutional investors, including other REITs, insurance companies, mutual funds, hedge funds, pension funds, investment banking firms, banks and other financial institutions that invest in the same types of assets. As we seek to expand our business, we face a greater number of competitors, many of whom are well-established in the markets we seek to penetrate. Many of these investors have greater financial resources and access to lower costs of capital than we do. The existence of these competitive entities, as well as the possibility of additional entities forming in the future, may increase the competition for the acquisition of mortgage assets, resulting in higher prices and lower yields on assets.

Federal Income Tax Considerations

General

          We elected to be taxed as a REIT for federal income tax purposes, commencing with our taxable year ended December 31, 2003. Our qualification and taxation as a REIT depends on our ability to continue to meet, through actual annual operating results, distribution levels and diversity of stock ownership, the various qualification tests imposed under the Internal Revenue Code of 1986, as amended, or Code, that are discussed in “Requirements for Qualification as a REIT”.

          Due to liquidity concerns, we did not make sufficient required distributions during 2007 to maintain our qualification as a REIT. Although we are permitted to make distributions through September 15, 2008 and relate such distributions back to 2007, due to our liquidity concerns, we may not be able to satisfy this requirement and therefore in accordance with generally accepted accounting principles, we recorded a provision for U.S. federal and state income tax. See Note 11 to our December 31, 2007 consolidated financial statements for additional information on our current REIT qualification.

          The provisions of the Code are highly technical and complex. The following summary discussion is not exhaustive of all possible tax considerations and neither gives a detailed discussion of any state, local or foreign tax considerations nor discusses all of the aspects of U.S. federal income taxation that may be relevant to particular types of stockholders that are subject to special tax rules.

You are urged to consult with your own tax advisor regarding U.S. federal, state, local and other tax considerations of a purchase, ownership or sale of our common stock.

Requirements for Qualification as a REIT

          To qualify for tax treatment as a REIT under the Code, we must meet certain tests, as described below.

     Stock Ownership Tests

          Our stock must be beneficially owned by at least 100 persons, which we refer to as the “100 stockholder rule,” and no more than 50% of the value of our stock may be owned, directly or indirectly, by five or fewer individuals (including certain pension trusts and other tax-exempt entities) at any time during the last half of the taxable year. These stock ownership requirements must be satisfied in each taxable year. We are required to solicit information from certain of our record stockholders to verify actual stock ownership levels, and our charter provides for restrictions regarding the ownership and transfer of our stock in order to aid in meeting the stock ownership requirements. If we were to fail either of the stock ownership tests, we would generally be disqualified as a REIT.

     Income Tests

          We must satisfy two gross income requirements annually to maintain our qualification as a REIT:

	•		under the “75% gross income test,” we must derive at least 75% of our gross income, excluding gross income from prohibited transactions, from specified real estate sources, including rental income, interest on obligations secured by mortgages on real property or on interests in real property, gain from the disposition of “qualified real estate assets,” i.e., interests in real property, mortgages secured by real property or interests in real property and some other assets, and income from certain types of temporary investments; and
	•		under the “95% gross income test,” we must derive at least 95% of our gross income, excluding gross income from prohibited transactions and certain qualified hedging transactions, from (1) the sources of income that satisfy the 75% gross income test, (2) dividends, interest and gain from the sale or disposition of stock or securities or (3) any combination of the foregoing.

          Our policy to maintain REIT qualification may limit the type of assets, including hedging contracts and other assets, which we otherwise might acquire.

     Asset Tests

          At the close of each quarter of our taxable year, at least 75% of the value of our total assets must be represented by qualified real estate assets, cash, cash items and government securities. We expect that substantially all of our assets will continue to be qualified REIT assets. On the last day of each quarter, of those securities not included in the 75% asset test, the value of any one issuer’s securities may not exceed 5% of the value of our total assets, and we generally may not own more than 10% by vote or value of any one issuer’s outstanding securities, in each case, except with respect to stock of any taxable REIT subsidiaries and qualified REIT subsidiaries. In addition, the aggregate value of the securities we own in any taxable REIT subsidiaries may not exceed 20% of the value of our total assets.

          We monitor the purchase and holding of our assets in order to comply with the above asset tests.

     Annual Distribution Requirements

          To maintain our qualification as a REIT, we are required to distribute annual dividends, other than capital gain dividends, to our stockholders in an amount generally at least equal to 90% of our REIT taxable income, which is computed without regard to the dividends paid deduction and our net capital gain. In addition, we are subject to a 4% nondeductible excise tax to the extent that the percentage of our income and capital gain that we distribute in a year is less than a required distribution amount.

          To date, we have not declared or paid all of the required cash distributions of REIT taxable income for 2007 as required to maintain our qualification as a REIT. We are considering alternatives related to the payment of our dividend and other issues related to

our current qualification as a REIT. See Note 11 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for additional information on our REIT qualification.

Taxation of Stockholders

          Distributions out of our current or accumulated earnings and profits, other than capital gain dividends, are taxable to U.S. stockholders as ordinary income. Distributions designated by us as capital gain dividends are taxable to U.S. stockholders as capital gain income. Stockholders that are corporations may be required to treat up to 20% of certain capital gain dividends as ordinary income. To the extent that we make distributions in excess of current and accumulated earnings and profits, the distributions will be treated as a tax-free return of capital to each stockholder and will reduce the adjusted tax basis that each stockholder has in our stock by the amount of the distribution, but not below zero. Distributions in excess of a stockholder’s adjusted tax basis in our stock is taxable as capital gain and is taxable as long-term capital gain if the stock has been held for more than one year.

          We expect to withhold tax at the rate of 30% on the gross amount of any ordinary income distributions made to a non-U.S. stockholder unless the stockholder provides us with a properly completed IRS form evidencing eligibility for a reduced withholding rate under an applicable income tax treaty.

          To the extent that we own REMIC residual interests or engage in time-tranched non-REMIC mortgage securitizations through one or more qualified REIT subsidiaries that are treated as taxable mortgage pools, or TMPs, we will recognize “excess inclusion income” or phantom income as a result of such ownership or transactions. We will allocate any excess inclusion income among our stockholders, which will have the following tax consequences for our stockholders:

	•		A stockholder’s share of the excess inclusion income is not allowed to be offset by any net operating losses otherwise available to the stockholder;
	•		A tax-exempt stockholder’s share of excess inclusion income generally is subject to tax as unrelated business taxable income; and
	•		A non-U.S. stockholder’s share of excess inclusion income is subject to U.S. withholding tax at the maximum rate (30%), without reduction for any otherwise applicable income tax treaty.

Employees

          At December 31, 2007, we had 26 full-time employees.

Website Access to Our Periodic SEC Reports

          Our corporate website address is www.luminentcapital.com. We make our periodic SEC reports on Forms 10-K and 10-Q and current reports on Form 8-K, as well as the beneficial ownership reports filed by our directors, officers and 10% or greater stockholders on Forms 3, 4 and 5 available free of charge through our website as soon as reasonably practicable after they are filed electronically with the SEC. We may from time to time provide important disclosures to investors by posting them in the investor relations section of our website, as allowed by SEC rules. The information on our website is not a part of this Form 10-K.

          Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains our reports, proxy and information statements, and other information regarding us that we file electronically with the SEC.

          We are in compliance with the requirements of the New York Stock Exchange, or NYSE, to make available on our website and in printed form upon request our Code of Business Conduct and Ethics and the respective charters of our Audit, Compensation and Governance Committees.

CEO/CFO Certifications

          We have included certifications of our chief executive officer and chief financial officer regarding the quality of our public disclosures as exhibits to this Form 10-K. In 2007, we submitted to the NYSE the certification of our chief executive officer required

by the rules of the NYSE certifying that he was not aware of any violation by us of the NYSE’s corporate governance listing standards.

ITEM 1A.  RISK FACTORS

          The following risk factors describe many potential occurrences that could adversely impact our results of operations and financial condition. We employ a number of strategies designed to counteract these potential occurrences which we describe under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7 of this Form 10-K.

General Risks Related to Our Business

          We may not be able to implement our new business strategy profitably.

          We plan to return to profitability by implementing new business strategies including investment in loans or mortgage-backed securities in both domestic and non-U.S. markets and pursuing fee-based asset management engagements. For our new business strategies to succeed, we need to identify appropriate opportunities where we can use our expertise in managing investments collateralized by residential real estate. These strategies will entail establishing relationships and, for some of these opportunities, we would need additional capital available to invest in order to support the implementation of the strategies. If we are unable to find sufficient opportunities or do not have sufficient capital to invest, we may be unable to implement our business strategy profitably.

          Even if we are able to stabilize our business and to resume purchasing new investments, we might not be able to purchase residential mortgage loans, mortgage-backed securities and other investments that meet our investment criteria or at favorable spreads over our borrowing costs.

          In accordance with our growth strategy, once we stabilize our business, we plan to resume purchasing mortgage loans and mortgage-backed securities. A significant portion of our anticipated future net income will depend on our ability to acquire residential mortgage loans, mortgage-backed securities and other investments at favorable spreads over our borrowing costs. Intense competition exists for the acquisition of mortgage loans, mortgage-backed securities and other investments. Our competitors for these types of investments include REITs, investment banking firms, savings and loan associations, banks, insurance companies and mutual funds, many of which have greater financial resources than we do. Our results of operations and financial condition could be adversely affected if we were not able to acquire a sufficient amount of residential mortgage loans, mortgage-backed securities and other investments at favorable spreads over our borrowing costs.

          The current dislocations in the sub-prime mortgage sector and the current weakness in the broader mortgage market have adversely affected our business and could result in further increases in our borrowing costs, reductions in our liquidity and reductions in the value of our investment portfolio.

          Although our direct exposure to sub-prime mortgages is limited, the current dislocations in the sub-prime mortgage sector and the current disruption in the broader mortgage market have adversely affected our ability to obtain funding for our whole loan purchases and our mortgage-backed securities portfolio and have caused some of our counterparties to be unwilling or unable to provide us with financing on even our highest quality AAA-rated mortgage-backed securities. These financing trends have increased our financing costs and reduced our liquidity. In addition, our liquidity has been adversely affected by margin calls under our repurchase agreements. Our repurchase agreements allow the counterparty, to varying degrees, to revalue the collateral to values that the lender considers to be appropriate market value. If a counterparty determines that the value of its collateral has decreased, the counterparty may initiate a margin call requiring us to post additional collateral or cash to cover the decrease. The current market dislocation has also negatively impacted the marketability of our whole loans and mortgage-backed securities and, due to our need for additional liquidity and to repay outstanding borrowings, we have had to sell some of our whole loans and most of our mortgage-backed securities at depressed prices. We cannot predict how long this market dislocation will last or if further dislocation will occur in the future. The continuation of the current market environment or further disruptions in the market could further increase our borrowing costs, further reduce our liquidity and further reduce the value of our investment portfolio.

          Our investment strategies employ a significant amount of leverage.

          Our investment strategies generally employ a significant amount of leverage. Our financing arrangements, including our repurchase agreements, warehouse financing, debt securities and other types of borrowings, and their related hedging instruments, contain operating and financial covenants with which we must comply on a continuing basis. Our failure to comply with these

operating and financial covenants could result in the declaration of default, cancellation or non-renewal of one or more of our financing or hedging arrangements.

          We manage the levels of the financing liabilities funding our portfolios based on recourse leverage. We generally seek to maintain an overall borrowing recourse leverage of less than ten times the amount of our equity and long-term debt. Our recourse leverage ratio as of December 31, 2007 exceeded our guidelines because of the significant decline in the fair value of our mortgage-backed securities. We actively manage our capital efficiency through our liability structure, including the non-recourse mortgage-backed notes issued to finance our securitized loans held for investment, in order to manage our liquidity and interest rate related risks.

          Leverage also amplifies the potential severity of the other risks discussed in these “Risk Factors”.

          Interest rate mismatches between residential mortgage loans and mortgage-backed securities we own and borrowings we have used to acquire these assets may adversely affect our results of operations.

          The interest rate repricing terms of our outstanding borrowings may differ from the interest rate repricing terms of our assets. As a result, during a period of rising interest rates, we could experience a decrease in, or elimination of, our net income or incur a net loss because the interest rates on our borrowings could increase faster than the yields on our assets. Conversely, during a period of declining interest rates and accompanying higher prepayment activity, we could experience a decrease in, or elimination of, our net income or generate a net loss as a result of higher premium amortization expense because the interest we receive on our assets may decrease more quickly than the interest we pay on our borrowings.

          Our use of certain types of financing may give our lenders greater rights in the event that either we or any of our lenders file for bankruptcy.

          Our borrowings under repurchase agreements and warehouse financing may qualify for a treatment under the bankruptcy code that could give our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay if we file for bankruptcy. Furthermore, this treatment of repurchase agreements and warehouse financing under the bankruptcy code may make it more difficult for us to recover our pledged assets in the event that any of our lenders files for bankruptcy. Thus, our use of repurchase agreements and warehouse financing exposes our pledged assets to risk in the event of a bankruptcy filing by us or any of our lenders.

          The residential mortgage loans and mortgage-backed securities we hold are subject to illiquidity, which might prevent us from selling them at reasonable prices should we find it necessary or believe it is advisable to sell them.

          From time to time, residential mortgage loans and mortgage-backed securities experience periods of illiquidity. A period of illiquidity might result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale. We bear the risk of being unable to dispose of the residential mortgage loans and mortgage-backed securities we hold at advantageous times and prices during periods of illiquidity which could increase our costs and reduce our book value. Periods of illiquidity could also adversely impact our results of operations and financial condition.

          Many of our investments are illiquid, and we may not be able to vary our portfolio in response to changes in economic and other conditions.

          The securities that we purchase in connection with privately negotiated transactions are not registered under the relevant securities laws, resulting in a prohibition against their transfer, sale, pledge or other disposition except in a transaction that is exempt from the registration requirements of, or is otherwise in accordance with, those laws. A majority of the mortgage-backed securities that we hold were acquired in private, unregistered transactions and are therefore subject to restrictions on resale or otherwise have no established trading market. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we have previously recorded our investments. Furthermore, we may face other restrictions on our ability to liquidate an investment in a business entity to the extent that we have or could be attributed with material non-public information regarding such business entity.

          Performance of our residential mortgage loans and mortgage-backed securities are subject to the overall health of the U.S. economy, and a national or regional economic slowdown could adversely impact our results of operations or financial condition.

          The health of the U.S. residential mortgage market correlates with the overall health of the U.S. economy. An overall decline in the U.S. economy could cause a significant decrease in the values of mortgaged properties throughout the U.S. This decrease, in turn, could increase the risk of delinquency, default or foreclosure on our residential mortgage loans and on the residential mortgage loans underlying our mortgage-backed securities, and could adversely impact our results of operations or financial condition. Furthermore, our financing is subject to credit risk of the counterparties in our financing transactions. Our inability to obtain a significant amount of financing through these sources would adversely impact our results of operations or financial condition.

          Our stockholders’ equity, or book value, is volatile.

          The fair values of the residential mortgage loans, mortgage-backed securities and hedging instruments that we hold are subject to daily fluctuations in market pricing resulting from changes in a number of factors, including interest rates, yield spreads and credit quality.

          We carry most of our mortgage-backed securities as “available-for-sale” and flow any changes in their fair value through the “other comprehensive income or loss” portion of stockholders’ equity on our balance sheet or statement of operations depending on our expectations of the recoverability of our losses on our securities. The daily fluctuations in market pricing of these mortgage-backed securities, and the corresponding effect of these fluctuations on our stockholders’ equity, creates volatility in our stockholders’ equity and book value.

          Hedging instruments are marked-to-market through our statement of operations. The daily fluctuation in market pricing of our hedging instruments, and the corresponding flow of these fluctuations through our statement of operations, may create volatility in our stockholders’ equity, or book value.

          Our residential mortgage loans, mortgage-backed securities and other investments are subject to the risks of delinquency, foreclosure and credit loss.

          Our risk of loss is dependent upon the performance of the residential mortgage loans that we own, as well as upon the performance of the residential mortgage loans underlying the mortgage-backed securities that we own.

          All of our residential mortgage loans and mortgage-backed securities are secured by underlying real property interests. We target prime quality residential mortgage loans with specific characteristics for our portfolio, including Alt-A documentation, which is considered non-conforming and may result in higher credit risks. Although we hold first lien positions on all of the mortgage-backed loans in our portfolio, borrowers may acquire a second lien against the underlying collateral, creating a higher risk of delinquency, foreclosure and losses. To the extent that the value of the property underlying our residential mortgage loans or mortgage-backed securities decreases, our security could be impaired and we could expect greater credit losses.

          A substantial deterioration in the financial strength of Fannie Mae, Freddie Mac or other corporate guarantors of the mortgage-backed securities that we own could increase our exposure to future delinquencies, foreclosures or credit losses and adversely impact our results of operations and financial condition.

          We own subordinated mortgage-backed securities that are structured to absorb a disproportionate amount of any credit losses on the underlying residential mortgage loans.

          We own subordinated mortgage-backed securities that have credit ratings below AAA. These subordinated mortgage-backed securities are structured to absorb a disproportionate share of the losses from their underlying residential mortgage loans and expose us to high levels of volatility in net interest income, interest rate risk, prepayment risk, credit risk and market pricing volatility.

          We own some mortgage-backed securities that are backed by mid-prime or sub-prime residential mortgage loans which are subject to higher delinquency, foreclosure and credit loss rates than the prime residential mortgage loans we typically purchase.

          Mid-prime and sub-prime residential mortgage loans are typically made to borrowers who have poor or limited credit histories and who, as a result, do not qualify for traditional mortgage products. Because of their poor or limited credit histories, mid-prime and sub-prime borrowers have a substantially higher rate of delinquencies and foreclosure and loss rates than prime credit quality borrowers.

          Our residential mortgage loans and mortgage-backed securities have material geographic concentrations.

          Our residential mortgage loans and mortgage-backed securities have material geographic concentrations. The residential mortgage loans and the residential mortgage loans underlying our mortgage-backed securities that we own related to properties located in California, Florida, Arizona, Virginia and Nevada constitute a material portion of our assets. Our delinquency, foreclosure and credit losses over time may be exacerbated by this geographic concentration which could adversely impact our results of operations and financial condition.

          We face the risk of greater than projected prepayment rates of the residential mortgage loans and mortgage-backed securities we own.

          The principal and interest payments that we receive from the residential mortgage loans and mortgage-backed securities we own are generally funded by the payments that borrowers make in accordance with the amortization schedules of their residential mortgage loans. When borrowers prepay their residential mortgage loans more quickly than we projected, we receive principal cash flows from our investments more quickly than we anticipated. Greater than projected prepayment rates can adversely affect our results of operations and financial condition. Changes in prepayment rates are difficult to predict. Prepayment rates generally increase when interest rates decline and decrease when interest rates rise. Prepayment rates may also be affected by other factors, including the condition of the housing and financial markets, the overall economy, residential mortgage loan interest rates currently available to borrowers in the market and the ability of borrowers to refinance their mortgages.

          We amortize any premiums or accrete discounts related to the residential mortgage loans and mortgage-backed securities we own through our results of operations over their expected terms. The amortization of a premium through our statement of operations reduces our interest income, while the accretion of a discount through our statement of operations increases our interest income. The expected terms for residential mortgage loans and mortgage-backed securities are a function of the prepayment rates for the residential mortgage loans or the residential mortgage loans underlying the mortgage-backed securities. If residential mortgage loans and mortgage-backed securities we purchased at a premium are subsequently prepaid in whole or in part more quickly than we anticipated, we are then required to amortize their respective premiums more quickly, which would decrease our net interest income and adversely impact our results of operations. Conversely, if residential mortgage loans and mortgage-backed securities we purchased at a discount are subsequently prepaid in whole or in part more slowly than we anticipated, we are then required to accrete their respective discounts more slowly, which could decrease our net interest income and adversely impact our results of operations.

          Our residential mortgage loans and mortgage-backed securities are subject to interest rate caps and payment caps with resets.

          The residential mortgage loans that we hold directly and the mortgage-backed securities collateralized by the residential mortgage loans that we own may be subject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount that the interest rate on a mortgage loan can increase during any given period. Lifetime interest rate caps limit the amount that the interest rate on a mortgage loan can increase during the life of the loan. The periodic adjustments to the interest rates of the residential mortgage loans that we hold directly and that underlie our mortgage-backed securities, known as resets, are based on changes in an objective benchmark interest rate index, such as the U.S. Treasury index or LIBOR. During a period of rapidly increasing interest rates, the interest rates we pay on our borrowings could increase without limitation, while interest rate caps and delayed resets could limit the increases in the yields we receive on the residential mortgage loans and mortgage-backed securities we hold. Further, some of the residential mortgage loans and mortgages underlying the mortgage-backed securities we hold may be subject to periodic interest rate payment caps that could result in a portion of the interest being deferred and added to the outstanding principal. As a result, we may receive less cash income on the residential mortgage loans and mortgage-backed securities we hold than we need to pay interest on our related borrowings. These factors could adversely impact our results of operations and financial condition.

          A significant portion of the mortgages we hold permit negative amortization. Negative amortization can increase our overall risk.

          We hold certain mortgages and certain mortgages collateralizing mortgage-backed securities that permit negative amortization. A negative amortization provision in a mortgage permits the borrower to defer payment of a portion of the monthly interest accrued on the mortgage and to add the deferred interest amount to the principal balance of the mortgage. As a result, during periods of negative amortization the principal balances of negatively amortizing mortgages increase and their weighted-average lives extend.

          When a mortgage or a mortgage collateralizing a mortgage-backed security experiences negative amortization, we continue to recognize interest income on the mortgage or mortgage-backed security even though we are not receiving cash interest in an amount equal to the deferred portion of the interest income. Unless we receive other sources of cash flow from these loans, such as principal repayment, we could experience negative cash flow. This negative cash flow could adversely impact our results of operations and financial condition. Securitization structures allocate the principal payments and prepayments on mortgage loans, including loans with negative amortization features. To date, prepayments on our mortgage loans with negative amortization have been sufficient to offset negative amortization such that all our securitization structures have made all their required payments to bondholders.

          In addition, when a mortgage experiences negative amortization, the principal balance of the mortgage increases while the underlying market value of the related mortgaged property can remain flat or decrease. In such cases, the then current loan-to-value ratio of the negatively-amortizing mortgage increases. Increasing current loan-to-value ratios on mortgages correspondingly increase the likelihood and severity of potential credit losses related to those mortgages. Our mortgage loans generally can experience negative amortization to a maximum amount of 110-125% of the original mortgage loan balance. As a result, given the relatively low average loan-to-value of 75.9% and effective loan-to-value ratio of 71.8% on our portfolio which includes the additional protection provided by mortgage insurance as of December 31, 2007, we believe that our portfolio would still have a significant homeowners’ equity cushion even if all negatively-amortizing loans reached their maximum permitted amount of negative amortization.

          To the extent a mortgage experiences negative amortization such that its loan-to-value ratio exceeds the fair market value of the real estate securing the mortgage at the time we purchased the mortgage, that mortgage will no longer constitute a qualifying asset for the test we are required to meet under the Investment Company Act of 1940, as amended, or the 1940 Act. If we fail to satisfy the test, our ability to use leverage would be substantially reduced, and we would be unable to conduct our business in accordance with our operating policies.

          The representations and warranties that we have made as part of our securitizations may subject us to liability.

          We have made representations and warranties regarding the residential mortgage loans that we transfer to securitization trusts. Each securitization trust has recourse to us for breach of the representations and warranties we have made regarding the loans at the time such residential mortgages loans were transferred to the securitization trust. However, the remedies available to the securitization trust could be broader than the remedies available to us. In the event the securitization trust enforces its remedies against us, we may not be able to enforce similar remedies against our originators.

          The use of residential mortgage loan and mortgage-backed securities securitizations with overcollateralization requirements could restrict our cash flow.

          We have used overcollateralization in connection with our securitizations, which could restrict our cash flow in the event loan delinquencies or credit losses on the securitized mortgage loans and mortgage-backed securities exceed certain levels. The terms of our securitizations generally provide that, if certain delinquencies and/or losses exceed specified levels based on rating agencies’ or applicable financial guaranty insurers’ analysis of the characteristics of the loans pledged to collateralize the securities, the required level of overcollateralization may increase or may not decrease as would otherwise be permitted. These and other tests may restrict our ability to receive net interest income from a securitization.

          We rely on assumptions and estimates when we calculate the fair values and projected cash flows for the residential mortgage loans, mortgage-backed securities and hedging instruments that we hold. As a result, these fair values and projected cash flows could be subject to subsequent adjustment.

          We rely on assumptions and estimates when we calculate the fair values and projected cash flows of certain residential mortgage loan commitments, mortgage-backed securities and hedging instruments. We use internally-managed complex cash flow and valuation models that utilize a number of assumptions to calculate these values. We have implemented controls to ensure that our internally-generated market values and cash flows are reasonable. If our internally-generated market values and cash flows subsequently prove not to be reasonable or correct due to modeling errors, incorrect or incomplete underlying assumptions, a failure of our internal controls or other factors, our results of operations and financial condition could be adversely affected. In addition, if we subsequently change one of the underlying assumptions used to determine the fair value and projected cash flow for a residential mortgage loan commitment, mortgage-backed security or hedging instrument, we could incur an impairment charge.

          We are subject to the risks associated with inadequate or untimely services from third-party service providers.

          Third-party service providers are responsible for many of our important operational functions, including the servicing of our residential mortgage loans, the loans underlying our mortgage-backed securities, our residential mortgage loan and mortgage-backed security securitizations, the custody of our assets, our bank accounts, the market pricing of some of our assets, income tax reporting for our assets, underwriting and credit management. As with any user of an external service provider, we are subject to the risks associated with inadequate or untimely services and are dependent upon the availability and quality of the performance of such providers. In addition, our inability to secure appropriate servicing of our residential mortgage loans could adversely impact our results of operations and financial condition.

          Our hedging activities might be unsuccessful.

          We use Eurodollar futures, interest rate swaps, caps and floors, corridors, credit default swaps and other derivative instruments in order to reduce, or “hedge,” our interest rate and credit risks. The amount of hedging activities that we utilize varies from time to time. Our hedging activities might mitigate our interest rate and credit risks, but cannot completely eliminate these risks. The effectiveness of our hedging activities will depend significantly upon whether we correctly quantify the interest rate and credit risks being hedged, as well as our execution, and ongoing monitoring, of our hedging activities. In some situations, we may sell hedging instruments at a loss in order to maintain adequate liquidity. Our hedging activities could adversely impact our results of operations and our book value, and, therefore, such activities could be limited.

          We reflect all changes in the value of our hedging instruments, including Eurodollar futures, interest rate swaps, caps and floors, corridors, credit default swaps and other derivative instruments, in our consolidated statement of operations. This change creates volatility in our results of operations, as the market value of our hedging instruments changes over time, and this volatility may adversely impact our results of operations, financial conditions and book value.

          If we move to elect hedge accounting treatment in the future, we would become subject to the ongoing monitoring requirements of hedge accounting treatment. These requirements are complex and rigorous. If we fail to meet those requirements, or if our hedging activities do not qualify for hedge accounting, we would be required to utilize mark-to-market accounting in our statements of operations. Such accounting could result in higher volatility in our stockholders’ equity, or book value.

          Arco and its affiliates compete with us, and conflicts may arise from Arco’s allocation of investment opportunities.

          Our agreements with Arco do not prevent Arco and its affiliates from engaging in additional investment opportunities. As a result, Arco and its affiliates currently are engaged in and may in the future engage in investment opportunities that have overlapping objectives with us. In particular, affiliates of Arco currently manage a separate investment fund that invests in the same non-mortgage-backed securities investments as we do, including other fixed income investments and private equity investments. In case Arco exercises the warrant, with respect to this entity and any other competing entities Arco may establish in the future, Arco and its affiliates may face conflicts in the allocation of investment opportunities. Arco’s allocation is solely at the discretion of Arco and could conflict with the interests of the holders of our shares.

          The NYSE may not elect to list our common shares.

          Under the rules of the NYSE on which our common stock is listed, a stock may be delisted if its average closing stock price is below $1.00 for 30 consecutive trading days or if our average market capitalization over 30 consecutive trading days falls below $25 million. On January 9, 2008, the NYSE notified us that our common stock had traded below $1.00 for 30 consecutive trading days and that we were not in compliance with this NYSE continued listing standard. We have submitted a plan to NYSE describing the definitive action we intend to take to bring us into conformity with the NYSE’s continued listing standards within six months. During this period, our common stock may continue to be listed on the NYSE, subject to ongoing reassessment by the NYSE. The NYSE has no obligation to accept our plan. The NYSE could also seek to delist our common stock in the event that we are unable to continue to satisfy the NYSE’s other qualitative and quantitative standards for continued listing such as the market capitalization requirement.

          Litigation pending against us may adversely affect us.

          The litigation pending against us could be resolved in a manner that would have a material adverse effect on us. The lawsuits allege, generally, that we and certain of our officers and directors violated federal securities laws by making material misrepresentations to the market concerning our operations and prospects, thereby artificially inflating the price of our common stock. The complaints seek unspecified damages. The lawsuits have been consolidated into a single action, and a consolidated complaint has been filed. This case involves complex issues of law and fact and have not yet progressed to the point where we can:

	•		predict its outcome;
	•		estimate damages that might result from the case; or
	•		predict the effect that final resolution of any litigation might have on our business, financial condition or results of operations, although such effect could be materially adverse.

          Our operations are significantly dependent on our information technology platform.

          We depend upon a complex and multi-layered information technology platform to conduct our operations. A disruption or loss of our information technology platform could have a material adverse effect on our results of operations and financial condition. Our technology platform consists of numerous software technology solutions provided by third-parties and our own internally-built and managed data warehouse which we rely on to manage substantially all of our business operations.

Regulatory risks

          Due to recent market disruptions that resulted in our need to sell assets to satisfy margin calls on our financing agreements, we are relying on a safe harbor exemption from the 1940 Act, in order to not become regulated as an investment company. Failure to maintain an exemption from the 1940 Act would harm our results of operations.

          We seek to conduct our business so as not to become regulated as an investment company under the 1940 Act. Because we conduct some of our business through wholly owned subsidiaries, we must ensure not only that we qualify for an exclusion or exemption from regulation under the 1940 Act, but also that each of our subsidiaries so qualifies. Under the 1940 Act, a company is not deemed to be an investment company if:

	•		it neither is, nor holds itself out as being, engaged primarily, nor proposes to engage primarily, in the business of investing, reinvesting or trading in securities; and
	•		it neither is engaged nor proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and does not own or propose to acquire investment securities having a value exceeding 40% of the value of its total assets on an unconsolidated basis. This test is known as the 40% Test.

          The term “investment securities” excludes U.S. government securities and securities of majority owned subsidiaries that are not themselves investment companies and are not relying on the exceptions from the definition of investment company under Section 3(c)(1) or Section 3(c)(7).

          We conduct our business primarily through wholly owned or majority owned subsidiaries. We must ensure that less than 40% of the value of our total assets consists of interests in subsidiaries that rely on Section 3(c)(1) or Section 3(c)(7) in order to meet the 40% Test.

          Several of our subsidiaries are designed to rely on Section 3(c)(5)(C). We call each of these a 3(c)(5)(C) subsidiary or a qualifying subsidiary. Based on a series of no-action letters issued by the SEC’s Division of Investment Management, or Division, in order for a subsidiary to qualify for this exemption, at least 55% of that subsidiary’s assets must consist of residential mortgage loans, or the “55% Test,” and other assets that are considered the functional equivalent of residential mortgage loans for purposes of the 1940 Act (collectively, “qualifying real estate assets”) and an additional 25% of that subsidiary’s assets must consist of real estate-related assets, or the “25% Test.”

          If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced, and we would be unable to execute our current operating policies and programs.

          Because of the recent market deterioration and resulting defaults on our financing obligations, we have sold assets to meet margin calls on our financing agreements and several of the our subsidiaries designed to rely on Section 3(c)(5)(C) currently fail to meet the 55% Test and must rely on Section 3(c)(7) to avoid registration as investment companies. As a result, we no longer satisfy the 40% Test.

          We are now relying upon Rule 3a-2 for our exemption from registration under the 1940 Act. Reliance upon Rule 3a-2 is permitted only once every three years. As a result, if our subsidiaries designed to rely on Section 3(c)(5)(C) fail to meet either the 55% Test or the 25% Test, or if we otherwise fail to maintain our exclusion from registration, within that three-year period, and another exemption is not available, we may be required to register as an investment company, or we may be required to acquire and/or dispose of assets in order to meet the 55% Test or other tests for exclusion. Any such asset acquisitions or dispositions may be of assets that we would not acquire or dispose of in the ordinary course of our business, may be at unfavorable prices or may impair our ability to make distributions to shareholders and result in a decline in the price of our common shares. If we are required to register under the 1940 Act, we would become subject to substantial regulation with respect to our capital structure including our ability to use leverage, management, operations, transactions with affiliated persons (as defined in the 1940 Act) and portfolio composition, including restrictions with respect to diversification and industry concentration and other matters. Accordingly, registration under the 1940 Act could limit our ability to follow our current investment and financing strategies, impair our ability to make distributions to our common shareholders and result in a decline in the price of our common stock and cause us to be taxed as a corporation for U.S. federal income tax purposes.

Legal and Tax Risks

     If we fail to qualify as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability.

          Qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist. Even a technical or inadvertent mistake could jeopardize our REIT qualification. Furthermore, Congress or the Internal Revenue Service, or IRS, might change tax laws or regulations and the courts might issue new rulings, in each case potentially having retroactive effect, that could make it more difficult or impossible for us to qualify as a REIT in a particular tax year. If we fail to qualify as a REIT in any tax year, then:

	•		we would be taxed as a regular domestic corporation, which, among other things, means that we would be unable to deduct distributions to our stockholders in computing taxable income and would be subject to U.S. federal income tax on our taxable income at regular corporate rates;
	•		any resulting tax liability could be substantial, would reduce the amount of cash available for distribution to our stockholders and could force us to liquidate assets at inopportune times, causing lower income or higher losses than would result if these assets were not liquidated; and
	•		unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and, thus, our cash available for distribution to our stockholders would be reduced for each of the years during which we did not qualify as a REIT.

          Even if we remain qualified as a REIT, we are subject to U.S. federal, state and local taxes that reduce our cash flow. Any of

these taxes would decrease the cash available for distribution to our stockholders. See Note 11 to our consolidated financial statements for further information on our current REIT qualification.

     Complying with REIT requirements might cause us to forego otherwise attractive opportunities.

          In order to qualify as a REIT for U.S. federal income tax purposes, we must satisfy tests concerning, among other things, our sources of income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. To satisfy the requirement that we annually distribute at least 90% of taxable REIT net income, determined without regard to the deduction for dividends paid and excluding net capital gain, we may be required to make distributions to our stockholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with REIT requirements may cause us to forego opportunities we would otherwise pursue.

          In addition, the REIT provisions of the Code impose a 100% tax on income from “prohibited transactions.” Prohibited transactions generally include sales of assets that constitute inventory or other property held for sale in the ordinary course of a business, other than foreclosure property. This 100% tax could impact our decision to sell mortgage-backed securities at otherwise opportune times if we believe such sales could be considered prohibited transactions or to execute securitization transactions at the REIT level that are treated as sales for federal income tax purposes.

     Complying with REIT requirements may limit our ability to hedge effectively.

          The REIT provisions of the Code substantially limit our ability to hedge mortgage-backed securities and related borrowings. Under these provisions, our annual income from qualified hedges, together with any other income not generated from qualified REIT real estate assets, is limited to less than 25% of our gross income. In addition, we must limit our aggregate income from non-qualified hedges and services from all sources, plus any other non-qualifying income, to less than 5% of our annual gross income. As a result, we might in the future have to limit our use of advantageous hedging techniques, which could leave us exposed to greater risks associated with changes in interest rates than we would otherwise want to bear. If we fail to satisfy these requirements, unless our failure was due to reasonable cause and we meet certain other technical requirements, we could lose our REIT qualification for federal income tax purposes. Even if our failure were due to reasonable cause, we might have to pay a penalty tax equal to the amount of our income in excess of certain thresholds, multiplied by a fraction intended to reflect our profitability.

     Complying with REIT requirements may force us to liquidate otherwise attractive investments.

          In order to qualify as a REIT, at the end of each calendar quarter at least 75% of the value of our assets must consist of cash, cash items, government securities, certain temporary investments and qualified REIT real estate assets. The remainder of our investment in securities generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, generally, no more than 5% of the value of our assets can consist of the securities of any one issuer. We might be required to liquidate otherwise attractive investments in order to satisfy these requirements. If we fail to comply with these requirements, we could lose our REIT qualification unless we are able to avail ourselves of certain statutory relief provisions. Under certain relief provisions, we would be subject to penalty taxes.

          In order to comply with REIT requirements we may be required to borrow to make distributions to our stockholders.

          As a REIT, we must distribute at least 90% of our annual taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains, to our stockholders. From time to time, we might generate taxable income greater than our net income for financial reporting purposes from, among other things, amortization of capitalized purchase premiums, or our taxable income might be greater than our cash flow available for distribution to our stockholders. If we do not have other funds available in these situations, we might be unable to distribute 90% of our taxable income as required by the REIT rules. In that case, we would need to borrow funds, sell a portion of our residential mortgage loans or mortgage-backed securities at disadvantageous prices or find another source of funds. These alternatives could increase our costs or reduce our equity and reduce amounts available to invest in residential mortgage loans or mortgage-backed securities.

          If we do not make required distributions, we would be subject to tax, which would reduce the cash available for distribution to our stockholders.

          To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we would be subject to federal corporate income tax on our undistributed income. In addition, we would incur a 4% non-deductible excise tax on

the amount, if any, by which our distributions in any calendar year were less than the sum of:

	•		85% of our REIT ordinary income for that year;
	•		95% of our REIT capital gain net income for that year; and
	•		100% of our undistributed taxable income from prior years.

     We did not pay all of the required cash distributions of REIT taxable income for 2007 as required to maintain our qualification as a REIT. We are considering alternatives related to the payment of our dividend and other issues related to our current qualification as a REIT. See Note 11 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for additional information on our REIT qualification.

          Our taxable income may substantially exceed our GAAP income and cash flow, which may require us to use cash reserves, incur debt or liquidate non-cash assets at unfavorable rates or times in order to satisfy the distribution requirement and to avoid corporate income and excise taxes.

          Our taxable income may substantially exceed our net income as determined on the basis of GAAP because of GAAP-tax accounting differences. For example, realized capital losses are deducted in determining our GAAP net income, but may not be deductible in computing our taxable income. In addition, we invest in assets, including equity and debt securities issued in REMIC and non-REMIC securitizations, that generate taxable income in excess of GAAP income or in advance of the corresponding cash flow from the assets, which we refer to as phantom income. Although some types of phantom income are excluded in determining the 90% distribution requirement, we will incur corporate income tax and the excise tax with respect to any phantom income items that we do not distribute on an annual basis. As a result of the foregoing, we may generate less cash flow than taxable income in a particular year. In that event, we may be required to use cash reserves, incur debt or liquidate non-cash assets at rates or times that we regard as unfavorable in order to satisfy the distribution requirement and to avoid corporate income tax and the excise tax in that year.

          We may lose our REIT qualification if the IRS successfully challenges our characterization of our income from our future investments in CLO and CDO issuers.

          We intend to treat certain income inclusions received from our future equity investments in CLO and CDO issuers as qualifying income for purposes of the 95% gross income test, but not the 75% gross income test, although there is no clear precedent with respect to the qualification of such income for purposes of the REIT gross income tests. In the event that such income were determined not to qualify for the 95% gross income test, we could be subject to a penalty tax with respect to such income to the extent it exceeds 5% of our gross income or we could fail to qualify as a REIT.

          To the extent any of our taxable REIT subsidiaries that are CLO and CDO issuers and are subject to U.S. federal income tax at the entity level, the amounts those entities could distribute to us and pay their creditors would be reduced.

          We intend that our taxable REIT subsidiaries that are CLO and CDO issuers will be organized as Cayman Islands companies and will rely on a specific exemption from U.S. federal income tax for non-U.S. corporations that restrict their activities in the United States to trading stock and securities for their own account or any activity closely related thereto. If the IRS were to succeed in challenging that tax treatment, the amount that those CLO and CDO issuers would have available to distribute to us and to pay to their creditors could be reduced.

          Our recognition of excess inclusion income could have adverse tax consequences to us and our stockholders.

          We likely will recognize excess inclusion income with respect to our assets. Recently issued IRS guidance indicates that our excess inclusion income will be allocated among our stockholders in proportion to dividends paid. Excess inclusion income may not be offset by net operating losses otherwise available to stockholders, represents unrelated business taxable income in the hands of an otherwise tax-exempt stockholder and is subject to withholding tax at the maximum rate of 30%, without regard to otherwise applicable exemptions or rate reductions, to the extent such income is allocable to a stockholder who is not a U.S. person. Although the law is not entirely clear, excess inclusion income may be taxable (at the highest corporate tax rates) to us, rather than our stockholders, to the extent allocable to our stock held in record name by disqualified organizations (generally, tax-exempt entities not subject to unrelated business income tax, including governmental organizations). Nominees who hold our stock on behalf of disqualified organizations also potentially may be subject to this tax.

          Generally, excess inclusion income is the income allocable to a REMIC residual interest in excess of the income that would have been allocable to such interest if it were a bond having a yield to maturity equal to 120% of the long-term applicable rate based on the weighted-average yields of treasury securities that are published monthly by the IRS for use in various tax calculations.

          Although we structure our securitization transactions to qualify as non-REMIC financing transactions for U.S. federal income tax purposes, we likely will recognize excess inclusion income attributable to the equity interests we retain in those securitization transactions. If a REIT holds 100% of the sole class of equity interest in a non-REMIC multi-class mortgage-backed securities offering that qualifies as a borrowing for U.S. federal income tax purposes, the equity interests retained by the REIT will be subject to rules similar to those applicable to a REMIC residual interest. Thus, because we undertake non-REMIC multi-class mortgage-backed securities transactions, we likely will recognize excess inclusion income.

          Generally, to maintain our REIT qualification, we must distribute at least 90% of our taxable income (determined without regard to the dividends paid deduction and by excluding any net capital gains) in each year. To the extent the sum of our excess inclusion income is less than 10% of our total taxable income, we may elect to pay tax on such excess inclusion income rather than treating a portion of our distributions as comprising excess inclusion income.

          Misplaced reliance on legal opinions or statements by issuers of mortgage-backed securities could adversely impact our results of operations or financial condition or result in our failure to comply with REIT income or assets tests.

          When purchasing mortgage-backed securities, we may rely on opinions of counsel for the issuer or sponsor of such securities, or statements made in related offering documents or confirmed trade tickets, for purposes of modeling our projected cash flows and market values for a mortgage-backed security, interest income recognition for a mortgage-backed security, and determining whether and to what extent a security constitutes a qualifying real estate asset for purposes of the REIT asset tests and produces income that qualifies under the REIT gross income tests. The inaccuracy of any such opinion, statement, offering document, confirmed trade ticket or other written or orally provided information related to a mortgage-backed security we purchase, may adversely affect our REIT qualification and could result in significant corporate-level tax.

ITEM 1B.  UNRESOLVED STAFF COMMENTS

          None.

ITEM 2.  PROPERTIES

          Our principal offices are located at 2005 Market Street, 21st Floor, Philadelphia, Pennsylvania 19103. Our Philadelphia office lease is for approximately 4,700 square feet of space and expires in 2008.

ITEM 3.  LEGAL PROCEEDINGS

     Shareholder Lawsuit

          Following the August 6, 2007 announcement of actions taken by the board of directors, we and certain officers and directors were named as defendants in six purported class action lawsuits. A consolidated complaint has been filed, on behalf of a purported class of investors who purchased our securities between June 25, 2007 and August 6, 2007. The lawsuit alleges generally, that the defendants violated federal securities laws by making material misrepresentations to the market concerning our operations and prospects, thereby artificially inflating the price of our common stock. The complaints seek unspecified damages.

          The case involves complex issues of law and fact and has not yet progressed to the point where we can:

	•		predict its outcome;
	•		estimate damages that might result from the case; or,
	•		predict the effect that final resolution that the case might have on our business, financial condition or results of operations, although such effect could be materially adverse. We believe these allegations to be without merit. We intend to seek dismissal of the lawsuit for failure to state a valid legal claim, and if the case is not dismissed on motion, to vigorously defend ourselves against these allegations. We maintain directors and officers liability

insurance which we believe should provide coverage to us and our officers and directors for most or all of any costs, settlements or judgments resulting from the lawsuit.

          In addition, a stockholder derivative action was filed on August 31, 2007 in the Superior Court of the State of California, County of San Francisco, in which an individual stockholder purports to assert claims on our behalf against numerous directors and officers for alleged breach of fiduciary duty, abuse of control and other similar claims. We believe the allegations in the stockholder derivative complaint to be without merit and filed motions to dismiss all claims. In response to these motions, plaintiff voluntarily filed an amended derivative complaint. We intend to file motions to dismiss the amended complaint; those motions are currently scheduled to be filed on April 13, 2008. Furthermore, any recovery in the derivative lawsuit would be payable to us, and this lawsuit is therefore unlikely to have a material negative effect on our business, financial condition or results of operations.

     Repurchase Agreement Litigation

          We have initiated legal proceedings against two repurchase agreement counterparties in U.S. District Court for the Southern District of New York regarding those counterparties’ disposition of certain mortgage-backed securities that were posted with them pursuant to certain repurchase agreements.  The lawsuits allege that during the summer of 2007 the counterparties, among other things, failed to act in good faith and in a commercially reasonable manner in purportedly attempting to liquidate the securities posted with them and/or in attempting to credit Luminent for the value of those securities, after certain margin calls were not met.  

          Both of the defendants dispute the lawsuits’ allegations and are claiming that the liquidation of the posted collateral resulted in a deficit that is owed by Luminent.  One of the defendants has asserted counterclaims in the lawsuit against us, alleging that it is owed approximately $6.6 million (purportedly consisting of the alleged deficit amount plus certain principal and interest amounts paid on the securities it had seized) and demanding legal fees.  The other counterparty has not yet asserted a counterclaim in the lawsuit against it, but had previously claimed a deficit of approximately $7.7 million. 

          On December 21, 2007, a repurchase agreement lender alleged that an event of default existed for an unspecified reason on our part under a master repurchase agreement. As a result, the repurchase agreement lender alleged that the repurchase date for reverse repurchase transactions by us having an aggregate repurchase price of approximately $8.0 million calculated as of December 21, 2007, would occur (to the extent that the repurchase date had not already occurred), and the repurchase agreement lender demanded our payment of that aggregate repurchase price, together with interest thereon and expenses. Subsequent to December 31, 2007, the repurchase agreement lender informed us that it had sold the collateral for the repurchase agreement at a deficit of $7.3 million.

          We do not agree with the repurchase agreement lender that the above-described event of default exists. Furthermore, we believe that most of the securities subject to the related reverse repurchase transactions were sponsored, issued and underwritten by affiliates of the repurchase agreement lender and then sold to us by the underwriter, which is an agent of the repo lender, in violation of federal and state securities laws. We seek to rescind the related sale. Approximately $7.0 million of the approximately $8.0 million demanded by the repurchase agreement lender relates to the securities sponsored, issued, and underwritten by affiliates of the repurchase agreement lender.

          On December 24, 2007, we filed a lawsuit against affiliates of the repurchase agreement lender relating to the issuance and sale of the aforementioned securities. The lawsuit alleges that the defendants misrepresented, and failed to disclose, material information relating to the securities they offered and sold to the Company and an affiliate, entitling us to rescission and/or monetary damages.

          The cases are in the early stages of discovery.  We cannot predict the effect that final resolution of the cases might have on our business, financial condition or results of operations, although such effect could be materially adverse.  We believe the counterparties’ claims are without merit and we intend to vigorously defend ourselves against them if and to the extent they are pursued in the lawsuits.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

          None.

PART II

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

          Our common stock is listed on the NYSE under the symbol “LUM.”

          Under the rules of the NYSE on which our common stock is listed, a stock may be delisted if its average closing stock price is below $1.00 for 30 consecutive trading days or if our average market capitalization over 30 consecutive trading days falls below $25 million. On January 9, 2008, the NYSE notified us that our common stock had traded below $1.00 for 30 consecutive trading days and that we were not in compliance with this NYSE continued listing standard. We have submitted a plan to NYSE describing the definitive action we intend to take to bring us into conformity with the NYSE’s continued listing standards within six months. During this period, our common stock may continue to be listed on the NYSE, subject to ongoing reassessment by the NYSE. The NYSE has no obligation to accept our plan. The NYSE could also seek to delist our common stock in the event that we are unable to continue to satisfy the NYSE’s other qualitative and quantitative standards for continued listing such as the market capitalization requirement.

          The following table sets forth the intra-day high and low sale prices for our common stock as reported on the NYSE for each quarterly period during the years ended December 31, 2007 and 2006:

2007		High				Low
First Quarter		$	10.46			$	8.10
Second Quarter			10.25				7.31
Third Quarter			10.78				0.36
Fourth Quarter			3.34				0.64

2006		High				Low
First Quarter		$	8.70			$	7.18
Second Quarter			9.26				7.58
Third Quarter			10.50				8.98
Fourth Quarter			10.84				9.60

Holders

          As of February 28, 2008, we had 43,283,339 issued and outstanding shares of common stock that were held by 421 holders of record. The 421 holders of record include Cede & Co., which holds shares as nominee for The Depository Trust Company, which itself holds shares on behalf of the beneficial owners of our common stock.

Distributions and Distribution Policy

          The following table sets forth the quarterly cash distributions declared per share of our common stock during the years ended December 31, 2007 and 2006:

		Cash Distributions				Declaration
2007		Declared Per Share				Date
First Quarter		$	0.30			March 30, 2007
Second Quarter (1)			0.32			June 27, 2007
Third Quarter		none					n/a
Fourth Quarter		none					n/a
2006
First Quarter		$	0.05			March 31, 2006
Second Quarter			0.20			June 12, 2006
Third Quarter			0.30			September 28, 2006
Special Dividend			0.075			October 10, 2006
Fourth Quarter			0.30			December 18, 2006

          The distributions we declared in 2007 and 2006 are not necessarily indicative of distributions that we will declare in the future. We expect that future distributions will be based on our REIT taxable net income in future periods our liquidity and the availability of funds to pay dividends, which we cannot predict with any certainty. All distributions are made at the discretion of our board of directors.

          Our distributions to date are taxable dividends and are not considered a return of capital. Distributions have been funded with cash flows from our ongoing operations, including principal and interest payments received on our mortgage-backed securities and loans held-for-investment.

          We intend to distribute all or substantially all of our REIT taxable net income, to our stockholders in each year. We intend to make regular quarterly distributions to our stockholders to be paid out of funds readily available for such distributions. We did not declare or pay all of the required distributions of REIT taxable income for 2007 as required to maintain our qualification as a REIT. We are considering alternatives related to the payment of our dividend and other issues related to our current qualification as a REIT. See Note 11 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for additional information on our REIT qualification.

          Our distribution policy is subject to revision at the discretion of our board of directors without stockholder approval or prior notice. We have not established a minimum distribution level and our ability to make distributions may be harmed for the reasons described in “Risk Factors” in Item 1A of this Form 10-K. All distributions will depend on our earnings and financial condition, maintenance of REIT qualification, applicable provisions of the MGCL and such other factors as our board of directors deems relevant.

          In order to avoid corporate income and excise tax and to maintain our qualification as a REIT under the Code, we must make distributions to our stockholders each year in an amount at least equal to:

	•		90% of our REIT taxable net income, plus
	•		90% of our after-tax net income, if any, from foreclosure property, minus
	•		the excess of the sum of specified items of our non-cash income items over 5% of REIT taxable net income.

          In general, our distributions are applied toward these requirements only if paid in the taxable year to which they relate, or in the following taxable year if the distributions are declared before we timely file our tax return for that year, the distributions are paid

on or before the first regular distribution payment following the declaration and we elect on our tax return to have a specified dollar amount of such distributions treated as if paid in the prior year. Distributions declared by us in October, November or December of one taxable year and payable to a stockholder of record on a specific date in such a month are treated as both paid by us and received by the stockholder during such taxable year, provided that the distribution is actually paid by us by January 31 of the following taxable year.

          We anticipate that distributions generally will be taxable as ordinary income to our stockholders, although a portion of such distributions may be designated by us as capital gain or may constitute a return of capital. We will furnish annually to each of our stockholders a statement setting forth distributions paid during the preceding year and their characterization as ordinary income, return of capital or capital gains.

          To the extent that we own REMIC residual interests or engage in time-tranched non-REMIC mortgage securitizations through one or more qualified REIT subsidiaries that are treated as taxable mortgage pools, or TMPs, we will recognize “excess inclusion income” or phantom income as a result of such ownership or transactions. Refer to “Taxation of Stockholders” included in the section titled “Federal Income Tax Considerations” in Item 1 of this Form 10-K for further discussion.

Equity Compensation Plan

          Effective June 4, 2003, we adopted a 2003 Stock Incentive Plan and a 2003 Outside Advisors Stock Incentive Plan pursuant to which up to 1,000,000 shares of our common stock may be awarded at the discretion of the Compensation Committee of our Board of Directors, or Compensation Committee. On May 25, 2005, these plans were amended to increase the total number of shares reserved for issuance from 1,000,000 shares to 2,000,000 shares and to set the share limits at 1,850,000 shares for the 2003 Stock Incentive Plan and 150,000 shares for the 2003 Outside Advisors Stock Incentive Plan. The plans provide for the grant of a variety of long-term incentive awards to our employees and officers 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 provide for the grant of awards that may meet the requirements of Section 422 of the Code, non-qualified stock options, stock appreciation rights, restricted stock, stock units and other stock-based awards and dividend equivalent rights. The maximum term of each grant is determined on the grant date by our compensation committee and may not exceed 10 years. The exercise price and the vesting requirement of each grant are determined on the grant date by the compensation committee.

          The following table illustrates common stock authorized for issuance under the 2003 Stock Incentive Plan and 2003 Outside Advisors Stock Incentive Plan as of December 31, 2007:

(a)

(c)

Number of

(b)

Number of

securities to be

Weighted-

securities remaining

issued upon

average

available for future

exercise of

exercise price

issuance under equity

outstanding

of outstanding

compensation plans -

options, warrants

options, warrants

excluding securities

Plan Category

and rights

and rights

reflected in column (a)

Incentive plans approved by stockholders

55,000

$

14.82

949,740

Incentive plans not approved by stockholders

—

—

—

Total

55,000

$

14.82

949,740

          See Note 7 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for further information regarding the 2003 Stock Incentive Plan and 2003 Outside Advisors Stock Incentive Plan.

Purchases of Equity Securities

          The following table summarizes share purchases for 2007 under our stock repurchase program:

										(c)				(d)
		(a)								Total				Maximum
		Total				(b)				Number of Shares				Number of Shares
		Number of				Average				Purchased as Part of				that May Yet Be
		Shares				Price Paid				Publicly Announced				Purchased Under
Period		Purchased				per Share				Program				the Program
January 1 – 31, 2007			—				—				—				2,405,715
February 1 – 28, 2007			—				—				—				2,405,715
March 1 – 31, 2007			—				—				—				2,405,715
April 1 – 31, 2007			1,234,600			$	8.18				1,234,600				1,171,115
May 1 – 31, 2007 (1)			3,540,000				8.72				3,540,000				2,500,950
June 1 – 30, 2007			—				—				—				2,500,950
July 1 – July 31, 2007			—				—				—				2,500,950
August 1 – August 31, 2007			—				—				—				2,500,950
September 1 – 30, 2007			130,165				1.32				130,165				2,370,785
October 1 – 31, 2007			—				—				—				2,370,785
November 1 — 30, 2007			—				—				—				2,370,785
December 1 — 31, 2007			—				—				—				2,370,785

Share Price Performance Graph

          The following graph compares the total cumulative stockholder return from a $100 investment in our common stock and in the stocks making up two comparative stock indices on December 19, 2003 (the date our common stock was listed on the NYSE) through December 31, 2007. The graph reflects stock price appreciation and the reinvestment of dividends paid on our common stock and for each of the comparative indices.

				12/19/2003					12/31/2003					12/31/2004					12/31/2005					12/31/2006					12/31/2007
	Luminent Mortgage Capital’ Inc.				100					104					100					69					98					8
	S & P500				100					105					117					122					142					150
	BBG REIT Mortgage Index				100					102					102					115					137					76

          This performance graph shall not be deemed filed or incorporated by reference into any filing by us under the Securities Act of 1933 or the Exchange Act, except to the extent that we specifically incorporate the performance graph by reference therein.

ITEM 6.   SELECTED FINANCIAL DATA

          The following selected financial data are derived from our audited financial statements at December 31, 2007, 2006, 2005 and 2004 and 2003 and for the years ended December 31, 2007, 2006, 2005 and 2004 and the period from April 26, 2003 through December 31, 2003. The selected financial data should be read in conjunction with the more detailed information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto in Item 8 of this Form 10-K.

																		For the Period
		For the Year				For the Year				For the Year				For the Year				from April 26,
		Ended				Ended				Ended				Ended				2003 through
		December 31,				December 31,				December 31,				December 31,				December 31,
		2007				2006				2005				2004				2003
						(Dollars in thousands, except share and per share amounts)
Statement of Operations Data:
Interest income		$	520,878			$	357,137			$	181,421			$	123,754			$	22,654
Interest expense			428,732				268,618				137,501				55,116				9,009
Net interest income			92,146				88,519				43,920				68,638				13,645
Other income (expense)			(696,424	)			(829	)			—				1,070				—
Expenses			94,478				42,443				14,026				12,596				3,053
Net income (loss)			(720,997	)			46,797				(82,991	)			57,112				2,761
Per Common Share Data:
Net income (loss) — basic		$	(16.21	)		$	1.15			$	(2.13	)		$	1.68			$	0.27
Net income (loss) — diluted			(16.21	)			1.14				(2.13	)			1.68				0.27
Cash distributions declared(1)			0.62				0.925				0.77				1.71				0.95
Book value (end of period)(2)			(7.18	)			9.86				9.76				10.93				11.38
Common shares outstanding (end of period)			43,172,839				47,808,510				40,587,245				37,113,011				24,814,000
Weighted-average shares outstanding — basic			44,481,292				40,788,778				39,007,953				33,895,967				10,139,280
Weighted-average shares outstanding — diluted			44,481,292				41,003,620				39,007,953				33,947,414				10,139,811
Balance Sheet Data (end of period):
Total mortgage-backed securities, at fair value			435,885				2,930,938				4,359,603				4,827,955				2,161,945
Loans held-for-investment, net			4,191,343				5,591,717				507,177				—				—
Total assets			4,721,918				8,613,795				4,933,471				4,879,828				2,179,340
Repurchase agreements			526,634				2,707,915				3,928,505				4,436,456				1,728,973
Mortgage-backed notes			3,914,643				3,917,677				486,302				—				—
Junior subordinated notes			92,788				92,788				92,788				—				—
Warehouse lending facilities			—				752,777				—				—				—
Commercial paper			—				637,677				—				—				—
Collateralized debt obligations			294,416				—				—				—				—
Convertible senior notes			90,000				—				—				—				—
Revolving line of credit			15,833				—				—				—				—
Margin debt			—				—				3,548				—				—
Total liabilities			5,031,943				8,142,240				4,537,150				4,474,325				1,896,844
Total stockholders’ equity (deficit)			(310,025	)			471,555				396,321				405,503				282,496
Financial Ratios:
Leverage ratio (period end)(3) (5)			(15.9	)			17.2				11.4				10.9				6.1
Recourse leverage ratio (period end)(4) (5)			(5.7	)			7.4				8.2				10.9				6.1

ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

          The following discussion of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and notes to those statements included in Item 8 of this Form 10-K. This discussion may contain certain forward-looking statements that involve risks and uncertainties. Forward-looking statements are those that are not historical in nature. See “Cautionary Note regarding Forward-looking Statements.” As a result of many factors, such as those set forth under “Risk Factors” in Item 1A of this on Form 10-K and elsewhere in this Form 10-K, our actual results may differ materially from those anticipated in such forward-looking statements.

Overview

     Business Conditions and Going Concern

          Our 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 we announced in a press release on August 6, 2007, the mortgage industry and the financing methods upon which the mortgage industry has historically relied deteriorated significantly and in an unprecedented fashion. Effectively, the secondary market for mortgage-backed securities closed, and as a result, we simultaneously experienced a significant increase in margin calls from certain of our repurchase agreement lenders and a decrease in the amount of financing our lenders would provide on a given amount of collateral. These events resulted in a significant loss of liquidity for us over a very short period of time and raised substantial doubt about our ability to continue as a going concern. We lost $721.0 million in the year ended December 31, 2007, which included $481.7 million in impairment losses on mortgage-backed securities, $39.3 million in provisions for loan losses, $181.1 million in losses on sales of securities and $45.1 million in losses on sales of loans. In addition, we recorded $21.3 million in corporate state and federal income taxes due to our inability to meet the threshold for tax benefit recognition as it relates to our qualification as a REIT.

Progress in the Stabilization of Our Business

          Progress in the stabilization of our lending facilities includes the following achievements.

	•		We obtained new financing arranged by Arco in the form of repurchase agreement financing and a revolving line of credit with a maximum amount of $190 million, which expires on September 26, 2012. See Note 5 and Note 14 to the December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for additional information about our borrowings from Arco and its affiliates and our relationship with Arco.
	•		As of December 31, 2007, we had completed the sale of approximately $2.4 billion of mortgage-backed securities to repay lenders and meet required margin calls at a net loss of approximately $181.1 million.
	•		We completed the sale or refinancing of assets financed by our asset-backed commercial program, and we no longer have any outstanding commercial paper liabilities under our asset-backed commercial paper program.
	•		We sold approximately $1.0 billion of loans and repaid all of our 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, and an additional warehouse line for $500.0 million expired in October 2007. No balances are currently outstanding on the remaining warehouse line totaling $1.0 billion. See Note 5 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for additional information on our warehouse facilities.
	•		As of December 31, 2007, we had stabilized $538.4 million of repurchase agreement financing with five repurchase agreement lenders by meeting all required margin calls. We are working to further stabilize our repurchase agreement financing by moving our repurchase agreement financing to Arco and its affiliates.
	•		We are working with an additional repurchase agreement lender to resolve a dispute on the fair value of the underlying collateral for that agreement to settle an additional $8.0 million of repurchase agreement financing.

          We have taken additional measures to improve our liquidity position, which include the implementation of operating expense reductions including a personnel reduction, the closure of our San Francisco, California corporate office on December 31, 2007 and the establishment of our corporate headquarters in Philadelphia, Pennsylvania where substantive operations were located.

          We are currently focused on maintaining the progress made to date in stabilizing our investment portfolio in the short-term, and then returning to profitability. These efforts will likely include additional sales of securities in order to provide additional liquidity, using affiliates of Arco for short-term financing and exploring long-term financing alternatives to replace our existing short-term financing. As of March 12, 2008, we had moved $166.2 million of third-party repurchase agreement financing to the facility provided by affiliates of Arco.

          Our longer-term strategy will focus on returning to profitability. Our strategy will include both new investments in mortgages and mortgage-backed securities as well as new business initiatives. We believe our existing credit management infrastructure is readily adaptable to asset management, particularly in three areas:

	•		First, we are offering our services as an advisor to holders of existing mortgage-backed securities or whole loan positions to provide forensic underwriting, loss mitigation oversight and surveillance services. We currently perform these functions in conjunction with managing our loan and mortgage-backed securities portfolios and can readily provide these services to third parties.
	•		Second, we intend to seek, through one or more taxable corporate subsidiaries, asset management engagements from institutional investors seeking to profit from the current turmoil in the mortgage-backed securities market. We will earn a management fee for these services and will invest our client funds with the same investment philosophy as we invest our own capital. Our credit underwriting, loss mitigation, surveillance and information technology systems have recently been upgraded to accommodate any reasonably expected increase in volume.
	•		Finally, we expect to serve as a sub-manager on investment funds. Our business plan includes opportunities in domestic markets as well as expansion to non-U.S. markets. We believe the current market environment provides significant opportunities to us to develop these new services, which would be closely aligned with our current expertise. However, we can provide no assurance that further market disruption will not occur or that we will be able to successfully execute our business or liquidity plans discussed herein.

          We did not declare or pay all of the required distributions of REIT taxable income for 2007 as required to maintain our qualification as a REIT. We are considering alternatives related to the payment of our dividend and other issues related to our current qualification as a REIT. See Note 11 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for additional information on our REIT qualification.

          Investment Activities

          Historically, we have invested in two core mortgage investment strategies. Under our residential mortgage credit strategy, we invested primarily in residential mortgage loans as well as subordinated mortgage-backed securities and other asset-backed securities that have credit ratings below AAA. Under our spread strategy, we unvested in U.S. agency and other highly-rated single-family, adjustable-rate and hybrid adjustable-rate mortgage-backed securities with the highest AAA credit ratings.

          Mortgage-backed securities have experienced significant declines in market values in the second half of 2007, and we have been forced to sell a significant portion of our investments in these securities at a loss due to our inability to meet required margin calls or to finance them profitability. At December 31, 2007, AAA-rated securities and securities rated below AAA represent only 4.3% and 4.9% of our total assets. We securitized the loans and some of the mortgage-backed securities that we had purchased and retained the securitization tranches that we believe are the most valuable tranches. Our securitizations reduced our sensitivity to interest rates and helped match the income we earned on our mortgage assets with the cost of our related liabilities. The debt that we incurred in these securitizations is non-recourse to us; however, we pledged our mortgage loans and mortgage-backed securities as collateral for the securities we issue. As of December 31, 2007, mortgage loans represent 88.8% of total assets. Given current market conditions, we do not intend to make new investments in our residential mortgage credit or spread strategies in the near-term. We review our investment strategy regularly and will resume investing under our residential mortgage credit and spread strategies when we believe the market for mortgage-related securities has stabilized and opportunities arise.

          Within the loan market, we have focused on acquiring prime quality, first lien Alt-A adjustable-rate mortgage loans. In the Alt-A market, borrowers choose the convenience of less than full documentation in exchange for a slightly higher mortgage rate. We neither directly originate mortgage loans nor directly service mortgage loans. We purchase pools of mortgage loans from our diverse network of well-capitalized origination providers. We employ a comprehensive underwriting process, driven by our experienced personnel, to review the credit risk associated with each mortgage loan pool we purchase. We require mortgage insurance on all loans with loan-to-value ratios in excess of 80%, and subsequent to July 2007, we purchased supplemental mortgage insurance down to a 75% loan-to-value ratio. In addition, we obtain representations and warranties from each originator to the effect that each loan is underwritten in accordance with the agreed-upon guidelines. An originator who breaches its representations and warranties may be obligated to repurchase loans from us.

          We have also acquired mortgage loans that permit negative amortization. A negative amortization provision in a mortgage allows the borrower to defer payment of a portion or all of the monthly interest accrued on the mortgage and to add the deferred interest amount to the mortgage’s principal balance. As a result, during periods of negative amortization, the principal balances of negatively amortizing mortgages will increase and their weighted-average lives will extend. Our mortgage loans generally can experience negative amortization ranging from 110-125% of the original mortgage loan balance. As a result, given the relatively low average loan-to-value ratio of 71.8%, net of mortgage insurance, on our portfolio at December 31, 2007, we believe that our portfolio would still have a homeowners’ equity cushion even if all negatively-amortizing loans reached their maximum permitted amount of negative amortization. Our securitization structures allow the reallocation of principal prepayments on mortgage loans to be used for interest payments on the debt issued in the securitization trusts. To date, prepayments on securitized loans have been sufficient to offset negative amortization such that all our securitization structures have made their required payments to bond holders.

          Exposure to Subprime Mortgage Loans

          The subprime mortgage banking environment has been experiencing considerable strain from rising delinquencies and liquidity pressures and some subprime mortgage lenders have failed. The increased scrutiny of the subprime lending market is one of the factors that have impacted general market conditions as well as perceptions of our business. Our credit underwriting standards have been structured to limit our exposure to the types of loans and investments that are currently experiencing high foreclosure and loss rates. Our mortgage loan portfolio has virtually no exposure to loans with FICO scores of less than 620 which are generally considered to be subprime loans. At December 31, 2007, we had eight loans out of a total of 10,491 loans with FICO scores below the subprime threshold of 620. None of these loans were seriously delinquent.

          Our mortgage-backed securities portfolio as of December 31, 2007 includes securities with a fair value of $139.8 million, or 3.0% of our mortgage-backed assets that were classified as subprime. Securities with a fair value of $76.9 million, or 1.6%, are included in a trust that is permanently financed by collateralized debt obligations, or CDO’s. We determine the credit quality classification of securities in this portfolio based on the assignment from a third-party service provider. In this portfolio as of December 31, 2007, the weighted-average credit rating of our subprime mortgage-backed securities was BBB. The weighted-average life of these securities is 5.8 years. One security in the principal amount of $0.2 million was a first loss security which absorbs losses from defaulted loans collateralizing the security prior to the remaining securities in the securitization that have higher credit ratings. We recorded impairment losses of $481.6 million for the year ended December 31, 2007, which includes impairments on subprime securities.

Critical Accounting Policies

          We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, or GAAP. These accounting principles require us to make some complex and subjective decisions and assessments. Our most critical accounting policies involve decisions and assessments that could significantly affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments upon which our consolidated financial statements are based were reasonable at the time made based upon information available to us at that time. See Note 2 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for a further discussion of our significant accounting policies. Management has identified our most critical accounting policies to be the following:

     Interest Income Recognition

          We account for interest income on our investments using the effective yield method. For investments purchased at par, the effective yield is the contractual coupon rate on the investment. We recognize unamortized premiums and discounts on mortgage-

backed securities in interest income over the contractual life, adjusted for actual prepayments, of the securities using the effective interest method. For securities representing beneficial interests in securitizations that are not highly rated (i.e., mezzanine and subordinate tranches of residential mortgage-backed securities), we recognize unamortized premiums and discounts over the contractual life, adjusted for estimated prepayments and estimated credit losses of the securities using the effective interest method. We review actual prepayment and credit loss experience and recalculate effective yields when differences arise between prepayments and credit losses that were originally anticipated compared to amounts actually received plus anticipated future prepayments.

          Interest income on loans includes interest at stated coupon rates adjusted for amortization of purchase premiums. We recognize unamortized premiums in interest income over the contractual life, adjusted for actual prepayments, of the loans using the effective interest method.

     Classifications of Investment Securities

          We generally classify our investment securities as available-for-sale and carry them on our consolidated balance sheet at their fair value. The classification of securities as available-for-sale results in changes in fair value being recorded as adjustments to accumulated other comprehensive income or loss, which is a component of stockholders’ equity, rather than through results of operations. If we classified our available-for-sale securities as trading securities, our results of operations could experience substantially greater volatility from period-to-period.

          We hold certain hybrid securities which we have elected to account for as trading securities in accordance with the Statement of Financial Accounting Standards, or SFAS No. 155, Accounting for Certain Hybrid Financial Instruments — an Amendment of FASB Statements No. 133 and 140 although these securities were not acquired for resale. Changes in the fair value of trading securities are required to be reported in our results of operations and therefore we may experience volatility in our results of operations from period to period due to changes in the fair value of these securities.

     Valuations of Mortgage-Backed Securities

          Our spread portfolio of mortgage-backed securities has fair values based on estimates provided by independent pricing services and dealers in mortgage-backed securities. Because the price estimates may vary between sources, we make certain judgments and assumptions about the appropriate price to use. Different judgments and assumptions could result in different presentations of value.

          We estimate the fair value of our residential mortgage credit portfolio of mortgage-backed securities using internally generated cash flow analysis, available market information and other appropriate valuation methodologies. We believe the estimates we use reflect the market values we may be able to receive should we choose to sell the mortgage-backed securities. Our estimates involve matters of uncertainty, judgment in interpreting relevant market data and are inherently subjective in nature. Many factors are necessary to estimate market values, including, but not limited to, interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, cash flows and other market factors. We apply these factors to our portfolio as appropriate in order to determine market values.

          We evaluate the determination of other-than-temporary impairment at least quarterly. When the fair value of an available-for-sale security is less than amortized cost, we consider whether there is an other-than-temporary impairment in the value of the security. We consider several factors when evaluating securities for an other-than-temporary impairment, including the length of time and the extent to which the market value has been less than the amortized cost, whether the security has been downgraded by a rating agency and our continued intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in market value. The determination of other-than-temporary impairment is a subjective process, requiring the use of judgments and assumptions. If we determine other-than-temporary impairment exists, we write down the cost basis of the security to the then-current fair value, and record the unrealized loss as a reduction of current earnings as if we had realize the loss in the period of impairment. If future evaluations conclude that impairment now considered to be temporary is other-than-temporary, we may need to realize a loss that would have an impact on results of operations. See Note 3 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for further detail of temporary and other-than temporary impairment on our mortgage-backed securities.

          Recently, due to disruptions in the mortgage market resulting in our sale of securities to repay lenders and our ongoing liquidity concerns, we have determined that we may not have the ability to hold available-for-sale securities that are at an unrealized loss until the loss in market value is recovered. These securities are considered to be other-than-temporarily impaired, and therefore, we have recognized all unrealized losses on available-for-sale securities in our statement of operations.

     Allowance and Provision for Loan Losses

          We maintain an allowance for loan losses at a level that we believe is adequate based on an evaluation of known and inherent risks related to our loan investments. When determining the adequacy of our allowance for loan losses, we consider historical and industry loss experience, economic conditions and trends, the estimated fair values of our loans, credit quality trends and other factors that we determine are relevant. In our review of national and local economic trends and conditions, we consider, among other factors, national unemployment data, changes in housing appreciation and whether specific geographic areas where we have significant loan concentrations are experiencing adverse economic conditions and events such as natural disasters that may affect the local economy or property values.

          To estimate our allowance for loan losses, we first identify impaired loans. We evaluate loans purchased with relatively smaller balances and substantially similar characteristics collectively for impairment. We evaluate seriously delinquent loans with balances greater than $1.0 million individually. We consider loans impaired when, based on current information, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement, including interest payments, or if it is unlikely that the seller will repurchase the loan in situations where we have the contractual right to request a repurchase. We carry impaired loans at the lower of the recorded investment in the loan or the fair value of the collateral less costs to dispose of the property.

          We establish our allowance for loan losses using mortgage industry experience and Moody’s rating agency projections for loans with characteristics that are broadly similar to our portfolio. This analysis begins with actual 60 day or more delinquencies in our portfolio, and projects ultimate default experience (i.e., the rate at which loans will go to liquidation) on those loans based on mortgage industry loan delinquency migration statistics. For all loans showing indications of probable default, we apply a “severity” factor for each loan, again using loss severity projections from a model developed by Moody’s rating agency for loans broadly similar to the loans in our portfolio. We then use our judgment to ensure we have considered all relevant factors that could affect our loss levels and adjust the allowance for loan losses if we believe that an adjustment is warranted. We include the effect of our contractual right to put loans back to sellers in the event of early pay default or fraud. We have established procedures to perform contract enforcement and have been successful in this effort.

          Our loss mitigation process begins as part of our underwriting procedures prior to our purchase of a loan. Our analytical procedures to identify loans with overinflated property values and weak borrow credit characteristics as well as our sampling techniques for in-depth loan reviews allow us to customize the loan pool we ultimately purchase and reduce our exposure to loans that we believe will ultimately default. We are monitoring market conditions particularly related to home price depreciation and increased foreclosure rates with a special emphasis on monitoring geographic areas that have been significantly affected by these market conditions where we have a high concentration of loans such as California, Florida and Nevada. We began purchasing additional mortgage insurance in the later half of 2006 to provide us with additional protection against losses that may occur due to these market conditions. We consider the availability of mortgage insurance to absorb losses when we project loss severity rates. With an average effective LTV for our loan portfolio of 71.8% at December 31, 2007 including the protection provided by mortgage insurance, we believe we have a cushion for home price depreciation or additional losses due to higher foreclosure rates because mortgage insurance will, to the maximum insurance coverage available, absorb losses first if they occur. Our loan-to-value ratio without the effect of mortgage insurance is 75.9%. We also monitor actual losses and include this analysis in the determination of the severity factor used to estimate our allowance. To date, actual severities have supported the adequacy of the severity projections used in the allowance estimate. See Note 4 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for further detail of our allowance for loan losses.

     Accounting for Derivative Financial Instruments and Hedging Activities

          We may enter into a variety of derivative contracts, including futures contracts, swaption contracts, interest rate swap contracts, interest rate cap contracts, credit default swaps, risk-sharing arrangements and purchase commitments to purchase mortgage loans as a means of mitigating our interest rate risk on forecasted interest expense as well as to mitigate our credit risk on credit sensitive mortgage-backed securities. Effective January 1, 2006, we discontinued the use of hedge accounting in accordance with SFAS No. 133. All changes in value of derivative contracts that had previously been accounted for under hedge accounting are recorded in other income or expense and could result in increased volatility in our consolidated results of operations.

     Accounting for Warrant

          In August 2007, we issued a warrant to purchase 51,000,000 shares of our common stock in exchange for a repurchase agreement financing arrangement. In accordance with SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, the warrant is to be classified as a liability with the initial value 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 change in fair value of the warrant from the issuance date until they are exercised is recorded as a liability and is recorded as other expense in consolidated statement of operations.

          We estimate the fair value of the warrant using the Black-Scholes Pricing Model. The Black-Scholes model is a commonly used model for estimating the fair value of equity related instruments, the exercise of which can create more shares of common stock and thus affect our stock price. The model uses observable data such as risk-free interest rates at a point in time, the warrant expiration date and the exercise price of the warrant and in addition, the model requires us to make certain assumptions related to our stock price volatility and future dividend payments that effect the calculation of the fair value of the warrant. Because all changes in the fair value of the warrant is recorded in other income or expense until the warrant is exercised, changes in fair value could result in increased volatility in our consolidated results of operations. See Note 6 to our December 31, 2007 consolidated financial statements included elsewhere in this Form 10-K for further information on the assumptions used in the estimation of the fair value of our warrant.

Results of Operations

     Year ended December 31, 2007 compared to the year ended December 31, 2006

          For the years ended December 31, 2007 and 2006, we had net losses of $721.0 million, or ($16.21) per weighted-average share outstanding (basic and diluted), and net income of $46.8 million, or $1.15 (basic) and $1.14 (diluted) per weighted-average share outstanding, respectively.

          Losses for the year ended December 31, 2007 were mainly comprised of impairment losses due to the decline in value of the mortgage-backed securities portfolio of $481.7 million, losses on the sale of mortgage-backed securities of $181.1 million, losses on the sale of whole loans of $45.1 million and losses on trading securities of $22.2 million.

          Due to the significant volume of sales from our mortgage-backed securities portfolio in the second half of 2007 and the higher discount rates applied to determine the fair value of the mortgage-backed securities portfolio as of December 31, 2007, the historical weighted-average yield on interest earning assets for the year ended December 31, 2007 is not representative of yields we expect in future periods. As of December 31, 2007, the weighted-average coupon on our interest-earning assets is 7.54% and the weighted-average coupon on our liabilities is 4.57%.

          Total interest income from mortgage assets was $520.9 million and $357.1 million for the years ended December 31, 2007 and 2006, respectively. The increase in interest income is primarily due to the growth of our mortgage loan portfolio and higher average balance of our credit-sensitive bond portfolio as well as higher yields on our mortgage assets that have resulted from the redeployment of our capital into the higher-yielding assets of our residential mortgage credit portfolio during the first quarter of 2006. In addition, due to adverse market conditions in the third and fourth quarters of 2007, we increased the discount rate used to estimate the fair value of our mortgage-backed securities which resulted in higher discount accretion, which is a component of interest income.

          The following table presents interest expense for the years ended December 31, 2007 and 2006 as a percentage of liabilities weighted by the respective average balance of each liability.

Components of Interest Expense
(dollars in thousands)

						Percentage								Percentage
		Year Ended				of Average				Year Ended				of Average
		December 31,				Financing				December 31,				Financing
		2007				Liabilities				2006				Liabilities
Interest expense on mortgage-backed notes		$	245,131				3.35	%		$	132,107				2.53	%
Interest expense on repurchase agreement liabilities			109,744				1.50				116,465				2.23
Interest expense on commercial paper facility			29,998				0.41				4,786				0.09
Interest expense on warehouse lending facilities			15,161				0.21				16,459				0.31
Interest expense on junior subordinated notes			7,911				0.11				7,768				0.15
Interest expense on CDOs			15,882				0.22				—				—
Interest expense on convertible senior notes			4,496				0.06				—				—
Interest expense on revolving line of credit			1,145				0.02				—				—
Amortization of net realized gains on futures and interest rate swap contracts			(1,474	)			(0.02	)			(7,468	)			(0.14	)
Net interest income on interest rate swap contracts			—				—				(1,676	)			(0.04	)
Other			738				0.01				177			nm
Total interest expense		$	428,732				5.87	%		$	268,618				5.13	%

          Interest expense consists primarily of interest payments on our debt, amortization of premiums and discounts on our mortgage-backed notes, collateralized debt obligations, commercial paper and repurchase agreements and amortization of debt issuance costs. Premiums and discounts occur when debt securities are issued at prices different from their principal value. Interest expense increased during the year ended December 31, 2007 compared to the year ended December 31, 2006, primarily due to the increase in the balance of the loans held-for-investment and mortgage-backed securities portfolios.

Components of Other Income
(in thousands)

		Year Ended
		December 31,
		2007				2006
Realized gains on derivative instruments, net		$	47,044			$	6,372
Unrealized gains (losses) on derivative instruments, net			(14,939	)			1,364
Net interest income on interest rate swaps			3,175				—
Other derivative-related expenses			(992	)			—
Gains (losses) on derivatives, net			34,288				7,736
Impairment losses on mortgage-backed securities			(481,654	)			(7,010	)
Sales of mortgage-backed securities:
Gains			1,573				993
Losses			(182,722	)			—
Sub-total			(181,149	)			993
Loss on sale of loans held-for-investment			(45,065	)			—
Mortgage-backed securities, trading change in fair value			(22,177	)			—
Warrant, change in fair value			(526	)			—
Other expense			(141	)			(829	)
Total		$	(696,424	)		$	890

          During the year ended December 31, 2007, our realized losses on the sale of mortgage-backed securities and other-than-temporary impairment losses were partially offset by realized and unrealized gains on derivative instruments that were structured to economically hedge credit risk. Impairment losses of $481.7 million for the year ended December 31, 2007 were primarily due to assumption changes on certain residential mortgage credit securities due to increased loss expectations on certain securities and increased discount rates used to value the securities, which reflect current market conditions for mortgage-backed securities. Due to

the significance of the mortgage industry deterioration discussed above and our ongoing liquidity concerns, we have recognized all unrealized holding losses on securities in our consolidated statement of operations at December 31, 2007.

          Impairment losses for the year ended December 31, 2006 related to spread securities that we did not intend to hold until their maturity.

Components of Operating Expenses
(in thousands)

		Year Ended
		December 31,
		2007				2006
Servicing expense		$	23,133			$	11,951
Provision for loan losses			39,293				5,176
Salaries and benefits			17,354				9,470
Professional services			6,302				3,133
Management compensation expense to related party			—				7,712
Other general and administrative expenses			8,396				5,001
Total expenses		$	94,478			$	42,443

          Our operating expenses for the year ended December 31, 2007 increased compared to the year ended December 31, 2006 due to costs of managing our larger and more diversified investment portfolio as well as the additional diversification we had included in our financing strategies prior to August 2007, when we began selling significant portions of our investment portfolio.

          We employ third parties to perform servicing of our mortgage loans. Servicing includes payments processing, collection activities and reporting of loan activity. For the year ended December 31, 2007 compared to the year ended December 31, 2006, servicing expense increased $11.2 million, or 93.6%. The increases in servicing expenses reflect the increase in the average balance of our mortgage loan portfolio for the year ended December 31, 2007, compared to the year ended December 31, 2006 and, to a lesser extent, the cost for purchasing additional mortgage insurance on our more recent securitizations.

          For the year ended December 31, 2007 compared to the year ended December 31, 2006, the provision for loan losses increased $34.1 million. This increase reflects the growth in size and seasoning of our mortgage loan portfolio.

          For the year ended December 31, 2007 compared to the year ended December 31, 2006, salaries and benefits expense increased $7.9 million, or 83.3%. The increase in salaries and benefits reflects the addition of employees from December 31, 2006 to August 31, 2007, to manage our larger and more diverse portfolio of assets and financing arrangements and well as severance costs related to staff reductions.

          In August 2007, due to the reduction in the size of our investment portfolio, we implemented a cost reduction program which included a reduction in personnel as well as other cost cutting measures including the consolidation of our office facilities to one location.

          For the year ended December 31, 2007 compared to the year ended December 31, 2006, professional services increased $3.2 million, or 101.1%. The increase in professional services include increases in attorney’s fees due to defense expenses for shareholder suits as well as legal fees related to various credit facilities and general corporate matters.

          Management compensation expense to related parties in 2006 was for compensation paid on the management of a portion of our spread assets. The management of these assets was performed in-house in 2007.

 Year ended December 31, 2006 compared to the year ended December 31, 2005

          For the years ended December 31, 2006 and 2005, our net income was $46.8 million, or $1.15 (basic) and $1.14 (fully diluted) per weighted-average share outstanding, respectively, and net losses of $83.0 million, or ($2.13) per weighted-average share (basic and fully diluted), respectively. Results for the year ended December 31, 2006 include certain non-recurring expenses,

including one-time charges of $6.1 million related to the termination of our management agreement with Seneca Capital Management LLC, or SCM. In addition, we recognized net realized and unrealized gains on derivative instruments of $7.7 million and net realized and unrealized losses of $0.8 million during the years ended December 31, 2006 and 2005, respectively.

          The table below details the components of our net interest spread for the years ended December 31, 2006 and 2005:

		For the Year Ended
		December 31,
		2006				2005
Weighted-average yield on average earning assets, net of premium amortization or discount accretion			6.57	%			3.79	%
Weighted-average cost of financing liabilities			5.13				3.07
Net interest spread			1.44	%			0.72	%

          Weighted-average yield on average earning assets, net of premium amortization or discount accretion, is defined as total interest income earned divided by the weighted-average amortized cost of our mortgage assets during the period. Weighted-average mortgage earning assets during the years ended December 31, 2006 and 2005 were $5.4 billion and $4.8 billion, respectively.

          Total interest income from mortgage assets was $357.1 million and $181.4 million for the years ended December 31, 2006 and 2005, respectively. The year-over-year increase in interest income is primarily due to higher yields on our mortgage assets that have resulted from the restructuring and sale of assets in our Spread portfolio and the redeployment of our capital into the higher-yielding assets of our Residential Mortgage Credit portfolio during 2006, as well as an increase in the overall levels of both mortgage assets and interest rates between December 31, 2005 and December 31, 2006.

          The following table presents interest expense for the years ended December 31, 2006 and 2005 as a percentage of liabilities weighted by the respective average balance of each liability.

		For the Year				Percentage				For the Year				Percentage
		Ended				of Average				Ended				of Average
		December 31,				Financing				December 31,				Financing
		2006				Liabilities				2005				Liabilities
Interest expense on mortgage-backed notes		$	132,107				2.53	%		$	3,719				0.08	%
Interest expense on repurchase agreement liabilities			116,465				2.23				138,076				3.08
Interest expense on commercial paper facility			4,786				0.09				—				—
Interest expense on warehouse lending facilities			16,459				0.31				1,507				0.03
Interest expense on junior subordinated notes			7,768				0.15				3,411				0.08
Amortization of net realized gains on futures and interest rate swap contracts			(7,468	)			(0.14	)			(1,415	)			(0.03	)
Net interest (income)/expense on interest rate swap contracts			(1,676	)			(0.04	)			(8,093	)			(0.18	)
Net hedge ineffectiveness (gains)/losses on futures and interest rate swap contracts			—				—				258				0.01
Other			177			nm					38			nm
Total interest expense		$	268,618				5.13	%		$	137,501				3.07	%

          We define our weighted-average cost of total financing liabilities as total interest expense divided by the weighted-average amount of our financing liabilities during the period, including mortgage-backed notes, repurchase agreements, commercial paper, warehouse lending facilities and junior subordinated notes. Interest expense consists primarily of interest payments on our debt, amortization of premiums and discounts on our mortgage-backed notes and commercial paper, and amortization of debt issuance costs. Mortgage-backed securities issuance premiums are created when interest-only securities and other mortgage-backed securities are issued at prices greater than their principal value. Refer to the section titled “Critical Accounting Policies” for a description of our accounting policy for derivative instruments and hedging activities and the impact on interest expense in 2005. Weighted-average financing liabilities during the years ended December 31, 2006 and 2005 were $5.2 billion and $4.4 billion, respectively.

          Interest expense for the years ended December 31, 2006 and 2005 was $268.6 million and $137.5 million, respectively. The increase in interest expense is primarily due to higher rates on our funding liabilities related to the shift to mortgage-backed notes from repurchase agreements resulting from the transition from our spread strategy to our residential mortgage credit strategy, as well as an increase in the overall levels of both funding liabilities and interest rates between December 31, 2005 and December 31, 2006.

          Other income and expense for the years ended December 31, 2006 and 2005 was net other income of $0.9 million and net other expense of $112.9 million, respectively, as summarized in the following table (dollars in millions):

		For the Years Ended
		December 31,
		2006				2005
Realized gains (losses) on derivative instruments, net(1):
Sales of derivative contracts		$	2.6			$	1.0
Purchase commitment derivatives			3.7				(1.4	)
Unrealized gains (losses) on derivative instruments, net(1):
Change in fair value of derivative contracts			1.4				(0.4	)
Sub-total			7.7				(0.8	)
Other-than-temporary impairment losses			(7.0	)			(112.0	)
Sales of mortgage-backed securities:
Gains			10.0				—
Losses			(9.0	)			(0.1	)
Sub-total			1.0				(0.1	)
Other expense			(0.8	)			—
Total		$	0.9			$	(112.9	)

          During the year ended December 31, 2006, we sold mortgage-backed securities totaling $3.8 billion, primarily as a result of repositioning our balance sheet. During the year ended December 31, 2005, we sold $136.3 million of mortgage-backed securities to reduce leverage and rebalance our portfolios. Other income for the years ended December 31, 2006 and 2005 includes other-than-temporary impairment losses on mortgage-backed securities in our spread portfolio related to certain spread assets that we did not intend to hold until their maturity or their unrealized losses recovered.

          Operating expenses for the years ended December 31, 2006 and 2005 were $42.4 million and $13.9 million, respectively. The year-over-year increases in operating expenses are primarily due to increased operating expenses that are required to manage our residential mortgage credit strategy as well as increased management compensation and incentive compensation expenses related to the termination of our management agreement with SCM.

          During the quarter ended September 30, 2006, we completed our transition to full internal management after reaching agreement with SCM to terminate the management agreement described below. Because the management agreement has been terminated, we were no longer required to make regular quarterly “minimum” payments to SCM through 2007, nor did we need to accrue future incentive compensation expense for SCM. Instead, we paid SCM a total of $5.8 million in cash and accelerated the vesting of 138,233 shares of restricted common stock issued to SCM.

          We paid base management compensation and incentive compensation to SCM for the years ended December 31, 2006 and 2005 pursuant to a management agreement. We entered into an amended agreement with SCM, dated March 1, 2005, which superseded our original management agreement dated June 11, 2003, and revised the computation of base management compensation and incentive management compensation. See Note 8 to our consolidated financial statements in Item 8 of this Form 10-K for further discussion about the management agreement.

          Base management compensation expense for the year ended December 31, 2006 was $6.9 million, including the installment payments due to SCM related to the termination of the management agreement described above. Base management compensation for the year ended December 31, 2005 was $4.2 million. Pursuant to the management agreement, base management compensation due to SCM was calculated based on a percentage of our average net worth that was managed by SCM, and also was subject to a minimum fee. The amount of assets managed by SCM decreased substantially during the first quarter of 2006 and further decreased in the second and third quarters of 2006 as a result of redeploying assets from the spread portfolio managed by SCM into our other portfolios. Consequently, the base management fee calculated pursuant to the “average net worth” formula was lower than the minimum fee payment due to SCM of $0.7 million for the first and second quarters of 2006. As a result, $1.4 million of the base management compensation expense for the year ended December 31, 2006 represented the minimum fee due to SCM.

          Incentive compensation expense for the years ended December 31, 2006 and 2005 was $0.8 million and $1.3 million, respectively. The increase in expense is primarily related to the termination of the amended management agreement noted above. Under the amended management agreement, SCM did not earn any incentive compensation during the years ended December 31, 2006 and 2005. The incentive compensation expense during the years ended December 31, 2006 and 2005 related primarily to

restricted common stock awards granted for incentive compensation earned in prior periods that vested during the periods. The incentive compensation expense for the year ended December 31, 2006 also includes the final vesting of all of the restricted stock awards granted to SCM earned in prior periods in connection with the termination agreement. Effective September 30, 2006, we will no longer recognize incentive compensation expense related to restricted stock awards granted to SCM.

          Servicing expense, which is a required expense for all of our mortgage loans held-for-investment, was $12.0 million and $0.4 million for the years ended December 31, 2006 and 2005, respectively. The increase in servicing expense year over year is due to the increase in our residential mortgage loan portfolio. In addition, salaries and benefits were $9.5 million and $3.0 million for the years ended December 31, 2006 and 2005, respectively, and reflects the addition of three new employees during the fourth quarter of 2006 and 17 new employees during the year ended December 31, 2006. In addition, for year ended December 31, 2006, we recorded a provision for loan losses of $5.2 million, based on an analysis of our portfolio of loans held-for-investment at the end of the second, third and fourth quarters of 2006. The increase in provision for loan losses for the year ended December 31, 2006 compared to 2005 is due to the seasoning of our residential mortgage loan portfolio.

        REIT taxable income

          We calculate REIT taxable income according to the requirements of the Code, rather than GAAP. We believe that REIT taxable income is an informative measure of our financial performance because REIT taxable income, and not GAAP income, is the basis upon which we make our cash distributions to our stockholders that enable us to maintain our REIT qualification.

          We estimate our REIT taxable income based upon a variety of information from third parties. Due to the timing of the receipt of some of this information, we make estimates in order to determine our REIT taxable income and dividend distributions within a reporting period. As a result, our REIT taxable income estimates are subject to adjustments to reflect the receipt of information on past events. Our REIT taxable income is also subject to changes in the Code, or in the interpretation of the Code, with respect to our business model. REIT taxable income for each fiscal year does not become final until we file our tax return for that fiscal year.

Reconciliation of GAAP Net Income to REIT Taxable Income
(in thousands, except share and per share data)

		For the Year Ended December 31,
		2007				2006				2005
GAAP net income (loss)		$	(720,997	)		$	46,797			$	(82,991	)
Adjustments to GAAP net income (loss):
Interest income and expenses, net			(20,344	)			(26,676	)			1,142
Impairment losses on mortgage-backed securities			481,654				7,010				112,008
Provision for loan losses			39,191				5,193				—
Servicing expense			21,857				10,263				—
Warrant expense			526				—				—
Losses (gains) on sales of mortgage-backed securities, net			248,391				(993	)			69
Gains on derivative instruments			(32,105	)			—				—
Other, net			31,314				(695	)			1,086
Net adjustments to GAAP net income (loss)			770,484				(5,898	)			114,305
REIT taxable net income		$	49,487			$	40,899			$	31,314
REIT taxable net income per share		$	1.10			$	0.97			$	0.77
Average shares outstanding on dividend record dates during the year			44,992,807				42,163,918				40,667,532

Estimated Undistributed REIT Taxable Income
(dollars in thousands, except per share data)

		For the Year Ended December 31,
		2007				2006				2005
Undistributed REIT taxable net income, beginning of period		$	4,429			$	3,154			$	1,794
REIT taxable net income during period			49,487				40,899				31,314
Distributions declared during period, net of dividend equivalent rights on restricted common stock			(27,858	)			(39,410	)			(29,954	)
Other adjustments			5,157				(214	)			—
Undistributed REIT taxable net income, end of period		$	31,215			$	4,429			$	3,154
Cash distributions per share declared during period		$	0.62			$	0.925			$	0.77

          We believe that these presentations of our REIT taxable income are useful to investors because they are directly related to the distributions to stockholders we are required to make in order to retain our REIT qualification. REIT taxable income entails certain limitations, and by itself is an incomplete measure of our financial performance over any period. As a result, our REIT taxable income

should be considered in addition to, and not as a substitute for, our GAAP-based net income as a measure of our financial performance. The calculations of REIT taxable income above are estimated based on information currently known to us. Our calculations of REIT taxable income are not finalized until we file our tax return. Amounts could vary materially from our estimates disclosed herein.

          In addition to the estimated $31.2 million of undistributed REIT taxable income as of December 31, 2007, we have declared but suspended dividends in the amount of $13.6 million, net of dividend equivalent rights. In order to maintain our qualification as a REIT, we must declare a dividend on the undistributed amount and pay the declared dividends through a cash distribution or distribution-in-kind prior to September 15, 2008. Because these distributions were not made prior to December 31, 2007, we will incur an excise tax on a portion of our undistributed REIT taxable income at a rate of 4.00%, payable on March 15, 2008. Such excise tax has been accrued and is reflected in our consolidated statement of operations as of December 31, 2007. We are currently considering various options related to the payment of the dividend.

Financial Condition

     Mortgage-backed securities

          Our investment strategy includes purchases of U.S. agency and other AAA-rated single-family adjustable-rate and hybrid adjustable-rate mortgage-backed securities and purchases of credit-sensitive residential mortgage-backed securities and other asset-backed securities that have credit ratings below AAA.

          The following table presents our mortgage-backed securities classified as either residential mortgage credit portfolio assets or spread portfolio assets and further classified by type of issuer and/or by rating categories.

Asset Quality
(dollars in thousands)

		December 31, 2007								December 31, 2006
						Percentage of								Percentage of
						Total								Total
						Mortgage-								Mortgage-
						backed								backed
		Fair Value				Securities				Fair Value				Securities
Residential Mortgage Credit Portfolio
Investment-grade MBS:
AA/Aa rating		$	27,747				6.4	%		$	129,096				4.4	%
A/A rating			70,802				16.1				238,623				8.1
BBB/Baa rating			40,904				9.4				273,359				9.3
Total Investment-grade MBS			139,453				31.9				641,078				21.8
Weighted-average credit rating			A								A-
Non-investment-grade MBS:
BB/Ba rating			44,101				10.1				145,741				5.0
B/B2 rating			7,621				1.8				—				—
CCC/Caa and below			35,986				8.3				—				—
Not rated			4,177				1.0				11,196				0.4
Total non-investment-grade MBS			91,885				21.2				156,937				5.4
Weighted-average credit rating (1)			B							BB
Total residential mortgage credit portfolio			231,338				53.1				798,015				27.2
Weighted-average credit rating (1)		BBB								BBB+
Spread Portfolio
Agency MBS			—				—				106,648				3.7
AAA/Aaa rating			204,547				46.9				2,026,275				69.1
Total spread portfolio			204,547				46.9				2,132,923				72.8
Weighted-average credit rating		AAA								AAA
Total mortgage-backed securities		$	435,885				100.0	%		$	2,930,938				100.0	%
Weighted-average credit rating			A							AA

Loans held-for-investment

Residential Loans Held-For Investment Product Data
(dollars in thousands)

														Weighted-
														Average
														Months to
														Reset of												Seriously								Number of
														Loans After								Principal				Delinquent								Seriously
		Weighted-				Weighted-				Weighted-				Effect of								Amount of				Loans as a				Number of				Delinquent
		Average				Average				Average				Cost of								Seriously				Percentage of				Seriously				Loans as a
		Interest				Maturity				Months to				Funds				Principal				Delinquent				Total				Delinquent				Percentage of
		Rate				Date				Reset				Hedging (1)				Balance				Loans (2)				Principal				Loans (2)				Total Loans
December 31, 2007
Floating rate mortgage			8.15	%			2038				1				1			$	3,045,983			$	199,985				4.84	%			451				4.30	%
Hybrid mortgage			6.61	%			2036				47				20				1,087,837				54,062				1.31				150				1.43
Total			7.72	%			2037				12				5			$	4,133,820			$	254,047				6.15	%			601				5.73	%
December 31, 2006
Floating rate mortgage			8.02	%			2037				1				1			$	4,089,015			$	20,830				0.38	%			45				0.33	%
Hybrid mortgage			6.57	%			2036				54				33				1,383,310				13,053				0.24				30				0.21
Total			7.65	%			2037				14				9			$	5,472,325			$	33,883				0.62	%			75				0.54	%

          At December 31, 2007 and December 31, 2006, our residential mortgage loans held-for-investment included unamortized premium of $95.7 million and $124.4 million, respectively. Our residential mortgage loans at December 31, 2007 consisted of $4.1 billion mortgage loans that collateralize mortgage-backed notes. Our residential mortgage loans held-for-investment at December 31, 2006 consisted of $4.7 billion of mortgage loans that collateralized mortgage-backed notes and $0.8 billion of unsecuritized adjustable-rate mortgage loans.

Residential Mortgage Loans Key Metrics
(dollars in thousands)

		December 31, 2007				December 31, 2006
Unpaid principal balance		$	4,133,820			$	5,472,325
Number of loans			10,491				13,942
Average loan balance		$	394			$	393
Weighted-average coupon rate			7.71	%			7.65	%
Weighted-average lifetime cap			10.66	%			10.64	%
Weighted-average original term, in months			376				375
Weighted-average remaining term, in months			356				366
Weighted-average effective loan-to-value ratio (LTV)(1)			71.8	%			72.6	%
Weighted-average FICO score			711				713
Number of loans with FICO scores below 620			8				11
Percentage of loans with FICO scores above 700			55.6	%			58.5	%
Percentage of loans with LTV greater than 80%			7.2	%			6.8	%
Percentage of loans with LTV greater than 90%			1.3	%			1.3	%
Percentage of loans with effective LTV greater than 80% (1)			0	%			0	%
Percentage of no documentation loans			2.2	%			2.5	%
Percentage of loans originated for refinancing purposes			58.3	%			58.0	%
Top five geographic concentrations (% exposure):
California			56.5	%			57.4	%
Florida			9.7	%			8.6	%
Arizona			4.3	%			4.1	%
Virginia			3.9	%			3.7	%
Nevada			3.7	%			3.4	%
Occupancy status:
Owner-occupied			85.8	%			86.5	%
Investor			14.2	%			13.5	%
Property type:
Single-family			83.1	%			83.6	%
Condominium			10.2	%			9.7	%
Other residential			6.7	%			6.7	%
Collateral type:
Alt A – first lien			100.0	%			100.0	%

          The following table presents our residential mortgage loan portfolio grouped by the percentages in each of three different documentation types, further stratified by loan-to-value ratios, net of mortgage insurance, and FICO scores:

Residential Mortgage Loan Quality

		FICO Scores
December 31, 2007		<620				620-659				660-699				700-739				740+				Total
Full Documentation:(1)
LTV:
<60%			0.0	%			0.2	%			0.2	%			0.2	%			0.2	%			0.8	%
60.01 – 70%			0.0				1.1				1.9				1.9				2.1				7.0
70.01 – 80%			0.0				1.6				2.4				1.9				2.1				8.0
> 80%			0.0				0.0				0.0				0.0				0.0				0.0
Total Full Documentation			0.0	%			2.9	%			4.5	%			4.0	%			4.4	%			15.8	%
Reduced Documentation:(2)
LTV:
<60%			0.0	%			0.5	%			1.3	%			1.3	%			2.1	%			5.2	%
60.01 – 70%			0.0				2.1				10.7				9.3				7.7				29.8
70.01 – 80%			0.1				3.8				16.7				14.8				11.6				47.0
> 80%			0.0				0.0				0.0				0.0				0.0				0.0
Total Reduced Documentation			0.1	%			6.4	%			28.7	%			25.4	%			21.4	%			82.0	%
No Documentation:(3)
LTV:
<60%			0.0	%			0.0	%			0.2	%			0.2	%			0.2	%			0.6	%
60.01 – 70%			0.0				0.1				0.3				0.4				0.5				1.3
70.01 – 80%			0.0				0.0				0.1				0.1				0.1				0.3
> 80%			0.0				0.0				0.0				0.0				0.0				0.0
Total No Documentation			0.0	%			0.1	%			0.6	%			0.7	%			0.8	%			2.2	%
Total Portfolio:
LTV:
<60%			0.0	%			0.7	%			1.7	%			1.7	%			2.5	%			6.6	%
60.01 – 70%			0.0				3.3				12.9				11.6				10.3				38.1
70.01 – 80%			0.1				5.4				19.2				16.8				13.8				55.3
> 80%			0.0				0.0				0.0				0.0				0.0				0.0
Total Portfolio			0.1	%			9.4	%			33.8	%			30.1	%			26.6	%			100.0	%