Arlington Asset Investment Corp. - Annual Report: 2008 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2008

OR

For the transition period from              to             

Commission File Number: 000-50230

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

(Exact name of registrant as specified in its charter)

1001 Nineteenth Street North,

Arlington, VA 22209

(Address of Principal Executive Offices) (Zip Code)

(703) 312-9500

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

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  ¨    No  x

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  ¨    No  x

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 filing requirements for the past 90 days:    Yes  x    No  ¨

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 definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K:  x

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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

The aggregate market value of the registrant’s voting equity held by nonaffiliates computed by reference to the price at which the registrant’s Class A common stock was last sold on June 30, 2008 was approximately $178 million. All shares of the registrant’s voting Class B common stock outstanding as of June 30, 2008 were held by affiliates of the registrant and have been excluded from this computation. In addition, all shares of Class A common stock beneficially owned on such date by the registrant’s directors, executive officers and each person who beneficially owned 10% or more of the registrant’s outstanding voting securities as of such date have been excluded from this computation. By doing so, the registrant does not admit that such persons are “affiliates” within the meaning of Rule 405 of the Securities Act of 1933, as amended, or for any other purpose.

As of February 27, 2009, there were 147,836,686 shares of Class A common stock outstanding and 11,372,293 shares of Class B common stock outstanding.

Documents incorporated by reference: Portion’s of the registrant’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders (to be filed with the Securities and Exchange Commission on or before April 30, 2009) are incorporated by reference in the Annual Report on Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

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CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING INFORMATION

This Annual Report on Form 10-K and the information incorporated by reference in this Annual Report on Form 10-K include forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended (Exchange Act). Some of the forward-looking statements can be identified by the use of forward-looking words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “plans,” “estimates” or “anticipates” or the negative of those words or other comparable terminology. Statements concerning projections, future performance developments, events, revenues, expenses, earnings, run rates, and any other guidance on present or future periods constitute forward-looking statements. Such statements include, but are not limited to, those relating to the effects of growth, our principal investing activities, levels of assets under management and our current equity capital levels. Forward-looking statements involve risks and uncertainties. You should be aware that a number of important factors could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to:

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We will not necessarily update the information presented or incorporated by reference in this Annual Report on Form 10-K if any of these forward looking statements turn out to be inaccurate. Risks affecting our business are described throughout this Annual Report on Form 10-K. This entire Annual Report on Form 10-K, including the consolidated financial statements and the notes and any other documents incorporated by reference into this Annual Report on Form 10-K should be read for a complete understanding of our business and the risks associated with that business.

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PART I

Unless the context otherwise requires or indicates, all references in this Annual Report on Form 10-K to “we,” “us,” “our,” the “Company,” “FBR,” and “FBR Group” refer to Friedman, Billings, Ramsey Group, Inc. and its consolidated subsidiaries, including FBR Capital Markets Corporation.

Our Company

Friedman, Billings, Ramsey Group, Inc. invests on a leveraged basis in residential mortgage-backed securities (MBS), either issued by a U.S. Government agency, or guaranteed as to principal and interest by U.S. Government agencies or U.S. Government-sponsored entities (agency-backed MBS). We also invest in both MBS issued by private organizations (private-label MBS) and net interest margin securities and we make merchant banking investments, subject to maintaining our exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (1940 Act).

In addition to our principal investing business described above, as of December 31, 2008, we beneficially owned 57% of the outstanding shares of common stock of FBR Capital Markets Corporation (FBR Capital Markets), a publicly-traded holding company (NASDAQ: FBCM) for various subsidiaries that conduct capital markets (investment banking and institutional brokerage), asset management and merchant banking businesses. These subsidiaries include Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.), Friedman, Billings, Ramsey International, Ltd. (FBRIL), FBR Investment Management, Inc. (FBRIM) and FBR Fund Advisors, Inc. (FBR Fund Advisors). FBR Capital Markets is managed under the direction of its board of directors, a majority of whom are independent of both us and FBR Capital Markets. As a result of our ownership of a majority of the issued and outstanding shares of common stock of FBR Capital Markets, our financial statements reflect our proportionate interest in the results of operations of FBR Capital Markets and its subsidiaries.

We are a Virginia corporation and our principal executive offices are located at Potomac Tower, 1001 Nineteenth Street North, Arlington, Virginia, 22209.

Recent Developments

On October 23, 2008, we announced our plan to downsize the MBS portfolio in order to reduce exposure to deteriorating market conditions while at the same time generating additional cash to fund the extinguishment of long-term debt. We also announced that we have retained financial advisors to evaluate strategic alternatives for the purpose of maximizing the value of our assets and liabilities including all of the trust preferred debt. Potential strategic alternatives include the sale of the Company or the assets or the distribution of the assets to shareholders. Consistent with this strategy, during the twelve months ended December 31, 2008, we extinguished approximately $65.8 million of long-term debt at a gain of approximately $39.1 million and disposed of approximately $1.6 billion of MBS from our MBS portfolio at a net loss of approximately $108.6 million. Subsequent to December 31, 2008 and through March 13, 2009, we extinguished an additional $201.7 million of long-term debt at a gain of approximately $131.5 million and disposed of an additional $56.1 million of MBS from our MBS portfolio at a loss of $1.1 million, substantially completing the current phase of our strategy announced on October 23, 2008. In addition, FBR Capital Markets also liquidated its remaining MBS portfolio of $454.3 million and related interest rate caps and repurchase agreements, recognizing an aggregate net investment loss of $1.0 million. We also liquidated $550.0 million of U.S. Treasury bonds and extinguished related repurchase agreement borrowings, recognizing no gain or loss from the transaction.

On February 23, 2009, we announced that we have begun doing business under the name “Arlington Asset Investment Corporation” and that we will seek shareholder approval at our next annual meeting of shareholders of a proposal to amend our charter to change our corporate name from “Friedman, Billings, Ramsey Group, Inc.” to “Arlington Asset Investment Corporation.” The Company had notified the New York Stock Exchange (NYSE) of the name change and received the approval from the NYSE to change the ticker symbol to “AI” from “FBR” on February 24, 2009. The Company will issue a press release when the symbol change becomes effective.

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We have elected to revoke our status as a REIT effective as of January 1, 2009, in part to use the net operating loss (NOL) carry-forwards and net capital loss (NCL) carry-forwards incurred at the parent company level to offset the taxable income of our former taxable REIT subsidiaries (TRSs). At December 31, 2008, we had $391.1 million of NOL carry-forwards and $521.1 million of NCL carry-forwards. Additionally, at December 31, 2008, our former wholly-owned TRSs had $52.0 million of NOL carry-forwards and no NCL carry-forwards. Our NCL carry-forwards and NOL carry-forwards will begin to expire in 2011 and 2027, respectively (see Note 9 to our consolidated financial statements). As a result of the taxable income recognized from the extinguishment of a portion of our former TRSs’ long-term debt during the first quarter of 2009 (described above), we anticipate that the taxable income of our former TRSs during the 2009 taxable year will exceed their NOL carry-forwards and current deductions. We could not use the NOL carry-forwards incurred at the parent level to offset the anticipated taxable income of our former TRSs unless we revoked or terminated our status as a REIT. Even though revoking our REIT status will allow us to use parent-level NOL carry-forwards against our former TRSs’ taxable income, we will still have at least some tax liability for 2009 and subsequent years that is attributable to federal alternative minimum tax and state taxes.

In addition, revoking our REIT status frees us from the income, asset, distribution, and stock ownership requirements applicable to REITs, which will provide us with more flexibility in executing our business strategy. Specifically, because we are no longer required to derive a significant portion of our income from mortgage or other real estate related investments, we will have greater flexibility to invest in other types of assets as part of our principal investing activity, subject to maintaining compliance with our exclusion from regulation as an investment company under the 1940 Act. In addition, because we will no longer be subject to the REIT distribution requirement, we will have greater flexibility to retain our earnings to fund future growth. Accordingly, based on the foregoing, our Board of Directors determined that it was in the best interests of our shareholders to revoke our status as a REIT effective as of January 1, 2009.

Available Information

You may read and copy the definitive proxy materials and any other reports, statements or other information that we file with the United States Securities and Exchange Commission (SEC or Commission) at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549. You may call the SEC at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public from commercial document retrieval services and at the Internet worldwide web site maintained by the SEC at http://www.sec.gov. These SEC filings may also be inspected at the offices of the New York Stock Exchange (NYSE), which is located at 20 Broad Street, New York, New York 10005.

Our website address is http://www.fbr.com. This website address will be changed to www.arlingtonasset.com in the near future in connection with our name change. We make available free of charge through our website this Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as well as the annual report to shareholders and Section 16 reports on Forms 3, 4 and 5 as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. In addition, our Articles of Incorporation, Bylaws, Statement of Business Principles (our code of ethics), Corporate Governance Guidelines, and the charters of our Audit, Compensation, Nominating and Governance and Risk Policy and Compliance Committees are available on our website and are available in print, without charge, to any shareholder upon written request in writing c/o our Secretary at 1001 Nineteenth Street North, Arlington, Virginia 22209. Information on our website should not be deemed to be a part of this report or incorporated into any other filings we make with the SEC.

Employees

As of December 31, 2008, we had 579 employees, of which 568 were employed by FBR Capital Markets and its subsidiaries. Our employees are not subject to any collective bargaining agreement and we believe that we have excellent relations with our employees.

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Financial Information by Segment

Prior to 2008, we operated for management reporting purposes in four business segments: principal investing, capital markets, asset management and mortgage banking. In January 2008, First NLC Financial Services, LLC (First NLC), our historic mortgage origination subsidiary, which we acquired in 2005, filed a voluntary petition for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code and later converted to a proceeding under Chapter 7 of the United States Bankruptcy Code, and we deconsolidated First NLC for financial reporting purposes. Since the deconsolidation of First NLC in the beginning of 2008, we have used the cost method of accounting to reflect our investment in First NLC. In the second quarter of 2006, we contributed our capital markets and asset management businesses to FBR Capital Markets. As a result of our passive, majority investment in FBR Capital Markets, we have continued to reflect our proportionate interest in FBR Capital Markets’ capital markets, asset management and principal investing businesses in our reportable segments.

Financial information concerning our Company as of December 31, 2008 and 2007 and for the fiscal years ended December 31, 2008, 2007 and 2006, including the amount of net revenues contributed by each segment in such periods, is set forth in our consolidated financial statements and the notes thereto in Part II, Item 8, of this Annual Report on Form 10-K. Information with respect to our operations by business segment is set forth under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Executive Overview” in Part II, Item 7, of this Annual Report on Form 10-K and in Note 17 to our consolidated financial statements in Part II, Item 8, of this Annual Report on Form 10-K.

Our Principal Investing Business

As of December 31, 2008, the majority of our principal investing activity consists of investing in U.S. Treasury bonds, agency-backed MBS and other mortgage assets, on a leveraged basis. We also invest in merchant banking opportunities, including investments in equity securities, mezzanine debt and senior loans. We constantly evaluate the rates of return that can be achieved in each investment category and for each individual investment in which we participate. We continuously evaluate investment opportunities against the returns available in each of our investment alternatives and attempt to allocate our assets and capital with an emphasis toward what we believe to be the highest risk-adjusted return available. This strategy will cause us to have different allocations of capital in different environments.

We may change our mortgage investment strategy, hedging strategy, asset allocation and operational policies at any time without the consent of our shareholders, which could result in our making investments or hedges that are different from, and possibly riskier than, the investments and hedges described in this Annual Report on Form 10-K. A change in our investment or hedging strategy may increase our exposure to interest rate, and real estate market fluctuations. A change in our asset allocation could result in us making investments in instrument categories different from those described in this Annual Report on Form 10-K. Our Board of Directors determines our operational policies and may amend or revise our policies, including those with respect to our acquisitions, growth, operations, indebtedness, capitalization and distributions or approve transactions that deviate from these policies without a vote of, or notice to, our shareholders. Operational policy changes could adversely affect the market value of our common stock and our ability to make distributions to our shareholders.

Liquidity, or ready access to funds, is essential to our business. Failures of similar businesses have often been attributable in large part to insufficient liquidity. Liquidity is of particular importance to our business and perceived liquidity issues may affect our clients’ and counterparties’ willingness to engage in transactions with us. Our liquidity could be impaired due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects us or third parties. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time. Additionally, our access to funds held by FBR Capital Markets and its subsidiaries is subject to approval by a majority of the disinterested directors serving on the FBR Capital Markets Board of Directors. We cannot guarantee that we will be able to access these funds. Regulatory requirements applicable to FBR Capital Markets’ broker-dealer

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subsidiaries could also limit our ability to access funds held by FBR Capital Markets and its subsidiaries. We cannot guarantee that we will be able to access funds from our subsidiaries to meet our obligations as they come due. If we cannot obtain funding from third parties or from our subsidiaries, our results of operations could be negatively impacted.

Our MBS Portfolio—Investment Strategy

Consistent with the plan announced on October 23, 2008, we downsized our MBS portfolio in order to reduce exposure to deteriorating market conditions and to generate cash to fund the extinguishment of our long-term debt. As a result, through December 31, 2008, we liquidated $1.6 billion in MBS at a loss of $108.6 million in connection with the strategy announced on October 23, 2008. As of December 31, 2008, the fair value of our MBS portfolio was $594.3 million. The net yield on our MBS for the fourth quarter of 2008 was 3.90%, with a corresponding cost of funds of 2.85%.

The following table summarizes our portfolio of MBS (including principal receivable) by issuer as of December 31, 2008:

We invest directly in residential MBS guaranteed as to principal and interest by Fannie Mae, Freddie Mac or Ginnie Mae (referred to as agency-backed MBS). The market value of these securities, however, is not guaranteed by these companies. The following is a description of the agency-backed MBS in which we invest:

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As of December 31, 2008, we held approximately $188.5 million of private-label MBS having an estimated fair value of approximately $65.9 million. Private-label MBS are MBS that are not issued by a U.S. Government agency or a U.S. Government-sponsored entity, such as Fannie Mae, Freddie Mac or Ginnie Mae and that are backed by a pool of single-family residential mortgage loans. These certificates are issued by originators of, investors in, and other owners of residential mortgage loans, including savings and loan associations, savings banks, commercial banks, mortgage banks, investment banks and special purpose “conduit” subsidiaries of these institutions. While agency-backed MBS are backed by the express obligation or guarantee of Fannie Mae, Freddie Mae, or Ginnie Mae as described above, private-label MBS are generally covered by one or more forms of private (i.e., non-governmental) credit enhancement. These credit enhancements provide an extra layer of loss coverage in the event that losses are incurred upon foreclosure sales or other liquidations of underlying mortgaged properties in amounts that exceed the equity holder’s equity interest in the property. Forms of credit enhancement include limited issuer guarantees, reserve funds, private mortgage guaranty pool insurance, over-

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collateralization and subordination. Subordination is a form of credit enhancement frequently used and involves the issuance of classes of senior and subordinated MBS to allocate losses on the underlying mortgage loans. Typically, one or more classes of senior MBS are created which are rated in one of the two highest rating levels by one or more nationally recognized rating agencies and which are supported by one or more subordinated MBS that bear losses on the underlying mortgage loans prior to the classes of senior MBS.

MBS differ from other forms of traditional fixed-income securities which normally provide for periodic payments of interest in fixed amounts with principal payments at maturity. Instead, MBS provide for a monthly payment that consists of both interest and principal. In effect, these payments are a “pass-through” of the monthly interest and principal payments made by borrowers on their mortgage loans, net of any fees paid to the servicer or guarantor of the MBS securities. In addition, outstanding principal on the MBS may be prepaid at any time due to prepayments on the underlying mortgage loans. These differences can result in significantly greater price and yield volatility than is the case with more traditional fixed-income securities. Whole mortgage loans and other mortgage assets share many of the characteristics of MBS.

We manage our portfolio of mortgage investments to provide a high risk-adjusted return on capital. Our principal investment strategy is to invest predominantly in adjustable-rate, agency-backed MBS of varying initial fixed periods and to finance these investments with short-term borrowings (generally 30 to 90 days). From time to time, we may invest in fixed-rate, agency-backed MBS financed with short-term borrowings. Although the coupon on adjustable-rate MBS will change over time, there are aspects of the security that result in the coupon being fixed for a period of time or the change in the coupon being limited. A significant portion of the adjustable-rate MBS are backed by mortgages that have fixed coupons for three to five years before adjusting annually thereafter (these types of securities are referred to as hybrid adjustable rate MBS). The initial fixed period results in the MBS having a longer duration than the short-term borrowings financing these investments. In addition, adjustable-rate mortgage loans typically have caps and floors that limit the maximum amount by which the mortgage coupon may be increased or decreased at periodic intervals or over the life of the security. To the extent that interest rates rise faster than mortgage rates are allowed to increase based on the interest rate caps, the change in the mortgage coupon may not fully offset increases in our funding costs.

Our MBS Portfolio—Use of Leverage

Because of the interest rate risk inherent in our investment strategy, we closely monitor the leverage (debt-to-equity ratio) of our agency-backed MBS portfolio. However, from time to time, the leverage may increase or decrease due to changes in the value of the underlying portfolio investments and the timing and amount of re-investments.

We may reduce the amount of equity capital we have invested in agency-backed MBS or other mortgage assets, by funding a portion of those investments with repurchase agreements, commercial paper, to the extent commercial paper is available on favorable terms or at all, or other borrowing arrangements. To the extent that revenue derived from those assets exceeds our interest expense and other costs of the financing, our net income will be greater than if we had not borrowed funds and had not invested in the assets. Conversely, if the revenue from our MBS and other mortgage assets does not sufficiently cover the interest expense and other costs of the financing, our net income will be less or our net loss will be greater than if we had not borrowed funds. Current conditions in the credit markets may make it impracticable for us to obtain short-term commercial paper financing for our agency-backed MBS portfolio.

Our MBS Portfolio—Hedging and Interest Rate Risk Management Strategy

We follow an interest rate risk management program intended to protect our MBS portfolio against the effects of major interest rate changes. Generally, our interest rate risk management program is formulated with the intent to ameliorate the potential adverse effects resulting from differences in the amount and timing of rate adjustment to our assets versus those affecting our corresponding liability. Our agency-backed MBS hedging strategy includes an element of reliance on coupon repricing of assets in addition to hedging our liability cost.

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Additionally, our interest rate risk management program may encompass from time to time a number of procedures, including the following:

We adjust the average maturity adjustment periods of our borrowings on an ongoing basis by changing the mix of maturities and interest rate adjustment periods as borrowings come due and are renewed. Through use of these procedures, we attempt to minimize the differences between the interest rate adjustment periods of our MBS and other mortgage assets and related borrowings that may occur.

We purchase from time-to-time interest rate swaps, interest rate collars, interest rate caps or floors, and similar financial instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the yield on our assets during a period of rising interest rates or to mitigate prepayment risk. It is not our policy to use derivatives to speculate on interest rates. These derivative instruments have an active secondary market and are intended to provide income and cash flow to offset potential reduced interest income and cash flow under certain interest rate environments. Certain of our interest rate management activities qualify for hedge accounting in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted (SFAS 133). We report the derivative financial instruments and any related margin accounts on our consolidated balance sheets at their fair value. We may hedge as much of the interest rate risk as our management determines is in our best interests, given the cost of the hedging transactions. This determination may result in our electing to bear a level of interest rate or prepayment risk that could otherwise be hedged when management believes, based on all relevant facts, that the cost of hedging exceeds the level of risk that management believes is present.

We seek to build a balance sheet and undertake an interest rate risk management program which is likely to generate positive earnings and maintain an equity liquidation value sufficient to maintain operations given a variety of potential environments. Our interest rate risk management strategies also provide support for our leverage strategies. In determining our target leverage, we monitor, among other things, our “duration.” This is the expected percentage change in market value of our assets that would be caused by a 1% change in short and long-term interest rates. To monitor duration and the related risks of fluctuations in the liquidation value of our equity, we model the impact of various economic scenarios on the market value of our MBS and other mortgage assets and liabilities. See additional discussion of interest rate risk relative to our leveraged portfolio of MBS and other mortgage assets included in “Quantitative and Qualitative Disclosures about Market Risk” in Part II, Item 7A, of this Annual Report on Form 10-K. We believe that our interest rate risk management program will allow us to maintain operations throughout a wide variety of potentially adverse circumstances. Nevertheless, in order to further preserve our capital base during periods when we believe a trend of rapidly rising interest rates has been established, we may decide to enter into or increase hedging activities or to sell assets. Each of these actions may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term.

We believe that we maintain a cost-effective asset/liability management program to provide a level of protection against interest rate and prepayment risks. However, no strategy can completely insulate us from interest rate changes and prepayment risks. In addition, asset/liability management involves transaction costs which increase dramatically as the period covered by the hedging protection increases. Therefore, we may be unable to hedge effectively our interest rate and prepayment risks.

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Our MBS Portfolio—Prepayment Risk Management

Mortgage prepayments are affected by factors including the level of interest rates, general economic conditions, the location and age of the mortgage, and other social and demographic conditions. Generally, prepayments on MBS and other mortgage assets increase during periods of falling mortgage interest rates and decrease during periods of rising mortgage interest rates. Reinvestment of prepayments may occur at higher or lower interest rates than the original investment, thus affecting the yield on our portfolio.

We seek to minimize the effects of faster or slower than anticipated prepayment rates through structuring a diversified portfolio with a variety of prepayment characteristics, investing in fixed-rate agency-backed MBS and other mortgage assets, investing in certain mortgage structures which have prepayment protections and balancing assets purchased at a premium with assets purchased at a discount. We monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.

Our Other Principal Investing Activities—Our Merchant Banking Portfolio

Our merchant banking investment strategy has been to invest in companies that compete in industries where we have investment expertise and a contextual understanding of industry dynamics. We rely on the investment banking group of Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.), which is the principal broker-dealer subsidiary of FBR Capital Markets, to provide us with potential merchant banking investment opportunities. Our merchant banking investment decisions are primarily based on a fundamental value-oriented approach. Almost all of our investments are in companies that are also investment banking clients of our affiliate. We are long-term investors but do not seek to control the companies in which we invest. In most cases, we intend to hold our merchant banking investments for greater than six months. Because of our broker-dealer affiliation, many of our investments in companies that are our investment banking clients are subject to lock-up restrictions which limit our ability to sell securities for a period of time.

Subject to maintaining our exclusion from regulation as an investment company under the Investment Company Act, we make merchant banking investments from time to time, primarily in equity securities of companies underwritten or privately placed by FBR Capital Markets’ broker-dealer subsidiaries. We follow a fundamental value-oriented investment approach and focus on the intrinsic value of the underlying business. We also consider factors such as strength of management, liquidity of the investment and prices of similar or comparable securities and/or companies.

As of December 31, 2008, we had invested in equity securities of various publicly-traded and privately-held companies having an estimated fair value of $40.2 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Principal Investing—Merchant Banking” in Part II, Item 7, of this Annual Report on Form 10-K.

Although our merchant banking investments have focused primarily on equities, we evaluate and from time to time and may invest in short to medium-term mezzanine and senior loans that may have a higher risk credit profile and yield higher returns than the typical senior loan made by a commercial bank or other traditional lending institution. In addition to the above considerations for an equity investment, we also consider the structural characteristics of mezzanine or senior loan investments. These loans may or may not be secured, may or may not be subordinated, have a variety of repayment structures and sources and typically compensate for the higher risk profile through higher interest rates rather than equity features.

We evaluate our merchant banking portfolio to recognize as other-than-temporary impairment the amounts by which the fair value of certain of our merchant banking investments were below their respective cost bases. In 2008, we recognized a $39.0 million non-cash write-down of equity positions in our merchant banking portfolio, reflecting general market conditions.

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FBR Capital Markets

As a result of our ownership of a majority of the issued and outstanding shares of common stock of FBR Capital Markets, our financial statements reflect the consolidated results of all of FBR Capital Markets’ operations. For more information regarding FBR Capital Markets’ businesses, please refer to the information under the headings “Business” (Part I, Item 1), which is incorporated by reference herein, and “Risk Factors” (Part I, Item 1A) in the FBR Capital Markets Form 10-K, also is incorporated by reference herein. You may obtain a copy of the FBR Capital Markets Annual Report on Form 10-K for the year ended December 31, 2008 from the SEC’s website (http://www.sec.gov) and from the FBR Capital Markets’ website (http://www.fbrcapitalmarkets.com). Information on or connected to the FBR Capital Markets’ website is not a part of or incorporated by reference in this Annual Report on Form 10-K unless otherwise expressly provided herein.

Capital Markets Business

FBR Capital Markets’ capital markets business, which is conducted by FBR Capital Markets’ investment banking and institutional brokerage (sales and trading and research) professionals through FBR & Co., and FBRIL, FBR Capital Markets’ broker-dealer subsidiaries. These professionals provide investment banking services, including capital raising and financial advisory services, and institutional brokerage services including sales and trading and research services, to our institutional clients across our core industry sectors.

FBR Capital Markets provides capital raising services in industry specific investment banking teams that operate across the following core industry sectors: consumer, diversified industrials, energy and natural resources, financial institutions, insurance, real estate and technology, media, and telecommunications (TMT), and these teams work closely with FBR Capital Markets’ mergers and acquisitions (M&A) investment banking group in connection with the delivery of financial advisory services. FBR Capital Markets also has a financial sponsors investment banking group that works closely with our industry-focused investment banking teams to deliver a full array of investment banking products and solutions to the private equity community and their portfolio companies.

Through its institutional brokerage professionals, FBR Capital Markets provides research and institutional sales and trading services to equity and high-yield investors in North America, Europe and elsewhere. FBR Capital Markets executes securities transactions for institutional investors such as mutual funds, insurance companies, hedge funds, banks, money managers and pension and profit-sharing plans. FBR Capital Markets institutional brokerage professionals provide trade execution and sales and trading services to a diverse institutional client base of more than 1,900 institutional investor accounts as of December 31, 2008.

Both we and FBR Capital Markets understand the importance of research and the role it plays in the institutional brokerage process, particularly for accounts that do not maintain a large in-house research team. As of December 31, 2008, FBR Capital Markets’ research analysts performed independent research on over 375 companies to help its clients understand the dynamics that drive the sectors and companies they cover.

Asset Management Business

As of December 31, 2008, FBR Capital Markets had approximately $1.4 billion in assets under management. At December 31, 2008, FBR Capital Markets managed client assets in excess of $1.2 billion through its traditional asset class equity and specialty mutual fund product lines as well as its money market fund.

FBR Capital Markets also manages hedge funds, including funds of funds, as well as private equity and venture capital funds. FBR Capital Markets, through its investment adviser subsidiary, FBRIM, has dedicated sales, compliance, investor relations and accounting personnel for its alternative asset management platform in addition to the supervisory and risk management personnel provided by FBR Capital Markets. In addition, FBR

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Capital Markets provides comprehensive private wealth management services to high net worth individuals, families and foundations through FBRIM’s Private Wealth group.

Accounting, Administration and Operations

Our accounting, administration and operations personnel are responsible for financial controls, internal and external financial reporting, human resources and personnel services, office operations, information technology and telecommunications systems, the processing of securities transactions, and corporate communications. With the exception of payroll processing, which is performed by an outside service bureau, and customer account processing, which is performed by our clearing brokers, most data processing functions are performed internally.

Compliance, Legal, Risk Management and Internal Audit

Our compliance, legal and risk management personnel (together with other appropriate personnel) are responsible for our compliance procedures with regard to the legal and regulatory requirements of our holding company and our operating businesses and for our procedures with regard to our exposure to market, credit, operations, liquidity, compliance, legal, reputational and equity ownership risk. In addition, our internal audit and compliance personnel test and audit for compliance by our personnel with our policies and procedures. Our legal personnel also provide legal service throughout our company, including advice on managing legal risk. The supervisory personnel in these areas have direct access to, and meet regularly with, our executive management and with the Audit Committee and the Risk Policy and Compliance Committee of our Board of Directors to ensure their independence in performing these functions. Pursuant to its charter, the Audit Committee has oversight of the staffing, qualifications and performance of our internal audit function. In addition to our internal compliance, legal, risk management and internal audit personnel, we outsource particular functions to outside consultants and attorneys for their particular expertise.

Competition

Our success depends, in large part, on our ability to acquire MBS and other mortgage-related assets at favorable spreads over our borrowing costs. In acquiring these assets, we compete with mortgage REITs, mortgage finance and specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders, governmental bodies and other entities. In addition, there are numerous mortgage REITs with similar asset acquisition objectives and others may be organized in the future. FBR Capital Markets may provide investment banking and financial advisory services to these mortgage REITs. The effect of the existence of additional mortgage REITs may be to increase competition for the available supply of agency-backed MBS, including CMOs, and other mortgage-related assets suitable for purchase by us. Moreover, the U.S. Treasury announced a program to purchase Fannie Mae-guaranteed and Freddie Mac-guaranteed agency-backed MBS in the open market pursuant to a congressional authority that expires December 31, 2009. The size and timing of the purchases are in the discretion of the U.S. Treasury Secretary and will be based on developments in the capital markets and housing markets. In addition, on November 25, 2008, the Federal Reserve announced that it will initiate a program to purchase $500.0 billion in mortgage-backed securities backed by Fannie Mae, Freddie Mac and Ginnie Mae. The purchases began in early January 2009. One of the effects of these programs has been, and may continue to be, to increase the price of agency-backed MBS and thereby decrease our net interest margin with respect to any agency securities we buy in the future. In addition, competition is also intense for the recruitment and retention of qualified professionals. Our ability to continue to compete effectively in our businesses will depend upon our continued ability to attract new professionals and retain and motivate our existing professionals. For a further discussion of the competitive factors affecting our business, see “Risk Factors” in Part I, Item 1A, of this Annual Report on Form 10-K.

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Risk Management

In conducting our business, we are exposed to a range of risks including, without limitation:

We have a corporate-wide risk management program approved by our Board of Directors. This program sets forth various risk management policies, provides for a risk management committee and assigns risk management responsibilities. The program is designed to focus on the following:

Although we believe that our risk management program and our internal controls are appropriately designed to address the risks to which we are exposed, we cannot provide assurance that our risk management program or our internal controls will prevent or reduce such risks.

Our Tax Status

We have elected to revoke our status as a REIT effective as of January 1, 2009, in part to use the NOL carry-forwards and NCL carry-forwards incurred at the parent company level to offset the taxable income of our former TRSs. At December 31, 2008, we had $391.1 million of NOL carry-forwards and $521.1 million of NCL carry-forwards. Additionally, at December 31, 2008, our former wholly-owned TRSs had $52.0 million of NOL carry-forwards and no NCL carry-forwards. Our NCL carry-forwards and NOL carry-forwards will begin to

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expire in 2011 and 2027, respectively (see Note 9 to our consolidated financial statements). As a result of the taxable income recognized from the extinguishment of a portion of our former TRSs’ long-term debt during the first quarter of 2009, we anticipate that the taxable income of our former TRSs during the 2009 taxable year will exceed their NOL carry-forwards and current deductions. We could not use the NOL carry-forwards incurred at the parent level to offset the anticipated taxable income of our former TRSs unless we revoked or terminated our status as a REIT. Even though revoking our REIT status will allow us to use parent-level NOL carry-forwards against our former TRSs’ taxable income, we will still have at least some tax liability for 2009 and subsequent years that is attributable to federal alternative minimum tax and state taxes.

In addition, revoking our REIT status frees us from the income, asset, distribution, and stock ownership requirements applicable to REITs, which will provide us with more flexibility in executing our business strategy. Specifically, because we are no longer required to derive a significant portion of our income from mortgage or other real estate related investments, we will have greater flexibility to invest in other types of assets as part of our principal investing activity, subject to maintaining compliance with our exclusion from regulation as an investment company under the 1940 Act. In addition, because we will no longer be subject to the REIT distribution requirement, we will have greater flexibility to retain our earnings to fund future growth. Accordingly, based on the foregoing, our Board of Directors determined that it was in the best interests of our shareholders to revoke our status as a REIT effective as of January 1, 2009.

As a REIT, we historically were not subject to corporate income tax to the extent we currently distributed our taxable income to our shareholders. However, our former TRSs were subject to corporate income tax on their income. As a result of revoking our REIT status, we will be subject to corporate income tax on our taxable income and gains that are not offset by our NOL and NCL carry-forwards. Moreover, because the restrictions in our articles of incorporation on owning more than 9.9% of our stock no longer apply, we may be more likely to experience an “ownership change” under sections 382 and 383 of the Internal Revenue Code, which could severely limit our ability to utilize our remaining NOL and NCL carry-forwards against our future taxable income. Finally, we are prohibited from again electing to be taxed as a REIT until 2014.

Our Exclusion from Regulation as an Investment Company

We intend to operate so as to be excluded from regulation under the 1940 Act. Historically, we have relied on Section 3(c)(5)(C) of the 1940 Act, which provides an exclusion for entities that are “primarily engaged in purchasing or otherwise acquiring . . . interests in real estate.” In 2008, in response to deteriorating market conditions, we began to decrease our real estate–related investments. As a result, we now rely on the exclusion provided by Section 3(a)(1)(C) of the 1940 Act. This provision requires that we neither engage nor propose to engage in the business of investing, reinvesting, owning, holding or trading in securities and not own or propose to acquire “investment securities” having a value exceeding 40% of the value of our total assets on an unconsolidated basis. For purposes of the 1940 Act, 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 exemption under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Accordingly, we need to ensure that no more than 40% of our assets, on an unconsolidated basis, excluding cash and government securities, consist of investment securities, or the 40% test.

We are a holding company that conducts our business through wholly-owned and majority-owned subsidiaries, including FBR Capital Markets. FBR Capital Markets also relies on the 40% test in order to be excluded from regulation under the 1940 Act. Because FBR Capital Markets is a majority-owned subsidiary and is not relying on Section 3(c)(1) or Section 3(c)(7) for its exemption, our interests in this subsidiary are not investment securities. We will need to ensure not only that we qualify for an exclusion or exemption from regulation under the 1940 Act, but also that each of our subsidiaries qualifies for such an exclusion or exemption. We intend to maintain our exclusion by monitoring the value of our interests in our subsidiaries. We may not be successful in this regard.

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If we fail to maintain our exclusion and another exclusion or exemption is not available, we may be required to register as an investment company, or we may be required to acquire or dispose of assets in order to meet our exemption. Any such asset acquisitions or dispositions may include assets that we would not acquire or dispose of in the ordinary course of business, may be at unfavorable prices and result in a decline in the price of our common stock. 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 and result in a decline in the price of our common stock.

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Investing in our company involves various risks, including the risk that you might lose your entire investment. Our results of operations depend upon many factors including our ability to implement our business strategy, the availability of opportunities to acquire assets, the level and volatility of interest rates, the cost and availability of short- and long-term credit, financial market conditions, and general economic conditions.

The following discussion concerns some of the risks associated with our business. These risks are interrelated, and you should treat them as a whole. Additional risks and uncertainties not presently known to us, may also materially and adversely affect the value of our common stock and our ability to pay dividends to our shareholders. In connection with the forward-looking statements that appear in this Annual Report on Form 10-K, including these risk factors and elsewhere, you should carefully review the section entitled “Cautionary Statement About Forward-Looking Information.”

In addition to the risk factors discussed below, you should carefully review the information discussed under the heading “Risk Factors” (Part I, Item 1A) of the FBR Capital Markets Annual Report on Form 10-K for the year ended December 31, 2008. Those risk factors are incorporated by reference herein.

Risks Related to Adverse Market Conditions

In general, changes in market conditions could further adversely and materially affect our businesses and the value of our common stock could be negatively impacted.

Risk is an inherent part of our business. Our businesses, by their nature, do not produce predictable earnings, and our business and FBR Capital Markets’ business are materially affected by conditions in the global financial markets and economic conditions generally. In the past twelve months, these conditions have changed suddenly and negatively and may continue to change adversely in 2009 and future periods.

Since mid-2007, and particularly during the second half of 2008, and continuing in 2009, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including equities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions, but more recently in companies in a number of other industries and in the broader markets. The decline in asset values has caused increases in margin calls for investors, requirements that derivatives counterparties post additional collateral and redemptions by mutual and hedge fund investors, all of which have increased the downward pressure on asset values and outflows of client funds across the financial services industry. In addition, the increased redemptions and unavailability of credit have required hedge funds and others to rapidly reduce leverage, which has increased volatility and further contributed to the decline in asset values.

Market conditions have also led to the failure or merger of a number of prominent financial institutions. Financial institution failures or near-failures have resulted in further losses as a consequence of defaults on securities issued by them and defaults under bilateral derivatives and other contracts entered into with such entities as counterparties. Furthermore, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to increase credit default swap spreads, to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in central bank borrowing rates and other government actions. Banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral. The markets for securitized debt offerings backed by mortgages, loans, credit card receivables and other assets have for the most part been closed.

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In 2008, and continuing in 2009, governments, regulators and central banks in the United States and worldwide have taken numerous steps to increase liquidity and to restore investor confidence, but asset values have continued to decline and access to liquidity continues to be very limited.

The ongoing liquidity crisis and the loss of confidence in financial institutions has increased our cost of funding and limited our access to some of our traditional sources of liquidity, including both secured and unsecured borrowings. While the numerous steps taken by governments, regulators and central banks have helped reduce these funding costs somewhat and increased our access to traditional and new sources of liquidity, increases in funding costs and limitations on our access to liquidity have negatively impacted our earnings and our ability to engage in certain activities.

In the event of further adverse changes in market conditions, such as interest or foreign exchange rates, equity, fixed income, commodity or real estate valuations, liquidity, availability of credit or volatility, our businesses could be adversely affected in many ways.

Our cash flows may decline as a result of adverse market conditions.

As of the end of 2008, business activity across a wide range of industries and regions is greatly reduced and local governments and many companies are in serious difficulty due to the lack of consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly. Overall declines in asset values, the lack of liquidity, general uncertainty about economic and market activities and a lack of consumer, investor and CEO confidence have negatively impacted our business. Unfavorable or uncertain economic and market conditions can be caused by: declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation, interest rates, exchange rate volatility, default rates or the price of basic commodities; outbreaks of hostilities or other geopolitical instability; corporate, political or other scandals that reduce investor confidence in capital markets; natural disasters or pandemics; or a combination of these or other factors. Overall, during fiscal 2008, the business environment has been extremely adverse and there can be no assurance that these conditions will improve in the near term. Until they do, we expect our results of operations to be adversely affected.

Our business has been and may continue to be adversely affected by disruptions in the credit markets, including reduced access to credit and higher costs of obtaining credit.

Widening credit spreads, as well as significant declines in the availability of credit, have adversely affected our ability to borrow on a secured and unsecured basis and may continue to do so. We fund ourselves on an unsecured basis by issuing commercial paper, to the extent the commercial paper market is available to us, promissory notes and long-term debt, or by obtaining bank loans or lines of credit. We seek to finance many of our assets, including our less liquid assets, on a secured basis, including by entering into repurchase agreements. Disruptions in the credit markets make it harder and more expensive to obtain funding for our businesses. If our available funding is limited or we are forced to fund our operations at a higher cost, these conditions may require us to curtail our business activities and increase our cost of funding, both of which could reduce our profitability, particularly in our businesses that involve investing, lending and taking principal positions, including market making. In addition, we may incur significant unrealized gains or losses due solely to changes in our credit spreads or those of third parties, as these changes may affect the fair value of our derivative instruments and the debt securities that we hold or issue.

General Risks Related to our Business

We are currently not in compliance with the continued listing requirements of the NYSE, and we may not be successful in reestablishing our compliance.

We are currently not in compliance with certain of the NYSE continued listing requirements, including the requirement that the stock price maintain a 30-day moving average of $1.00 per share. The NYSE has granted us

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an opportunity to cure our non-compliance with the continued listing requirements, and we are endeavoring to cure the non-compliance. Our efforts to cure the non-compliance may include, among other actions, effecting a reverse stock split, which would require the approval of our shareholders. We cannot guarantee that we will be successful in curing the non-compliance during the allotted cure period. If we are not able to cure the non-compliance during the allotted cure period, we may be forced to de-list our Class A common stock from the NYSE. If that were to occur, we may list our Class A common stock on another alternative securities exchange or other trading venue.

The voting power of our principal shareholders and other executive officers, directors and nominees may result in corporate action with which you do not agree and may discourage third party acquisitions of our company and prevent our shareholders from receiving any premium above market price for their shares.

Eric F. Billings has significant influence over our operations through his ownership of our common stock, which, as of February 27, 2009, represents approximately 15.5% of the total voting power of our common stock. In addition, Mr. Billings serves as Chairman of our Board of Directors and as our Chief Executive Officer. Mr. Billings also serves as a member of the board of directors and as Chairman of FBR Capital Markets. As of February 27, 2009, Mr. Billings and all of our other executive officers, directors and nominees, as a group, control approximately 18.7% of our total voting power. The extent of the influence that Mr. Billings and our other officers, directors and nominees have over us may have the effect of discouraging offers to acquire control of our company and may preclude holders of our common stock from receiving any premium above market price for their shares that may be offered in connection with any attempt to acquire control of our company without the approval of Mr. Billings.

The trading prices of our Class A common stock may be adversely affected by factors outside of our control.

Any negative changes in the public’s perception of the prospects for our business or the types of assets in which we invest, could depress our stock price regardless of our results. The following factors could contribute to the volatility of the price of our Class A common stock:

Many of these factors are beyond our control.

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We may experience significant fluctuations in quarterly operating results.

Our revenues and operating results may fluctuate from quarter to quarter and from year to year due to a combination of factors which are beyond our control. As a result, we may fail to meet profitability or dividend expectations, if our board of directors elects to resume payment of a cash dividend in the future, which may, in turn, negatively affect the market price of our Class A common stock and our ability to pay dividends to our stockholders.

We did not pay any cash dividends during 2008, and we cannot assure you that we will be able to pay dividends in the future.

Our Board of Directors did not authorize the payment of any cash dividends to our shareholders during 2008. Pursuant to our variable dividend policy, our Board of Directors, in its sole discretion, may reinstate the payment of cash dividends when appropriate in the future, but there can be no assurances as to when it will do so, if ever. As a result of the revocation of our REIT status effective as of January 1, 2009, we may retain any available funds and future earnings to fund the development and growth of our business.

Loss of our exclusion from regulation as an investment company under the 1940 Act would adversely affect us and reduce the market price of our shares.

To avoid regulation under the 1940 Act, we rely on Section 3(a)(1)(C) for our exclusion from the registration requirements of the 1940 Act. This provision requires that we neither engage nor propose to engage in the business of investing, reinvesting, owning, holding or trading in securities and not own or propose to acquire “investment securities” having a value exceeding 40% of the value of our total assets on an unconsolidated basis. For purposes of the 1940 Act, 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 exemption under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Accordingly, we need to ensure that no more than 40% of our assets, on an unconsolidated basis, excluding cash and government securities, consist of investment securities for purposes of the 40% test.

We are a holding company that conducts our business through wholly-owned and majority-owned subsidiaries, including FBR Capital Markets. FBR Capital Markets also relies on the 40% test in order to be excluded from regulation under the 1940 Act. Because FBR Capital Markets is a majority-owned subsidiary and is not relying on Section 3(c)(1) or Section 3(c)(7) for its exemption, our interests in this subsidiary are not investment securities. We will need to ensure not only that we qualify for an exclusion or exemption from regulation under the 1940 Act, but also that each of our subsidiaries qualifies for such an exclusion or exemption. We intend to maintain our exclusion by monitoring the value of interests in our subsidiaries. We may not be successful in this regard.

If we fail to maintain our exclusion and another exclusion or exemption is not available, we may be required to register as an investment company, or we may be required to acquire or dispose of assets in order to meet our exemption. Any such asset acquisitions or dispositions may include assets that we would not acquire or dispose of in the ordinary course of business, may be at unfavorable prices and result in a decline in the price of our common stock. 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 and result in a decline in the price of our common stock.

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We face intense competition for personnel which could adversely affect our business and in turn negatively affect the market price of our common stock and our ability to pay dividends to our stockholders.

We are dependent on highly skilled, and often highly specialized, individuals we employ. Retention of specialists to manage our MBS portfolio and our merchant banking and other principal investments are particularly important to our prospects. Competition for the recruiting and retention of employees may increase elements of our compensation costs. We cannot assure you that we will be able to recruit and hire a sufficient number of new employees with the desired qualifications in a timely manner. We regularly review our compensation policies, including stock incentives. Nonetheless, our incentives may be insufficient to recruit and retain our employees. Increased compensation costs could adversely affect the amount of cash available for distribution to shareholders and our failure to recruit and retain qualified employees could materially and adversely affect our future operating results.

We are dependent on a small number of key senior professionals and loss of the professionals could adversely affect our results and may, in turn, negatively affect the market price of our Class A common stock and our ability to pay dividends.

We generally do not have employment agreements with our senior officers and other key professionals. The loss of the members of our senior management and other key professionals could materially and adversely affect our operating results. We cannot guarantee that we will continue to have access to members of our senior management team or other key professionals.

We are highly dependent on systems and third parties, and systems failures could significantly disrupt our business, which may, in turn, negatively affect the market price of our Class A common stock and our ability to pay dividends.

Our business is highly dependent on communications and information systems, including systems provided by our clearing brokers and by and for other third parties. Any failure or interruption of our systems, the systems of our clearing brokers, or third-party trading or information systems could cause delays or other problems in our securities trading activities, including MBS trading activities, which could have a material adverse effect on our operating results and negatively affect the market price of our common stock and our ability to pay dividends.

Indemnification agreements with our affiliates may increase the costs to us of litigation against our company.

Our charter documents allow indemnification of our officers, directors and agents to the maximum extent permitted by Virginia law, as may the charter documents of our subsidiaries in their respective jurisdictions of incorporation. We have entered into indemnification agreements with these persons. We also have agreed to indemnify FBR Capital Markets against claims that relate to our capital markets businesses that we contributed to FBR Capital Markets prior to completion of the FBR Capital Markets 2006 private offering. In the future we may be the subject of indemnification assertions under these charter documents or agreements by our affiliates who are or may become defendants in litigation. Amounts paid pursuant to these indemnification agreements could adversely affect our financial results and the amount of cash available for distribution to stockholders.

Risks Related to our Principal Investing Activities

Continued adverse developments in the residential mortgage market may adversely affect the value of our agency securities and our ability to borrow against our agency security assets.

During the past year, the residential mortgage market in the United States has experienced a variety of difficulties and changed economic conditions that may adversely affect the performance and market value of the mortgage securities in which we invest. Securities backed by residential mortgage loans originated in 2006 and 2007 have experienced a higher and earlier than expected rate of delinquencies. Additionally, other earlier

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vintages of MBS may not be performing as expected. Many MBS have been downgraded by the rating agencies during the past year and the rating agencies may in the future downgrade MBS. As a result, the market for these securities may be adversely affected for a significant period of time.

The increase in delinquencies described above has not been limited to “subprime” mortgage loans, which are made to borrowers with impaired credit. The increase in delinquencies has also affected “Alt-A” mortgage loans, which are made to borrowers with limited documentation, and also “prime” mortgage loans, which are made to borrowers with excellent credit who provide full documentation.

During the past year, housing prices and appraisal values in many states have declined or stopped appreciating, after extended periods of significant appreciation. A continued decline or an extended flattening of those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, particularly with respect to second homes and investor properties and with respect to any residential mortgage loans whose aggregate loan amounts (including any subordinate liens) are close to or greater than the related property values.

Another factor that may in the future contribute to higher delinquency rates is the potential increase in monthly payments on adjustable rate mortgage loans. Borrowers with adjustable rate mortgage loans may be exposed to increased monthly payments if the related mortgage interest rate adjusts upward from the initial fixed rate or a low introductory rate, as applicable, in effect during the initial period of the mortgage loan to the rate computed in accordance with the applicable index and margin. This increase in borrowers’ monthly payments, together with any increase in prevailing market interest rates, after the initial fixed rate period, may result in significantly increased monthly payments for borrowers with adjustable rate mortgage loans and an increase in default on their obligations.

Current market conditions may impair borrowers’ ability to refinance or sell their properties, which may contribute to higher delinquency and default rates. Borrowers seeking to avoid increased monthly payments by refinancing may no longer be able to find available replacement loans at comparably low interest rates. A decline in housing prices may also leave borrowers with insufficient equity in their homes to permit them to refinance. Borrowers who intended to sell their homes or refinance their existing mortgage loans on or before the expiration of the fixed rate periods on their mortgage loans may find that they cannot sell their property for an amount equal to or greater than the unpaid principal balance of their loans or obtain new financing at lower rates. In addition, some mortgage loans may include prepayment premiums that may further inhibit refinancing.

Servicers of residential mortgage loans also have the authority to modify mortgage loans that are in default, or for which default is reasonably foreseeable, if such modifications are in the best interests of the holders of the mortgage securities and such modifications are done in accordance with the terms of the relevant agreements. Loan modifications are more likely to be used when borrowers are less able to refinance or sell their homes due to market conditions, and when the potential recovery from a foreclosure is reduced due to lower property values. A significant number of loan modifications could result in a significant reduction in cash flows to the holders of the mortgage securities on an ongoing basis.

Over the past year, a number of originators of mortgage loans have experienced serious financial difficulties and, in many cases, have entered bankruptcy proceedings. These difficulties have resulted in part from declining markets for their mortgage loans as well as from claims for repurchases of mortgage loans previously sold under provisions that require repurchase in the event of early payment defaults or for breaches of representations regarding loan quality. In addition, a rising interest rate environment and declining real estate values may decrease the number of borrowers seeking or able to refinance their mortgage loans, which would result in a decrease in overall originations.

Various federal, state and local regulatory authorities have taken or proposed actions that could hinder the ability of the servicer to foreclose promptly on defaulted mortgage loans. Any such actions may adversely affect the performance of the loans and the yield on and value of the mortgage securities.

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Investors should consider that the general market conditions discussed above may adversely affect the market value of the securities in our MBS portfolio and make it difficult or more expensive for us to borrow against those securities.

The conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government, may adversely affect our business.

Due to increased market concerns about Fannie Mae and Freddie Mac’s ability to withstand future credit losses associated with securities held in their investment portfolios, and on which they provide guarantees, without the direct support of the federal government, on July 30, 2008, the government passed the Housing and Economic Recovery Act of 2008 (HERA). On September 7, 2008, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship and, together with the U.S. Treasury, established a program designed to boost investor confidence in Fannie Mae’s and Freddie Mac’s debt and mortgage-backed securities. As the conservator of Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of Fannie Mae and Freddie Mac and may (1) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of the shareholders, the directors and the officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (2) collect all obligations and money due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (4) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (5) contract for assistance in fulfilling any function, activity, action or duty of the conservator. A primary focus of this new legislation is to increase the availability of mortgage financing by allowing Fannie Mae and Freddie Mac to continue to grow their guarantee business without limit, while limiting net purchases of agency-backed MBS to a modest amount through the end of 2009. Beginning in 2010, Fannie Mae and Freddie Mac will gradually reduce their agency security portfolios.

In addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, the U.S. Department of Treasury, or the U.S. Treasury, has taken three additional actions: (i) the U.S. Treasury and FHFA have entered into preferred stock purchase agreements between the U.S. Treasury and Fannie Mae and Freddie Mac pursuant to which the U.S. Treasury will ensure that each of Fannie Mae and Freddie Mac maintains a positive net worth; (ii) the U.S. Treasury has established a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac and the Federal Home Loan Banks, which is intended to serve as a liquidity backstop, which will be available until December 2009; and (iii) the U.S. Treasury has initiated a temporary program to purchase agency-backed MBS issued by Fannie Mae and Freddie Mac. Initially, Fannie Mae and Freddie Mac each issued $1.0 billion of senior preferred stock to the U.S. Treasury and warrants to purchase 79.9% of the fully-diluted common stock outstanding of each government sponsored enterprise, or GSE, at a nominal exercise price. Pursuant to these agreements, each of Fannie Mae’s and Freddie Mac’s mortgage and agency security portfolio may not exceed $850 billion as of December 31, 2009, and will decline by 10% each year until such portfolio reaches $250 billion. Given the highly fluid and evolving nature of these events, it is unclear how our business will be impacted.

Although the U.S. Treasury has committed capital to Fannie Mae and Freddie Mac, there can be no assurance that these actions will be adequate for their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer losses and could fail to honor their guarantees and other obligations. The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantees could be considerably limited relative to historical measurements. Any changes to the nature of the guarantees provided by Fannie Mae and Freddie Mac could redefine what constitutes an agency security and could have broad adverse market implications.

The size and timing of the federal government’s agency security purchase program is subject to the discretion of the U.S. Secretary of the Treasury, who has indicated that the scale of the program will be based on developments in the capital markets and housing markets. Purchases under this program have already begun, but

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there is no certainty that the U.S. Treasury will continue to purchase additional agency-backed MBS in the future. The U.S. Treasury can hold its portfolio of agency-backed MBS to maturity, and, based on mortgage market conditions, may make adjustments to the portfolio. This flexibility may adversely affect the pricing and availability for our target assets. It is also possible that the U.S. Treasury’s commitment to purchase agency-backed MBS in the future could create additional demand that would negatively affect the pricing of agency-backed MBS that we seek to acquire.

The U.S. Treasury could also stop providing credit support to Fannie Mae and Freddie Mac in the future. The U.S. Treasury’s authority to purchase agency-backed MBS and to provide financial support to Fannie Mae and Freddie Mac under the HERA expires on December 31, 2009. The problems faced by Fannie Mae and Freddie Mac resulting in their being placed into conservatorship have stirred debate among some federal policy makers regarding the continued role of the federal government in providing liquidity for mortgage loans. Following expiration of the current authorization, each of Fannie Mae and Freddie Mac could be dissolved and the federal government could stop providing liquidity support of any kind to the mortgage market. If Fannie Mae or Freddie Mac were eliminated, or their structures were to change radically, we would not be able to acquire agency-backed MBS from these companies, which would eliminate the major component of our business model.

Our income could be negatively affected in a number of ways depending on the manner in which related events unfold. For example, the current credit support provided by the U.S. Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the future, could have the effect of lowering the interest rate we expect to receive from agency-backed MBS that we seek to acquire, thereby tightening the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio. A reduction in the supply of agency-backed MBS could also negatively affect the pricing of agency-backed MBS we seek to acquire by reducing the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio.

As indicated above, recent legislation has changed the relationship between Fannie Mae and Freddie Mac and the federal government and requires Fannie Mae and Freddie Mac to reduce the amount of mortgage loans they own or for which they provide guarantees on agency-backed MBS. Future legislation could further change the relationship between Fannie Mae and Freddie Mac and the federal government, and could also nationalize or eliminate such entities entirely. Any law affecting these GSEs may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by Fannie Mae or Freddie Mac. As a result, such laws could increase the risk of loss on investments in Fannie Mae and/or Freddie Mac agency security. It also is possible that such laws could adversely impact the market for such securities and spreads at which they trade. All of the foregoing could materially adversely affect our business, operations and financial condition.

On November 25, 2008, the Federal Reserve announced that it will initiate a program to purchase $100 billion in direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks and $500 billion in agency-backed MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae. The Federal Reserve stated that its actions are intended to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally. The purchases of direct obligations began during the first week of December 2008, and the purchases of agency-backed MBS began in early January 2009. The Federal Reserve’s program to purchase agency-backed MBS could cause an increase in the price of agency-backed MBS, which would negatively impact the net interest margin with respect to new agency-backed MBS we may purchase.

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There can be no assurance that the actions of the U.S. Treasury, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets, or market response to those actions, will achieve the intended effects, our business may not benefit from these actions and further government or market developments could adversely impact us.

In response to the financial issues affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the Emergency Economic Stabilization Act of 2008, or EESA, was enacted on October 3, 2008. The EESA provided the U.S. Secretary of the Treasury with the authority to establish the Troubled Asset Relief Program, or TARP, to purchase from financial institutions up to $700 billion of residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, as well as any other financial instrument that the U.S. Secretary of the Treasury, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, upon transmittal of such determination, in writing, to the appropriate committees of the U.S. Congress. The EESA also provides for a program that would allow companies to insure their troubled assets.

On October 14, 2008, the U.S. Treasury announced the voluntary Capital Purchase Program, or the CPP, which was implemented under authority provided in the EESA. Under the CPP, the U.S. Treasury will purchase up to $250 billion of senior preferred shares in qualifying U.S. controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that elect to participate by November 14, 2008. Nine of the largest banks in the United States, as well as other financial institutions, have accepted investments under the CPP. The U.S. Treasury has also taken under consideration the expansion of the CPP to non-financial institutions, including life or other insurance companies. As of January 30, 2009, the U.S. Treasury Department has made $195.3 billion of investments, receiving preferred stock and warrants from participating institutions.

There can be no assurance that programs and proposals recently initiated and announced by the U.S. Treasury or Federal Reserve will have a beneficial impact on the financial markets, including current extreme levels of volatility. To the extent the market does not respond favorably to these programs and proposals or the initiatives do not function as intended, our business may not receive the anticipated positive impact from the legislation. In addition, the U.S. Treasury, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis. We cannot predict whether or when such actions may occur or what impact, if any, such actions could have on our business, results of operations and financial condition.

To the extent that we invest in agency-backed MBS that are guaranteed by Fannie Mae and Freddie Mac, we are subject to the risk that these U.S. Government-sponsored entities may not be able to fully satisfy their guarantee obligations or that these guarantee obligations may be repudiated, which may adversely affect the value of our investment portfolio and our ability to sell or finance these securities.

The interest and principal payments we receive on the agency-backed MBS in which we invest are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Unlike the Ginnie Mae certificates in which we may invest, the principal and interest on securities issued by Fannie Mae and Freddie Mac are not guaranteed by the U.S. government. All the agency-backed MBS in which we invest depend on a steady stream of payments on the mortgages underlying the securities.

As conservator of Fannie Mae and Freddie Mac, FHFA may disaffirm or repudiate contracts (subject to certain limitations for qualified financial contracts) that Freddie Mac or Fannie Mae entered into prior to FHFA’s appointment as conservator if it determines, in its sole discretion, that performance of the contract is burdensome and that disaffirmation or repudiation of the contract promotes the orderly administration of its affairs. The HERA requires FHFA to exercise its right to disaffirm or repudiate most contracts within a reasonable period of time after its appointment as conservator. Fannie Mae and Freddie Mac have disclosed that the FHFA has

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disaffirmed certain consulting and other contracts that these entities entered into prior to FHFA’s appointment as conservator. Freddie Mac and Fannie Mae have also disclosed that the FHFA has advised that it does not intend to repudiate any guarantee obligation relating to Fannie Mae’s and Freddie Mac’s mortgage-related securities, because FHFA views repudiation as incompatible with the goals of the conservatorship. In addition, the HERA provides that mortgage loans and mortgage-related assets that have been transferred to a Freddie Mac or Fannie Mae securitization trust must be held for the beneficial owners of the related mortgage-related securities, and cannot be used to satisfy the general creditors of Freddie Mac or Fannie Mae.

If the guarantee obligations of Freddie Mac or Fannie Mae were repudiated by FHFA, payments of principal and/or interest to holders of agency-backed MBS issued by Freddie Mac or Fannie Mae would be reduced in the event of any borrowers’ late payments or failure to pay or a servicer’s failure to remit borrower payments to the trust. In that case, trust administration and servicing fees could be paid from mortgage payments prior to distributions to holders of agency-backed MBS. Any actual direct compensatory damages owed due to the repudiation of Freddie Mac’s or Fannie Mae’s guarantee obligations may not be sufficient to offset any shortfalls experienced by holders of agency-backed MBS. FHFA also has the right to transfer or sell any asset or liability of Freddie Mac or Fannie Mae, including its guarantee obligation, without any approval, assignment or consent. If FHFA were to transfer Freddie Mac’s or Fannie Mae’s guarantee obligations to another party, holders of agency-backed MBS would have to rely on that party for satisfaction of the guarantee obligation and would be exposed to the credit risk of that party.

New laws may be passed affecting the relationship between Fannie Mae and/or Freddie Mac, on the one hand, and the U.S. Government, on the other, which could adversely affect the availability and pricing of agency-backed MBS.

Legislation has been passed and additional legislation may be proposed in the future to change the relationship between Fannie Mae and Freddie Mac, on the one hand, and the U.S. Government, on the other hand, or that requires Fannie Mae and Freddie Mac to reduce the amount of mortgages they own or limit the amount of securities they guarantee. If any such further legislation is enacted into law, it may lead to market uncertainty and the actual or perceived impairment in the credit quality of securities issued by Fannie Mae or Freddie Mac. This may increase the risk of loss on investments in Fannie Mae- and/or Freddie Mac-issued securities. Any legislation requiring Fannie Mae or Freddie Mac to reduce the amount of mortgages they own or for which they guarantee payments on could adversely affect the availability and pricing of agency-backed MBS and therefore, adversely affect our business prospects.

Market conditions may upset the historical relationship between interest rate changes and prepayment trends, which would make it more difficult for us to analyze our investment portfolio.

Our success depends on our ability to analyze the relationship of changing interest rates on prepayments of the mortgage loans that underlie our MBS. Changes in interest rates and prepayments affect the market price of MBS that we intend to purchase and any MBS that we hold at a given time. As part of our overall portfolio risk management, we analyze interest rate changes and prepayment trends separately and collectively to assess their effects on our investment portfolio. In conducting our analysis, we will depend on certain assumptions based upon historical trends with respect to the relationship between interest rates and prepayments under normal market conditions. If the recent dislocations in the residential mortgage market or other developments change the way that prepayment trends have historically responded to interest rate changes, our ability to (i) assess the market value of our investment portfolio, (ii) implement our hedging strategies and (iii) implement techniques to reduce our prepayment rate volatility would be significantly affected, which could materially adversely affect our financial position and results of operations.

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Mortgage loan modification programs, future legislative action and changes in the requirements necessary to qualify for refinancing a mortgage with Fannie Mae, Freddie Mac or Ginnie Mae may adversely affect the value of, and the returns, on the MBS in which we invest.

During the second half of 2008 and in early 2009, the U.S. government, through the FHA and the Federal Deposit Insurance Corporation, or FDIC, commenced implementation of programs designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures including the Hope for Homeowners Act of 2008, which allows certain distressed borrowers to refinance their mortgages into FHA-insured loans. The programs may also involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans. Members of the U.S. Congress have indicated support for additional legislative relief for homeowners, including an amendment of the bankruptcy laws to permit the modification of mortgage loans in bankruptcy proceedings. These loan modification programs, future legislative or regulatory actions, including amendments to the bankruptcy laws, that result in the modification of outstanding mortgage loans, as well as changes in the requirements necessary to qualify for refinancing a mortgage with Fannie Mae, Freddie Mac or Ginnie Mae may adversely affect the value of, and the returns on, our MBS. Depending on whether or not the bond was purchased at a premium or discount the yield may be positively or negatively impacted.

Declines in the market values of the securities in our MBS portfolio may adversely affect periodic reported results and credit availability, which may reduce earnings and, in turn, cash available for distribution to our stockholders.

A substantial portion of our assets are classified for accounting purposes either as “trading securities” or as “available-for-sale.” Changes in the market values of those assets will be directly charged or credited to stockholders’ equity. As a result, a decline in value may reduce the book value of our assets. Moreover, if the decline in value of an available-for-sale security is other-than-temporary, such decline will reduce earnings, as will a decline in the value of our securities classified as trading securities for accounting purposes.

A decline in the market value of the securities in our MBS portfolio may adversely affect us particularly in instances where we have borrowed money based on the market value of those assets. If the market value of those assets declines, the lender may require us to post additional collateral to support the loan. If we were unable to post the additional collateral, we would have to sell the assets at a time when we might not otherwise choose to do so. A reduction in credit available may reduce our earnings and, in turn, cash available for distribution to shareholders.

Our mortgage investing strategy involves leverage, which could adversely affect our operations and negatively affect cash available for distribution to our shareholders.

Using debt to finance the purchase of MBS will expose us to the risk that margin calls will be made and that we will not be able to meet those margin calls. To meet margin calls, we may sell the applicable mortgage-related securities and such sales could result in realized losses, and negatively affect cash available for distribution to our shareholders. While it is not our current policy to leverage the equity securities or loan investments in our merchant banking portfolio, if we were to leverage these investments, this leverage could expose us to the risk that margin calls will be made and that we will not be able to meet them. A leveraged company’s income and net assets will tend to increase or decrease at a greater rate than if borrowed money were not used.

We enter into repurchase agreements to finance our MBS, which can amplify the effect of a decline in value resulting from an interest rate increase. For example, assume that we finance $96 million of MBS through repurchase agreements to acquire $100 million of 8% MBS. If prevailing interest rates were to increase sufficiently, the value of the MBS may decline to a level below the amount required to be maintained under the terms of the repurchase agreements. If the MBS were then sold, we would have to transfer additional assets to secure the borrowings.

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Changes in interest rates could negatively affect the value of our MBS, which could result in reduced earnings or losses and negatively affect the cash available for distribution to our stockholders.

We invest indirectly in mortgage loans by purchasing MBS and we currently intend to continue this investment strategy. Under a normal yield curve, an investment in MBS will decline in value if long-term interest rates increase. Despite Fannie Mae, Freddie Mac or Ginnie Mae guarantees of the agency-backed MBS we own, those guarantees do not protect us from declines in market value caused by changes in interest rates. Declines in market value may ultimately reduce earnings or result in losses to us, which may negatively affect cash available for distribution to our stockholders.

A significant risk associated with our portfolio of mortgage-related assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates were to increase significantly, the market value of these MBS would decline and the weighted average life of the investments would increase. We have realized losses in last three years, and could realize a loss in the future if the MBS were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on the repurchase agreements we enter into in order to finance the purchase of MBS. Market values of MBS may decline without any general increase in interest rates for a number of reasons, such as increases in defaults, increases in voluntary prepayments and widening of credit spreads. In addition, changes in interest rates may impact some our merchant banking equity investments in non-conforming mortgage loan originators and other companies whose business models are sensitive to interest rates.

Limitations on our access to capital could impair our liquidity and our ability to conduct our business.

Liquidity, or ready access to funds, is essential to our business. Failures of similar businesses have often been attributable in large part to insufficient liquidity. Liquidity is of particular importance to our business and perceived liquidity issues may affect our clients’ and counterparties’ willingness to engage in transactions with us. Our liquidity could be impaired due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects us or third parties. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time.

In addition, our access to funds held by FBR Capital Markets and its subsidiaries is subject to approval by a majority of the disinterested directors serving on the FBR Capital Markets Board of Directors. We cannot guarantee that we will be able to access these funds. Regulatory requirements applicable to FBR Capital Markets’ broker-dealer subsidiaries could also limit our ability to access funds held by FBR Capital Markets and its subsidiaries. We cannot guarantee that we will be able to access funds from our subsidiaries to meet our obligations as they come due. If we cannot obtain funding from third parties or from our subsidiaries, our results of operations could be negatively impacted.

An increase in our borrowing costs relative to the interest we receive on our mortgage-related assets may adversely affect our profitability, which may negatively affect cash available for distribution to our stockholders.

As our repurchase agreements and other short-term borrowing instruments mature, we will be required either to enter into new repurchase agreements or to sell a portion of our mortgage-related assets or other investment securities. Current conditions in the credit markets may make it impracticable to enter into new repurchase agreements or other short-term facilities “—Risks Related to Adverse Market Conditions.”

An increase in short-term interest rates at the time that we seek to enter into new repurchase agreements would reduce the spread between our returns on our mortgage-related assets and the cost of our borrowings. This change in interest rates would adversely affect our returns on our mortgage-related assets portfolio, which might reduce earnings and, in turn, cash available for distribution to our stockholders.

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Prepayment rates could negatively affect the value of our MBS, which could result in reduced earnings or losses and negatively affect the cash available for distribution to our stockholders.

In the case of residential mortgage loans, there are seldom any restrictions on borrowers’ abilities to prepay their loans. Homeowners tend to prepay mortgage loans faster when interest rates decline. Consequently, owners of the loans have to reinvest the money received from the prepayments at the lower prevailing interest rates. Conversely, homeowners tend not to prepay mortgage loans when interest rates increase. Consequently, owners of the loans are unable to reinvest money that would have otherwise been received from prepayments at the higher prevailing interest rates. This volatility in prepayment rates may affect our ability to maintain targeted amounts of leverage on our mortgage-based securities portfolio and may result in reduced earnings or losses for us and negatively affect the cash available for distribution to our shareholders. Despite Fannie Mae, Freddie Mac or Ginnie Mae guarantees of principal and interest related to the agency-backed MBS we own, those guarantees do not protect us against prepayment risks.

Rapid changes in the values of our investments may make it more difficult for us to maintain our exemption from the 1940 Act.

Changes in the market value or income potential of certain of our investments may prevent us from maintaining our exemption from the 1940 Act. We may have to make investment decisions that we otherwise would not make absent the 1940 Act requirements.

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders.

We have entered into and may enter into interest rate swap agreements or pursue other hedging strategies. Our hedging activity will vary in scope based on the level and volatility of interest rates and principal prepayments, the type of MBS held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

Our hedging activity may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders.

We may change our mortgage investment strategy, hedging strategy, asset allocation and operational policies without shareholder consent, which may result in riskier investments and adversely affect the market value of our common stock and our ability to make distributions to our shareholders.

We may change our mortgage investment strategy, hedging strategy, asset allocation and operational policies at any time without the consent of our shareholders, which could result in our making investments or hedges that are different from, and possibly riskier than, the investments and hedges described in this Annual Report on Form 10-K. A change in our investment or hedging strategy may increase our exposure to interest rate, and real estate market fluctuations. A change in our asset allocation could result in us making investments in instrument categories different from those described in this Annual Report on Form 10-K. Our Board of Directors determines our operational policies and may amend or revise our policies, including those with respect

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to our acquisitions, growth, operations, indebtedness, capitalization and distributions or approve transactions that deviate from these policies without a vote of, or notice to, our shareholders. Operational policy changes could adversely affect the market value of our common stock and our ability to make distributions to our shareholders.

Loans that we may make to highly leveraged companies may have a greater risk of loss which, in turn, could adversely affect our earnings and cash available for distribution to our shareholders.

Leverage may have material adverse consequences to the companies to which we may make loans to the extent we make these types of principal investments and to us as an investor in these companies. These companies may be subject to restrictive financial and operating covenants. Leverage may impair these companies’ ability to finance their future operations and capital needs. As a result, these companies’ flexibility to respond to changing business and economic conditions and to business opportunities may be limited. A leveraged company’s income and net assets will tend to increase or decrease at a greater rate than if borrowed money were not used. As a result, leveraged companies have a greater risk of loss.

Our due diligence may not reveal all of a portfolio company’s liabilities and may not reveal other weaknesses in a portfolio company’s business.

Before making an investment in a business entity, we assess the strength and skills of the entity’s management and other factors that we believe will determine the success of the investment. In making the assessment and otherwise conducting customary due diligence, we rely on the resources available to us and, in some cases, an investigation by third parties. This process is particularly important and subjective with respect to newly-organized entities because there may be little or no information publicly available about the companies. We cannot assure you that our due diligence processes will uncover all relevant facts or risks about a company or investment that we make, or that any investment will be successful. Any unsuccessful investment may have a material adverse effect on our financial condition and results of operations.

We depend on management and have limited ability to influence management of portfolio companies.

We generally do not control the management, investment decisions or operations of the enterprises in which we have investments. Management of those enterprises may decide to change the nature of their assets or business plan, or management may otherwise change in a manner that is not satisfactory to us. We typically have no ability to affect these management decisions, and as noted below, may have only limited ability to dispose of these investments.

We may make merchant banking investments that have limited liquidity, which may reduce the return on those investments to our stockholders.

The equity securities of a new publicly-held or privately-held entity in which we invest are likely to be restricted as to resale and may otherwise be highly illiquid. We expect that there will be restrictions on our ability to resell the securities of any private or newly-public company that we acquire for a period of at least one year after we acquire those securities. A public market sale may be subject to volume limitations or dependent upon securing a registration statement for a secondary offering of the securities. The securities of newly-public entities may trade less frequently and in smaller volume than securities of companies that are more widely held and have more established trading patterns. Sales of these securities may cause their values to fluctuate more sharply. Because we are affiliated with FBR Capital Markets, our ability to invest in companies whose securities are underwritten or privately placed by FBR Capital Markets will be restricted by applicable securities laws and regulations and the rules of FINRA and similar self-regulatory organizations.

Prices of the equity securities of new entities in which we invest may be volatile. We may make investments that are significant relative to the portfolio company’s overall capitalization, and resales of significant amounts of these securities might adversely affect the market and the sales price for the securities.

The short- and medium-term loans we make are based, in part, upon our knowledge of the borrower and its industry. In addition, we do not yet nor may we ever have a significant enough portfolio of loans to easily sell them to a third party. As a result, these loans are and may continue to be highly illiquid.

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Disposition value of our merchant banking investments is dependent upon general and specific market conditions which could result in a decline of the value of the investments.

Even if we make an appropriate investment decision based on the intrinsic value of an enterprise, we cannot assure you that the trading market value of the investment will not decline, perhaps materially, as a result of general market conditions. For example, an increase in interest rates, a general decline in the stock markets, or other market conditions adverse to companies of the type in which we invest could result in a decline in the value of our investments.

The market for investment opportunities is competitive, which could make it difficult for us to purchase or originate investments at attractive yields, which could have an adverse effect on cash available for distribution to our stockholders.

We gain access to investment opportunities only to the extent that they become known to us. Gaining access to investment opportunities is highly competitive. We compete with other companies that have greater capital, more long-standing relationships, broader product offerings and other advantages. Competitors include, but are not limited to, business development companies, small business investment companies, commercial lenders and mezzanine funds and other broker-dealers. Increased competition would make it more difficult for us to purchase or originate investments at attractive yields, which could have an adverse effect on cash available for distribution to our stockholders.

We may incur losses as a result of our merchant banking and other principal investments.

We may invest, either directly or through funds managed by FBR Capital Markets, in companies in the early stages of their development or in industry sectors that are historically volatile. Our business and prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in early stages of development, particularly companies in new and rapidly evolving markets. Moreover, investments made by us or funds in which we invest may be in privately held companies as to which little public information is available. Accordingly, either we or the fund managers of the funds in which we invest may not be successful in obtaining adequate information to evaluate potential returns. Also, these companies frequently have less diverse product lines and smaller market presence than large competitors. They are thus generally more vulnerable to economic downturns and may experience substantial variations in operating results.

Moreover, many of our portfolio companies will require additional equity funding to satisfy their continuing working capital requirements. Because of the circumstances of those companies or market conditions, it is possible that one or more of these portfolio companies will not be able to raise additional financing or may be able to do so only at a price or on terms that are unfavorable to them. Adverse returns with respect to these investments could adversely affect us and our operating results, which could negatively affect the market price of our Class A common stock and our ability to pay dividends.

Tax Risks of our Business and Structure

Our ability to use net operating loss carryovers and net capital loss carryovers to reduce our taxable income may be limited.

Historically, we have elected to be taxed as a REIT under the Internal Revenue Code and were generally not subject to corporate income tax to the extent we currently distributed our taxable income to our stockholders. We elected to revoke our status as a REIT effective as of January 1, 2009, in part to maximize the use of potential tax benefits flowing from our existing NOLs or NCLs and certain other tax attributes. We must have taxable income or gains to benefit from theses NOLs, NCLs and certain other tax attributes. Although we believe that a significant portion of our NOLs will be utilized to offset the 2009 taxable income of our former taxable REIT subsidiaries, no assurance can be provided that we will have taxable income or gains in the future to apply against our remaining NOLs and NCLs.

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In addition, our NOL and NCL carryovers may be limited by Sections 382 and 383 of the Internal Revenue Code if we undergo an “ownership change.” Generally, an “ownership change” occurs if certain persons or groups increase their aggregate ownership in our company by more than 50 percentage points looking back over the relevant testing period. If an ownership change occurs, our ability to use our NOLs, NCLs and certain recognized built-in losses to reduce our taxable income in a future year would be limited to a Section 382 limitation equal to the fair market value of our stock immediately prior to the ownership change multiplied by the long-term tax-exempt interest rate in effect for the month of the ownership change. The long-term tax-exempt rate for March 2009 is 5.49%. In the event of an ownership change, NOLs and NCLs that exceed the Section 382 limitation in any year will continue to be allowed as carryforwards for the remainder of the carryforward period and such losses can be used to offset taxable income for years within the carryforward period subject to the Section 382 limitation in each year. However, if the carryforward period for any NOL or NCL were to expire before that loss had been fully utilized, the unused portion of that loss would be lost. The carryforward period for NOLs is 20 years from the year in which the losses giving rise to the NOLs were incurred, and the carryforward period for NCL is five years from the year in which the losses giving rise to the NCL were incurred. Our use of new NOLs or NCLs arising after the date of an ownership change would not be affected by the Section 382 limitation (unless there were another ownership change after those new losses arose).

Based on our knowledge of our stock ownership, we do not believe that an ownership change has occurred since our losses were generated. Accordingly, we believe that at the current time there is no annual limitation imposed on our use of our NOLs and NCLs to reduce future taxable income. The determination of whether an ownership change has occurred or will occur is complicated and depends on changes in percentage stock ownership among stockholders. There are currently no restrictions on the transfer of our stock that would discourage or prevent transactions that could cause an ownership change, although we may adopt such restrictions in the future. In addition, we have not obtained, and currently do not plan to obtain, a ruling from the Internal Revenue Service, or IRS, regarding our conclusion as to whether our losses are subject to any such limitations. Furthermore, we may decide in the future that it is necessary or in our interest to take certain actions that could result in an ownership change. Therefore, no assurance can be provided as to whether an ownership change has occurred or will occur in the future.

Preserving the ability to use our NOLs and NCLs may cause us to forgo otherwise attractive opportunities.

Limitations imposed by Sections 382 and 383 of the Internal Revenue Code may discourage us from, among other things, redeeming our stock or issuing additional stock to raise capital or to acquire businesses or assets. Accordingly, our desire to preserve our NOLs and NCLs may cause us to forgo otherwise attractive opportunities.

Failure to qualify as a REIT in prior years would subject us to federal income tax.

Prior to our 2009 tax year, we operated in a manner that was intended to cause us to qualify as a REIT for federal income tax purposes. However, the tax laws governing REITs are extremely complex, and interpretations of the tax laws governing qualification as a REIT are limited. Qualifying as a REIT required us to meet numerous income and other tests. Given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, and the possibility of changes in our circumstances, no assurance can be given that we qualified for any particular year.

If we failed to qualify as a REIT prior to our 2009 tax year and we do not qualify for certain statutory relief provisions, we would have to pay federal income tax on our taxable income for the year of the failure and for the following four years. Our payment of income tax attributable to our failure to qualify as a REIT prior to our 2009 taxable year would decrease the amount of our income available for distribution to our stockholders.

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If we make distributions in excess of our current and accumulated earnings and profits, those distributions will be treated as a return of capital, which will reduce the adjusted basis of your stock, and to the extent such distributions exceed your adjusted basis, you may recognize a capital gain.

Unless you are a tax-exempt entity, distributions that we make to you generally will be subject to tax as ordinary income to the extent of our current and accumulated earnings and profits as determined for federal income tax purposes. If the amount we distribute to you exceeds your allocable share of our current and accumulated earnings and profits, the excess will be treated as a return of capital to the extent of your adjusted basis in your stock. This will reduce your basis in your stock but will not be subject to tax. If the amount we distribute to you exceeds both your allocable share of our current and accumulated earnings and profits and your adjusted basis, this amount will be treated as a gain from the sale or exchange of a capital asset.

None.

Our principal executive offices are located at Potomac Tower, 1001 Nineteenth Street North, Arlington, Virginia 22209. FBR Capital Markets and its affiliates occupy nine floors of office space in the Potomac Tower building in Arlington, and we occupy 4,000 square feet of that office space for our corporate offices. FBR Capital Markets and its subsidiaries operate their capital markets, asset management and principal investing segments in the remainder of the office space located in the Potomac Tower and in offices in Boston, Massachusetts (capital markets and asset management); Dallas, Texas (capital markets); Irvine, California (capital markets); New York, New York (capital markets); San Francisco, California (capital markets); and London, England (capital markets). We believe these facilities are sufficient for the current and projected needs of our business and the businesses operated by FBR Capital Markets.

Overview

Except as described below, as of December 31, 2008, we are not a defendant nor a plaintiff in any lawsuits or arbitrations nor involved in any governmental or SRO matters that are expected to have a material adverse effect on our financial condition, results of operations or liquidity. We are a defendant in a small number of civil lawsuits and arbitrations (together, litigation) relating to our businesses. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on our financial condition or results of operations in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on our financial condition, results of operations or liquidity.

Many aspects of FBR Capital Markets business involves substantial risks of liability and litigation. Underwriters, broker-dealers and investment advisers are exposed to liability under federal and state securities laws, other federal and state laws and court decisions, including decisions with respect to underwriters’ liability and limitations on indemnification, as well as with respect to the handling of customer accounts. For example, underwriters may be held liable for material misstatements or omissions of fact in a prospectus used in connection with the securities being offered and broker-dealers may be held liable for statements made by their securities analysts or other personnel. FBR & Co., FBR Capital Markets’ U.S. broker-dealer subsidiary, has been named as a defendant in a small number of securities claims involving investment banking clients of FBR & Co. as a result of FBR & Co.’s role as an underwriter. In these cases, the underwriting agreement provides, subject to certain conditions, that the investment banking client is required to indemnify FBR & Co. against certain claims or liabilities, including claims or liabilities under the Securities Act or contribute to payments which FBR & Co. is required to make as a result of the litigation. Although these cases involving FBR & Co. are at a preliminary stage, based on management’s review with counsel and present information currently known by management,

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resolution of such matters is not expected to have a material effect on our financial condition or results of operations. In certain circumstances, broker-dealers and asset managers may also be held liable by customers and clients for losses sustained on investments. In recent years, there has been an increasing incidence of litigation and actions by government agencies and SROs involving the securities industry, including class actions that seek substantial damages. We are also subject to the risk of litigation, including litigation that may be without merit. As we intend to actively defend such litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against us could materially affect our financial condition, results of operations and liquidity.

Our business (through our subsidiary First NLC and its affiliated entities) historically included the origination, acquisition, pooling, securitization and sale of non-conforming residential mortgage loans. Consequently, we were subject to additional federal and state laws in this area of operation, including laws relating to lending, consumer protection, privacy and unfair trade practices.

Shareholders’ Derivative Action

On September 16, 2008, a shareholder derivative action captioned Kornfeld, et al. v. Billings, et al., No. 08-1144, was filed in the Circuit Court of Arlington County, Virginia, by Bill Kornfeld and Edward Lapinski. We were named as a nominal defendant along with certain current and former officers and directors as individual defendants. The complaint asserts claims under Virginia law against the individual defendants for breach of fiduciary duty and against certain of the individual defendants for unjust enrichment in connection with certain decisions concerning executive compensation. Our Board of Directors established a special committee to conduct a review and evaluation of the plaintiffs’ allegations and make a final decision concerning whether maintenance of the litigation was in our best interests. The special committee concluded that the litigation was not in our best interest. On December 8, 2008, we moved to dismiss the shareholder derivative action based on the special committee’s recommendation and the individual defendants filed demurrers. On March 5, 2009, the court denied the individual defendants’ demurrers, granted the plaintiffs’ motion for certain discovery and denied our motion to dismiss with leave to renew the motion following discovery. We cannot predict the likely outcome of this action or its likely impact on us or our results of operations at this time.

Other Litigation

As previously reported by our company, on January 18, 2008, First NLC, our non-conforming residential mortgage loan origination subsidiary, filed a voluntary petition for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code in order to effectuate an orderly liquidation of First NLC’s assets. The filing was made in the United States Bankruptcy Court for the Southern District of Florida, West Palm Beach Division (“Bankruptcy Court”). On May 9, 2008, First NLC voluntarily converted its bankruptcy case from a case under Chapter 11 of the United States Bankruptcy Code to a case under Chapter 7 of the United States Bankruptcy Code. Deborah Menotte was appointed the Chapter 7 Trustee of the First NLC bankruptcy estate. In December 2008, the Trustee sent a letter to certain of our officers and employees, who served on the board of managers of First NLC, alleging certain wrongful acts by First NLC’s board of managers. We have entered into a settlement agreement with the Trustee to obtain a release of all claims that the Trustee or the bankruptcy estate of First NLC may have against our Company and our officers, directors, employees and affiliates, including without limitation those referenced in the Trustee’s December letter, in exchange for the payment by us of approximately $4.0 million which the Company has accrued for as of December 31, 2008. Under the settlement agreement, we will and each of our officers, directors, employees and affiliates will release all claims against the trustee and the First NLC bankruptcy estate. The released claims include a general unsecured claim for subrogation/reimbursement based on the payment of certain of First NLC’s lease obligations under a guaranty by an affiliate of ours to First NLC’s primary landlord. The settlement agreement is subject to approval by the Bankruptcy Court. On the basis of our Company’s review of its relationship with First NLC and an opinion of our Company’s counsel regarding the likelihood of piercing the corporate veil, we believe that our Company has no further obligations to First NLC and that First NLC’s creditors would not pierce the corporate veil between First NLC and our Company.

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However, the First NLC bankruptcy proceeding is an ongoing matter that has not yet been concluded and we cannot predict the outcome of the proceeding.

As previously disclosed by us in our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2008, on September 26, 2008, we sued Lehman Brothers Inc. (Lehman) and the Securities Investor Protection Corporation (SIPC) in the Securities Investor Protection Act liquidation proceeding of Lehman before the United States Bankruptcy Court for the Southern District of New York. We sought the return of an agency-backed MBS with a face amount of $250 million under a repurchase agreement maintained with Lehman. The lawsuit and the request for return of the security was part of our normal, ongoing management of our assets and capital and was necessitated by an inability to secure satisfactory responses from the various parties associated with the Lehman liquidation proceeding. As of October 16, 2008, the Company satisfactorily resolved the status of the security and dismissed the law suit against both Lehman and SIPC.

None.

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PART II

Our Class A common stock is listed on the NYSE under the symbol “FBR.” On November 4, 2008, we were notified by the NYSE that we were not in compliance with an NYSE continued listing standard in that the average price of our Class A common stock had fallen below $1.00 per share for a consecutive 30 trading-day period. Our Class A common stock remains listed on the NYSE under the symbol “FBR,” but has been assigned a “.BC” indicator by the NYSE. The NYSE has granted us an opportunity to cure our non-compliance with the continued listing requirements and we are endeavoring to reestablish our compliance; however, we cannot guarantee that we will be able to satisfy those initial listing standards.

On February 24, 2009, in connection with our name change to Arlington Asset Investment Corporation, we have received the approval from the NYSE to change our symbol to “AI” from “FBR.” The Company will issue a press release when the symbol change becomes effective.

The following table shows the high and low sales prices of our Class A common stock during each fiscal quarter during the years ended December 31, 2008 and 2007, and the cash dividend per share declared during those periods.

On February 27, 2009, there were approximately 328 record holders of our Class A common stock. There is no established public trading market for our Class B common stock and on February 27, 2009, there were approximately 23 record holders of our Class B common stock. Class B shares receive dividends in the same amounts and on the same dates as Class A shares.

Our Board of Directors did not authorize the payment of any cash dividends to our shareholders during 2008. Pursuant to our variable dividend policy, our Board of Directors, in its sole discretion, may reinstate the payment of cash dividends when appropriate in the future.

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The following table provides information on our share repurchases during the fourth quarter of 2008:

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Stock Comparison Graph

The following graph compares the change in the cumulative total shareholder return for our Class A common stock from December 31, 2003 to December 31, 2008 with the comparable cumulative return of two indexes: the Standard & Poors (S&P) 500 Stock Index and the FSA Mid-Cap Index published by Financial Service Analytics, Inc.

Our Class A common stock trades on the NYSE. The graph assumes $100 invested on December 31, 2003 in our Class A common stock and $100 invested at the same time in each of the above-mentioned indexes. The comparison assumes that all dividends are reinvested.

Comparison of 5-Year Cumulative Total Return Among Friedman, Billings, Ramsey Group, Inc.,

the S&P 500 Index and the FSA Mid-Cap Index

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SELECTED CONSOLIDATED FINANCIAL INFORMATION

(Dollars in thousands, except per share amounts)

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Overview

Friedman, Billings, Ramsey Group, Inc. invests on a leveraged basis in residential mortgage-backed securities (MBS), either issued by a U.S. Government agency, or guaranteed as to principal and interest by U.S. Government agencies or U.S. Government-sponsored entities (agency-backed MBS). We also invest in both MBS issued by private organizations (private-label MBS) and net interest margin securities and we make merchant banking investments, subject to maintaining our exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (1940 Act).

In addition to our principal investing business described above, as of December 31, 2008, we beneficially owned 57% of the outstanding shares of common stock of FBR Capital Markets Corporation (FBR Capital Markets), a publicly-traded holding company (NASDAQ: FBCM) for various subsidiaries that conduct capital markets (investment banking and institutional brokerage), asset management and merchant banking businesses. These subsidiaries include Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.), Friedman, Billings, Ramsey International, Ltd. (FBRIL), FBR Investment Management, Inc. (FBRIM) and FBR Fund Advisors, Inc. (FBR Fund Advisors). FBR Capital Markets is managed under the direction of its board of directors, a majority of whom are independent of both us and FBR Capital Markets. As a result of our ownership of a majority of the issued and outstanding shares of common stock of FBR Capital Markets, our financial statements reflect our proportionate interest in the results of operations of FBR Capital Markets and its subsidiaries.

When we use the terms “FBR,” “we” “us” “our” and “the Company,” we mean Friedman, Billings, Ramsey Group, Inc. and its consolidated subsidiaries. We historically have conducted most of our principal investing activities at the parent company level and through a qualified REIT subsidiary (QRS) (principal investing). Historically, we have operated in a manner that qualifies us to be taxed as a real estate investment trust (REIT) for federal income tax purposes and we conducted our investment banking and institutional brokerage activities (capital markets), and investment management and advisory activities (asset management) in our former taxable REIT subsidiaries (TRSs). In order to use the net operating losses incurred at the parent level to offset anticipated taxable income of our former TRSs, our Board of Directors decided to revoke our REIT election effective as of January 1, 2009. As a result, we are currently taxed as a C corporation for federal income tax purposes. Our Company operates primarily in the United States and Europe.

Because of the continued deterioration of the non-prime mortgage market, on January 18, 2008, First NLC filed a voluntary petition for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code in order to effectuate an orderly liquidation of First NLC’s assets and on May 9, 2008, First NLC filed a notice of conversion with the bankruptcy court to convert First NLC’s petition for bankruptcy protection from a petition under Chapter 11 of the United States Bankruptcy Code to a petition under Chapter 7 of the United States Bankruptcy Code. As a result, on January 18, 2008, the Company deconsolidated First NLC and recognized its investment in First NLC under the cost-method thereafter.

In addition, the Company recorded a non-cash reversal of its $73.0 million negative investment in First NLC because the Company has no continuing involvement with First NLC. As a result of the bankruptcy and based on the Company’s review of its relationship with First NLC and an opinion of the Company’s counsel to the effect that First NLC’s creditors would not be able to pierce the corporate veil between First NLC and the Company, the Company believes it has no remaining guarantees of the debt or any other obligation of First NLC, and it is considered remote that the Company would have any further obligations related to First NLC.

On October 23, 2008, we announced our plan to downsize the MBS portfolio in order to reduce exposure to deteriorating market conditions while at the same time generating additional cash to fund the extinguishment of long-term debt. We also announced that we have retained financial advisors to evaluate strategic alternatives for

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the purpose of maximizing the value of our assets and liabilities including all of the trust preferred debt. Potential strategic alternatives include the sale of the Company or the assets or the distribution of the assets to shareholders. Consistent with this strategy, during the twelve months ended December 31, 2008, we extinguished approximately $65.8 million of long-term debt at a gain of approximately $39.1 million and disposed of approximately $1.6 billion of MBS from our MBS portfolio at a net loss of approximately $108.6 million. Subsequent to December 31, 2008 and through March 13, 2009, we extinguished an additional $201.7 million of long-term debt at a gain of approximately $131.5 million and disposed of an additional $56.1 million of MBS from our our MBS portfolio at a loss of $1.1 million, substantially completing the current phase of our strategy announced on October 23, 2008.

On February 23, 2009, we announced that we have begun doing business under the name “Arlington Asset Investment Corporation” and that we will seek shareholder approval at our next annual meeting of shareholders of a proposal to amend our charter to change our corporate name from “Friedman, Billings, Ramsey Group, Inc.” to “Arlington Asset Investment Corporation.” The Company had notified the NYSE of the name change and received the approval to change the ticker symbol to “AI” from “FBR” on February 24, 2009. The Company will issue a press release when the symbol change becomes effective.

Business Environment

Our MBS portfolio is affected by general U.S. residential real estate fundamentals and the overall U.S. economic environment. In particular, our MBS investing strategy and the performance of our MBS portfolio is influenced by the specific characteristics of these markets, including prepayment rates, interest rates and the interest rate yield curve. Our results of operations with respect to our MBS portfolio primarily depend on, among other things, the level of our interest income and the amount and cost of borrowings we may obtain by pledging our investment portfolio as collateral for the borrowings. Our interest income, which includes the amortization of purchase premiums and accretion of discounts, varies primarily as a result of changes in prepayment speeds of the securities in our MBS portfolio. Our borrowing cost varies based on changes in interest rates and changes in the amount we can borrow which is generally based on the fair value of the MBS portfolio and the advance rate the lenders are willing to lend against the collateral provided.

Concerns about increased mortgage delinquencies and foreclosures, declining home prices and rising unsold home inventory have caused many investors to question the underlying risk and value of mortgage-related assets across the ratings spectrum. Since the middle of 2007, commercial banks, investment banks and insurance companies have announced extensive losses from exposure to the U.S. mortgage market. These losses have reduced financial industry capital leading to reduced liquidity for mortgage assets, more volatile valuations of mortgage assets and in some cases forced selling of mortgage assets. As a result, repurchase financing for MBS, including agency-backed MBS, has been more volatile.

The liquidity crisis could adversely affect one or more of our lenders and could cause one or more of our lenders to be unwilling or unable to provide us with additional financing. This could potentially increase our financing costs and reduce liquidity. If one or more major market participants fails, it could negatively impact the marketability of all fixed income securities, including agency-backed MBS, and this could negatively impact the value of the securities in our MBS portfolio. Furthermore, if many of our lenders are unwilling or unable to provide us with additional financing, we could be forced to sell securities in our MBS portfolio at an inopportune time when prices are depressed.

The payment of principal and interest on the agency-backed MBS that we invest in is guaranteed by Ginnie Mae, Freddie Mac or Fannie Mae. The payment of principal and interest on agency-backed MBS issued by Ginnie Mae is guaranteed by the full faith and credit of the U.S. government, while payment of principal and interest on agency-backed MBS issued by Freddie Mac or Fannie Mae is not guaranteed by the U.S. government. Any failure to honor its guarantee of agency-backed MBS by Freddie Mac or Fannie Mae or any downgrade of securities issued by Freddie Mac or Fannie Mae by the rating agencies could cause a significant decline in the value of and cash flow from, any agency-backed MBS we own that are guaranteed by such entity.

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Due to increased market concerns about Fannie Mae and Freddie Mac’s ability to withstand future credit losses associated with securities held in their investment portfolios, and on which they provide guarantees, without the direct support of the federal government, the government passed the Housing and Economic Recovery Act of 2008, or the HERA, on July 30, 2008. As a result of this legislation, Fannie Mae and Freddie Mac have been placed into the conservatorship of the Federal Housing Finance Agency, or FHFA, their federal regulator, pursuant to its powers under the HERA. As the conservator of Fannie Mae and Freddie Mac, the FHFA now controls and directs the operations of Fannie Mae and Freddie Mac and may (i) take over the assets of and operate Fannie Mae and Freddie Mac with all the powers of the shareholders, the directors, and the officers of Fannie Mae and Freddie Mac and conduct all business of Fannie Mae and Freddie Mac; (ii) collect all obligations and money due to Fannie Mae and Freddie Mac; (iii) perform all functions of Fannie Mae and Freddie Mac which are consistent with the conservator’s appointment; (iv) preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and (v) contract for assistance in fulfilling any function, activity, action or duty of the conservator. A primary focus of this new legislation is to increase the availability of mortgage financing by allowing Fannie Mae and Freddie Mac to continue to grow their guarantee business without limit, while limiting net purchases of agency-backed MBS to a modest amount through the end of 2009. Beginning in 2010, Fannie Mae and Freddie Mac will gradually reduce their agency security portfolios.

In addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, the U.S. Department of Treasury, or the U.S. Treasury, has taken three additional actions: (i) the U.S. Treasury and FHFA have entered into separate preferred stock purchase agreements with Fannie Mae and Freddie Mac pursuant to which the U.S. Treasury will ensure that each of Fannie Mae and Freddie Mac maintains a positive net worth; (ii) the U.S. Treasury has established a new secured lending credit facility available until December 2009 to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, which is intended to serve as a liquidity backstop; and (iii) the U.S. Treasury has initiated a temporary program to purchase RMBS issued by Fannie Mae and Freddie Mac.

Initially, Fannie Mae and Freddie Mac each issued $1.0 billion of senior preferred stock to the U.S. Treasury and warrants to purchase 79.9% of the fully-diluted common stock outstanding of each government sponsored entity, or GSE, at a nominal exercise price. Pursuant to these agreements, each of Fannie Mae’s and Freddie Mac’s mortgage and agency security portfolio may not exceed $850 billion as of December 31, 2009, and will decline by 10% each year until such portfolio reaches $250 billion. Given the highly fluid and evolving nature of these events, it is unclear how our business will be impacted. Although the U.S. Treasury has committed capital to Fannie Mae and Freddie Mac, there can be no assurance that these actions will be adequate for their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer losses and could fail to honor their guarantees and other obligations which could materially adversely affect our business, operations and financial condition.

The Emergency Economic Stabilization Act of 2008, or EESA, was enacted on October 3, 2008. The EESA provides the U.S. Secretary of the Treasury with the authority to establish a Troubled Asset Relief Program, or TARP, to purchase from financial institutions up to $700 billion of residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008. In addition, it may purchase other financial instruments that the U.S. Secretary of the Treasury, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability. The EESA also provides for a program that would allow companies to insure their troubled assets.

On October 14, 2008, the U.S. Treasury announced the voluntary Capital Purchase Program, or the CPP, which was implemented under authority provided in the EESA. Under the CPP, the U.S. Treasury will purchase up to $250 billion of senior preferred shares in qualifying U.S. controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities, that elect to participate by November 14, 2008. Nine of the largest banks in the United States, as well as other financial institutions, have accepted investments under the CPP. The U.S. Treasury has also taken under consideration the expansion of the CPP to non-financial institutions, including life or other insurance companies. As of January 30, 2009, the U.S.

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Treasury Department has made $195.3 billion of investments, receiving preferred stock and warrants from participating institutions.

In addition, during 2008, the U.S. Federal Reserve, or the Federal Reserve, also initiated a number of other programs aimed at improving broader financial markets, such as establishing a $1.8 trillion commercial paper funding facility and a $200 billion facility to finance consumer asset-backed securities. In addition, in order to provide further liquidity to financial institutions, the Federal Reserve has provided primary dealers with access to the Federal Reserve’s discount window and, in instances of distress, arranged financing for certain entities.

On November 25, 2008, the Federal Reserve announced that it will initiate a program to purchase $100 billion in direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks and $500 billion in agency-backed MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae. The Federal Reserve stated that its actions are intended to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally. The purchases of direct obligations began during the first week of December 2008, and the purchases of agency-backed MBS are expected to begin shortly. The Federal Reserve’s program to purchase agency-backed MBS could cause an increase in the price of agency-backed MBS, which would negatively impact the net interest margin with respect to new agency-backed MBS we may purchase.

During 2008, the U.S. government, through the FHA and the Federal Deposit Insurance Corporation, or the FDIC, also initiated programs in an effort to restore confidence and functioning in the banking system and attempt to reduce foreclosures through loan modifications. To assist the banking system, the FDIC will now insure deposits up to $250,000 up from $100,000 through December 31, 2009, provide finite guarantees on qualified bank debt and, in limited cases, provide loan guarantees to certain financial institutions. Additionally, in an attempt to reduce foreclosures, the FDIC encouraged uniform guidelines for loan modifications, which include reduction of interest rate, extension of maturity and balance reductions.

There can be no assurance that the programs and proposals recently initiated and announced by the U.S. Treasury or Federal Reserve will have a beneficial impact on the financial markets. To the extent the market does not respond favorably to these programs and proposals or the initiatives do not function as intended, our business may not receive any positive impact from the legislation. In addition, the U.S. Treasury, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis. We cannot predict whether or when such actions may occur or what impact, if any, such actions could have on our business, results of operations and financial condition.

As an investment banking, institutional sales, trading and research, asset management, and investment firm, our businesses are materially affected by conditions in the U.S. financial markets, general U.S. economic conditions and, to a lesser degree, global economic conditions. The decreased level of capital markets activities during 2008 as compared to the comparable 2007 period exhibited the effects of the uncertainty in economic conditions due to continuing negative economic trends. Our investment banking revenues and MBS valuations have been adversely affected by the continued mortgage and credit market dislocation that began in the latter half of 2007 and continued through 2008, and we may be further impacted should there be continued or further credit market dislocations or a sustained market downturn. With trading volume in the MBS market diminishing, price discovery is difficult which has resulted in a widening of the bid/ask spreads. However, as investors continue to liquefy their positions, they have been forced to accept prices that are well below “pre-credit squeeze” levels. Other factors contributing to the current weak economic conditions are an increasing unemployment rate coupled with decreases in home prices and deterioration in consumer confidence.

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We believe the general business environment will continue to be challenging, with continued dampened capital markets activity, both domestically and internationally, and potential tightening in interest rate spreads. Our growth outlook is dependent in part on the extent and severity of the financial market dislocation, results from fiscal and monetary policy actions, the overall market value of U.S. equities and liquidity. The underpinnings of these growth assumptions also form our view on prospective investment banking, institutional sales, trading and research, asset management and investment activities. For further discussions on how markets conditions may affect our businesses see “Risk Factors.”

Executive Summary

Our revenues consist primarily of: underwriting and placement fees for capital raising and advisory fees in investment banking; agency commissions and principal transactions mark-ups and mark-downs in institutional brokerage; base management fees and incentive allocations and fees in asset management; and net interest income, earnings from investment funds and dividend income, net interest income and gains and losses in principal investing. The current year net loss reflects the effects of the difficult environment most of our business segments have endured as a result of the severe deterioration of global economic conditions. These conditions have had a significant negative impact on our 2008 operating results including the limited number of capital raising transactions completed within the financial services industry and our firm, resulting in a reduction in our investment banking revenues and the negative impact on our portfolio of equity investments, resulting in other-than-temporary impairments on much of our investment portfolio. In addition, our 2008 results include the impact of several actions taken by us during the year to position the Company for improved results in future periods. These include severance and other costs associated with a 25 percent reduction in employees during 2008 to better align our cost structure to current market conditions. In addition, we reduced the amount of liquid capital invested in our MBS portfolio, in order to reduce our exposure to leveraged investments and to generate additional cash to fund the extinguishment of long-term debt, resulting in realized losses and other-than-temporary impairment losses as of December 31, 2008. These actions along with adjustments to our variable expense structure and addition of new employees and lines of business which complement our core strengths will reduce our cost structure, provide additional avenues to generate revenues and reduce the risk on our liquid capital as the Company moves forward.

Consistent with the strategy announced on October 23, 2008, the Company extinguished $65.8 million of long-term debt for a gain of $39.1 million and the Company further reduced its MBS portfolio by $1.6 billion at a net loss of $209.5 million, which included $100.9 million in previously recognized other-than-temporary impairment. Subsequent to December 31, 2008, the Company continued to extinguish an additional $201.7 million of long-term debt at a gain of $131.5 million and further reduced its MBS portfolio by $56.1 million, at a loss of $1.1 million, substantially completing the current phase of our strategy announced on October 23, 2008. In addition, FBR Capital Markets also liquidated its remaining MBS portfolio of $454.3 million and related interest rate caps and repurchase agreements, recognizing an aggregate net investment loss of $1.0 million. The Company also liquidated $550.0 million of its U.S. Treasury bond holdings and related repurchase agreements, recognizing no gain or loss from the transaction.

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For the year ended December 31, 2008, our total revenues, net of interest expenses, were $(197.0) million compared to $107.2 million in 2007. The 2008 net loss of $417.5 million, or $2.76 loss per share, compared to a net loss of $658.6 million, or $3.94 loss per share, in 2007. The components of the net losses by segment are as follows (dollars in thousands):