Cohen & Co Inc. - Quarter Report: 2006 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended: September 30, 2006

OR

For the transition period from              to             

Commission File Number: 001-32026

ALESCO FINANCIAL INC.

(Exact name of registrant as specified in its governing instruments)

Cira Centre

2929 Arch Street, 17^th Floor

Philadelphia, Pennsylvania 19104

(Address of principal executive offices, Zip Code)

(215) 701-9555

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports and 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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

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

As of October 27, 2006, there were 24,368,514 shares of common stock ($0.001 par value) of Alesco Financial Inc. outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Alesco Financial Inc.

Consolidated Balance Sheets

(in thousands, except share data)

See accompanying notes to consolidated financial statements.

Alesco Financial Inc.

Unaudited Consolidated Statements of Operations

(in thousands, except per share data)

See accompanying notes to consolidated financial statements.

Alesco Financial Inc.

Unaudited Consolidated Statements of Other Comprehensive Income (Loss)

(in thousands)

See accompanying notes to consolidated financial statements.

Alesco Financial Inc.

Unaudited Consolidated Statement of Stockholders’ Equity

(in thousands)

See accompanying notes to consolidated financial statements.

Alesco Financial Inc.

Unaudited Consolidated Statements of Cash Flows

(in thousands)

See accompanying notes to consolidated financial statements.

Alesco Financial Inc.

Notes to Unaudited Consolidated Financial Statements

Note 1 – Organization

Alesco Financial Inc. (formerly Sunset Financial Resources, Inc. or Sunset) was incorporated in Maryland on October 6, 2003, completed its initial public offering of common stock on March 22, 2004 and was traded on the NYSE under the ticker symbol SFO. We elected to be taxed as a real estate investment trust (REIT) under the Internal Revenue Code of 1986, as amended (“Code”). We had limited operations until receiving the proceeds from our initial public offering, at which time we began executing the business strategy of investing in residential mortgage related securities and commercial bridge loans. On April 27, 2006, we announced our decision to merge with Alesco Financial Trust (AFT), and to enter into an interim management agreement with Cohen & Company Management, LLC (formerly Cohen Brothers Management, LLC) (Cohen). Under the operating guidelines of the interim management agreement, we began redeploying our assets into investments consistent with the investment strategy of the combined company, including collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) and similar securitized obligations, which are collateralized by mortgage loans and other real estate-related senior and subordinated debt securities, residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), subordinated debt financings primarily in the form of trust preferred securities issued by banks and insurance companies (TruPS), and leveraged loans to small and mid-sized companies. On October 6, 2006, we closed our merger with AFT following the approval of the merger by our stockholders, and we changed our name to Alesco Financial Inc. Pursuant to the terms of the Amended and Restated Agreement and Plan of Merger, as amended by letter agreements dated September 5, 2006 and September 29, 2006 (the “Merger Agreement”), upon the completion of the merger each share of AFT was converted into the right to receive 1.26 of our shares and we issued an aggregate of 14,415,530 shares in the merger. In connection with the merger we assumed the management agreement of AFT with Cohen. In accordance with U.S. generally accepted accounting principles (“GAAP”) the transaction is to be accounted for as a reverse acquisition, and therefore, AFT is the accounting acquirer. Pro forma financial information for the combined company is presented in Note 12 herein. On October 9, 2006, we began trading on the NYSE under the ticker symbol “AFN”.

Note 2 – Summary of Significant Accounting Policies

Basis of Presentation

The accompanying interim unaudited consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America, and should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005, as filed with the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in this report on Form 10-Q pursuant to the Rules and Regulations of the SEC. In our opinion, the disclosures contained in this report are adequate to make the information presented not misleading.

Accounting measurements at interim dates inherently involve greater reliance on estimates than at year end, and the results of operations for the interim periods shown in this report are not necessarily indicative of results to be expected for the fiscal year. In our opinion, the accompanying unaudited consolidated financial statements include all adjustments (of a normal recurring nature) necessary to present fairly the consolidated financial position of the Company as of September 30, 2006, the consolidated results of our operations and comprehensive operations for the three and nine months ended September 30, 2006 and 2005, the consolidated statement of stockholders’ equity for the nine months ended September 30, 2006 and the consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005.

Principles of Consolidation

The consolidated financial statements reflect the accounts of the Company and majority-owned and/or controlled subsidiaries and those entities for which we are determined to be the primary beneficiary in accordance with Financial Accounting Standard Board (FASB) Interpretation No. 46R, “Consolidation of Variable Interest Entities” (FIN 46R). The portions of these entities not owned by us are presented as minority interest as of the date and for the period presented in the consolidated financial statements. All intercompany accounts and transactions have been eliminated in consolidation.

Under our revised investment strategy, we obtain explicit or implicit interest in other entities. In each case, we evaluate the entity to determine if the entity is a variable interest entity (“VIE”), and, if so, whether or not we are deemed to be the primary beneficiary of the VIE, in accordance with FIN 46R. We consolidate VIEs of which we are deemed to be the primary beneficiary or non-VIEs which we control. The primary beneficiary of a VIE is the variable interest holder that absorbs the majority of the variability in the expected losses or the residual returns of the VIE. When determining the primary beneficiary of a VIE, we consider our aggregate explicit and implicit variable interests as a single variable interest. Our aggregate explicit and implicit interest in a VIE includes variable interests that related parties hold in the same VIE. Related parties include those parties identified in FASB Statement No. 57 (“SFAS No. 57”), “Related Party Disclosures”, and certain other parties that are acting as de facto agents or de facto principals

of the variable interest holder. In the event that the aggregate variable interest held by our related party group would, if held by a single party, identify that party as the primary beneficiary, then the party, within the related party group, that is most closely associated with the VIE is the primary beneficiary of the VIE. If our single or aggregate variable interest absorbs the majority of the variability in the expected losses or the residual returns of the VIE, we are considered the primary beneficiary of the VIE. We consolidate CDO entities that are VIE entities when we are determined to be the primary beneficiary. We reconsider our determination of whether an entity is a VIE and whether we are the primary beneficiary of such VIE if certain events occur. In the case of non-VIEs or VIEs where we are not deemed to be the primary beneficiary and we do not control the entity, but have the ability to exercise significant influence over the entity, we account for our investment under the equity method.

We have determined that certain special purpose trusts formed by third party issuers of TruPS to issue such securities are VIEs (“Trust VIEs”) and that the holder of the majority of the TruPS issued by the Trust VIEs would be the primary beneficiary of the special purpose trust. In most instances, we are the primary beneficiary of the Trust VIEs because we hold, either explicitly or implicitly, the majority of the TruPS issued by the Trust VIEs. Certain TruPS issued by Trust VIEs are initially financed directly by CDOs or through our warehouse facilities. Under the warehouse agreements, we deposit cash collateral with an investment bank and bear the first dollar risk of loss, up to our collateral deposit, if an investment held under the warehouse facility is liquidated at a loss. This arrangement causes us to hold an implicit interest in the Trust VIEs that issued TruPS held by warehouse providers. The primary assets of the Trust VIEs are subordinated debentures issued by third party sponsors of the Trust VIEs in exchange for the TruPS proceeds and the common equity securities of the Trust VIE. These subordinated debentures have terms that mirror the TruPS issued by the Trust VIEs. Upon consolidation of the Trust VIEs, these subordinated debentures, which are assets of the Trust VIE, are included in our financial statements and the related TruPS are eliminated. Pursuant to Emerging Issues Task Force Issue No. 85-1: “Classifying Notes Received for Capital Stock,” subordinated debentures issued to Trust VIEs as payment for common equity securities issued by Trust VIEs to third party sponsors are recorded net of the common equity securities issued.

Use of Estimates

The preparation of consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires us to make estimates and assumptions that affect reported amounts of certain assets, liabilities, contingent assets and liabilities, revenues and expenses as of and for the reporting periods. Actual results may differ from such estimates.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with a maturity of three months or less. The carrying amount approximates fair market value. From time to time, cash balances may be subject to restrictions, such as when balances are pledged to meet margin calls related to derivative transactions or reverse repurchase agreements.

Restricted Cash

Restricted cash represents amounts held on deposit by investment banks as collateral for derivative contracts, cash held by trustees of CDO entities that is generated from earnings on the collateral assets and cash held by trustees of CDO entities that is generated from the issuance of CDO notes payable by consolidated CDO securitizations that are restricted for the purpose of funding additional collateral.

Warehouse Deposits and Off-Balance Sheet Arrangements

Warehouse deposits represent amounts held as collateral by providers, typically investment banks, of warehouse facilities. During the accumulation period, the warehouse providers fund investments, and our collateral deposits bear the first dollar risk of loss, up to the collateral amount, if an investment is liquidated from the warehouse facility at a loss.

These warehouse financing arrangements are accounted for as off-balance sheet arrangements. Under the warehouse agreements, we are required to deposit cash collateral with the warehouse provider and, as a result, we bear the first dollar risk of loss up to the warehouse deposit, if (i) an investment funded through the warehouse facility becomes impaired or (ii) a CDO is not completed by the end of the warehouse period, and in either case, the warehouse provider is required to liquidate the securities at a loss. These off-balance sheet arrangements are not consolidated because our risk of loss is generally limited to the cash held as collateral by the warehouse providers. However, since we hold an implicit variable interest in certain entities funded under our warehouse facilities, we may be required to consolidate the Trust VIEs while the TruPS they issue are held on the warehouse facilities.

Prior to the completion of a CDO securitization that is collateralized by TruPS, warehouse providers acquire investments in accordance with the terms of the warehouse facilities. We receive the difference between the interest earned

on the investments under the warehouse facilities and the interest charged by the warehouse providers from the dates on which the respective investments were acquired. The net difference earned from these warehouse facilities is considered a free-standing derivative and is recorded at fair value in the financial statements. Changes in fair value are reflected in earnings in the respective period.

Investments

We invest primarily in debt securities, residential mortgage portfolios, leveraged loans and may invest in other types of real estate-related assets. We account for our investments in securities under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” as amended and interpreted (“SFAS No. 115”), and designate each investment as a trading security, an available-for-sale security, or a held-to-maturity security based on management’s intent at the time of acquisition. Under SFAS No. 115, trading securities are recorded at their fair value each reporting period with fluctuations in fair value reported as a component of earnings. Available-for-sale securities are recorded at fair value with changes in fair value reported as a component of other comprehensive income (loss). Fair value of investments is based primarily on quoted market prices from independent pricing sources when available for actively traded securities or discounted cash flow analyses developed by management using current interest rates and other market data for securities without an active market. Our estimate of fair value is subject to a high degree of variability based upon market conditions and our assumptions. Upon the sale of an available-for-sale security, the realized gain or loss is computed on a specific identification basis and will be recorded as a component of earnings in the respective period. Held-to-maturity investments are carried at amortized cost at each reporting period.

We account for our investments in subordinated debentures owned by Trust VIEs that we consolidate as available-for-sale securities. The subordinated debentures are classified as available-for-sale due to the ability of the investment bank financing the warehouse agreement to transfer TruPS during the warehouse period or the Company’s ability to exit the warehouse facility agreement, either of which could result in a deconsolidation event. These VIEs have no ability to sell, pledge, transfer or otherwise encumber the trust or the assets of the trust until such subordinated debenture’s maturity. We account for investments in securities where the transfer meets certain criteria under Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS No. 140”) as a financing at amortized cost. Investments in security-related receivables represent interests in securities that were transferred to CDO securitization entities by transferors that maintained some level of continuing involvement.

In accordance with SFAS No. 115, we account for our investments in the preference shares of CDO or CLO structures, which we are not determined to be the primary beneficiary under FIN 46R, as debt securities classified as available-for-sale. These investments represent retained interests in securitizations that can be contractually prepaid or otherwise settled in such a way that the holder may not recover substantially all of its recorded investment.

We account for our investments in loans, including securitized mortgage loans, residential mortgage loans, commercial loans and leveraged loans at amortized cost. Securitized mortgages include mortgage loans that have been transferred to a securitization trust. Although there has been a change in ownership structure, this transfer does not qualify as a sale, and is made at book value, since we maintain ownership interest in the trust. The carrying value of these investments is adjusted for origination discounts/premiums, nonrefundable fees and direct costs for originating loans which are amortized into income over the terms of the loans using the effective yield method adjusted for the effects of estimated prepayments based on SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases – an amendment of FASB Statements No. 13, 60 and 65 and a rescission of FASB Statement No. 17”.

Other-than-Temporary Impairment

We use judgment in evaluating securities for other-than-temporary impairment. Generally, securities that have been in a continuous loss position may be evaluated for other-than-temporary impairment. However, other factors, such as government-sponsored agency guarantees, credit risk, the financial condition of the related entity and our ability and intent to hold investments until a forecasted recovery of fair value, are also considered in the evaluation. If we determine that an investment carried at amortized cost has sustained an other-than-temporary decline in its value, the asset is written down to its fair value by a charge to earnings, and a new cost basis is established for the investment. If a security that is available for sale sustains an other-than-temporary impairment, the identified impairment is reclassified from accumulated other comprehensive income (loss) to earnings, thereby establishing a new cost basis.

Allowance for Loan Losses

We provide an allowance for loan losses related to our loan portfolio. Loan loss provisions are based on an assessment of numerous factors affecting the portfolio, including, but not limited to, current and projected economic conditions, delinquency status, credit losses to date on underlying mortgages, collateral values of properties securing loans and any remaining credit protection. Loan loss provision estimates are reviewed periodically and adjustments are reported in earnings when they become known. Loans are charged-off when, in the opinion of management, the balance is no longer collectable.

Commercial mortgage loans are evaluated for impairment in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and 15,” when, based on current information and events, it is probable that we will be unable to collect principal and interest according to contractual terms of the agreement. Any provisions recorded are based on cash flow analysis, discounted at the loan’s effective interest rate, or, if the loan is collateral dependant, on the fair value of the collateral less the estimated costs to sell.

Fixed Assets

Long-lived assets to be used in the business generally consist of furniture, fixtures, computer equipment, software and leasehold improvements. These assets are depreciated or amortized on a straight line basis over their estimated useful lives, which range from two to five years. Leasehold improvements are amortized over the shorter of the estimated life of the asset or the life of the lease. At September 30, 2006, we had the intent to sell or otherwise dispose of our fixed assets and have recorded an impairment charge of $113,000 to reduce the carrying value to estimated net realizable value.

Reverse Repurchase Agreements

We borrow money through the use of reverse repurchase agreements. Under these repurchase agreements, we sell securities, securitized loans, or residential mortgage loans to a lender and agree to repurchase the same instruments at a predetermined price and date. Although structured as a sale and repurchase obligation, a repurchase agreement operates as a financing under which we pledge assets as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. We retain beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, we are required to repay the loan and concurrently receive back our pledged collateral from the lender or, with the consent of the lender, we may renew such agreement at the then prevailing financing rate. These repurchase agreements may require us to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.

Should a counterparty decide not to renew a repurchase agreement at maturity, we must either refinance elsewhere or be in a position to satisfy this obligation. To mitigate risk, we enter into repurchase agreements only with investment grade institutions.

Derivative Instruments

We use derivative financial instruments to attempt to hedge all or a portion of the interest rate risk associated with our borrowings. Certain of the techniques used to hedge exposure to interest rate fluctuations may also be used to protect against declines in the market value of assets that result from general trends in debt markets. The principal objective of such agreements is to minimize the risks and/or costs associated with our operating and financial structure as well as to hedge specific anticipated transactions.

In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted (“SFAS No. 133”), we measure each derivative instrument (including certain derivative instruments embedded in other contracts) at fair value and record such amounts in our consolidated balance sheet as either an asset or liability. For derivatives designated as fair value hedges, the changes in fair value of both the derivative instrument and the hedged item are recorded in earnings. For derivatives not designated as hedges, the changes in fair value are recorded in earnings. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in other comprehensive income (loss). Changes in the ineffective portions of cash flow hedges are recognized in earnings.

We maintain warehouse financing arrangements with various investment banks that are accounted for as off-balance sheet arrangements. Prior to the completion of a CDO securitization that is collateralized by TruPS, warehouse providers acquire investments in accordance with the terms of the warehouse facilities. We receive the difference between the interest earned on the investments under the warehouse facilities and the interest charged by the warehouse providers from the dates on which the respective investments were acquired. The net difference earned from these warehouse facilities is considered a free-standing derivative and is recorded at fair value in the financial statements. Changes in fair value are reflected in earnings in the respective period.

Accumulated Other Comprehensive Income

We account for the change in fair market value of our available for sale securities and the effective portion of the change in fair market value of derivative financial instruments in other comprehensive income.

Other comprehensive income (loss) does not include the impact of market value changes of any assets or liabilities that are carried at cost, such as our loan portfolio.

Revenue Recognition

Interest income from investments in debt securities, residential mortgages, and securitized loans is recognized over the estimated life of the underlying financial instruments on a yield to maturity basis. Premiums and discounts associated with the purchase of investment securities are amortized into interest income over the lives of the securities using the effective interest yield adjusted for the effects of estimated prepayments based on SFAS No. 91. Adjustments are made using the retrospective method to the effective interest computation each reporting period based on the actual prepayment experiences to date.

Interest income on commercial mortgage loans is accrued based on the outstanding principal amount and the stated interest rate, unless we consider the collection of interest to be uncertain. Loans are evaluated for non-accrual status on an individual basis when payments in accordance with contractual terms are delinquent in excess of 60 days, or sooner if deemed appropriate. In general, when a loan is placed on nonaccrual, interest accrued during that period is reversed, and any future income is recognized on a cash basis. Loan fees are deferred and amortized over the expected life of the loan.

Accounting for Share-Based Compensation

We account for share-based compensation in accordance with the fair value recognition provisions of SFAS No. 123(R), “Share-Based Payment.” We record expenses for the estimated value of stock based awards for both employees and non-employees. These awards are valued using the Black-Scholes option pricing model, which requires assumptions related to stock price volatility, dividend yield, expected option life, and a risk free rate of return. Changes in the volatility of our stock, or other assumption changes, would affect the amount of expense recorded in our financial statements.

Income Taxes

We elected to be taxed as a Real Estate Investment Trust (REIT) under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and have been taxed as such beginning with the taxable year ended December 31, 2004. To qualify as a REIT, we must meet certain organizational and operational requirements, including a requirement to currently distribute at least 90% of our REIT taxable income to stockholders. As a REIT, we generally will not be subject to federal income tax on taxable income that we distribute to our stockholders. If we fail to qualify as a REIT in any taxable year, we will then be subject to federal income taxes on taxable income at regular corporate rates starting with that year and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service were to grant relief under certain statutory provisions.

We maintain domestic taxable REIT subsidiaries (“TRS”), which are subject to U.S. federal, state and local income taxes. Current and deferred taxes are provided for on the portion of earnings recognized with respect to our interest in domestic taxable REIT subsidiaries. Deferred income tax assets and liabilities are computed based on temporary differences between the GAAP consolidated financial statements and the federal and state income tax basis of assets and liabilities as of the consolidated balance sheet date.

Certain TRS entities are domiciled in the Cayman Islands and, accordingly, taxable income generated by these entities may not be subject to local income taxation, but generally will be included in our income on a current basis, whether or not distributed. Upon distribution of any previously included income, no incremental U.S. federal, state, or local income taxes would be payable.

Earnings per Share (EPS)

Earnings per share is calculated under SFAS No. 128, “Earnings per Share.” Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding during the period plus the effect of dilutive potential common shares outstanding using the treasury stock method. Dilutive potential shares include stock options, restricted stock and warrants.

Concentrations of Credit Risk

Our investments are concentrated in securities that pass through collections of principal and interest from underlying mortgages, and there is a risk that some borrowers on the underlying mortgages will default. However, we mitigate this credit risk by holding securities that are either guaranteed by government or government-sponsored agencies or have actual or implied AAA credit ratings.

We also have investments in commercial bridge loans, which are collateralized with real estate. We periodically evaluate collateral adequacy, and any shortage is reviewed for impairment. We have not entered into any new commercial loans since July 2005.

Our new target asset classes are in investments collateralized by leveraged loans to small and midsized companies, subordinated debt financings primarily in the form of trust preferred securities issued by banks and insurance companies, as well as residential and commercial mortgage related assets. At the balance sheet date, we did not have a significant concentration of credit risk within any of our new target asset classes.

We enter into reverse repurchase agreements and swap agreements with various counterparties, and also have cash deposits with financial institutions that exceed federally insured amounts. In the event the counterparties and financial institutions do not fulfill their obligations, we could be exposed to risk of loss. To mitigate this risk, we only enter into agreements with creditworthy institutions. We also look to establish netting arrangements with those counterparties providing both financing and hedging as a mechanism to mitigate credit risk. Under such an arrangement, any value captured in the hedge is applied towards satisfying expected margin calls due to a drop in the financed position’s market value.

Our securities portfolio and financing instruments are impacted by changes in interest rates. To mitigate a portion of the volatility caused by changing rates, we enter into derivative instruments, typically swaps, to hedge the portfolio.

Reclassifications

Certain prior period amounts have been reclassified to conform with current period presentation.

Note 3 – Investments in Securities

At September 30, 2006 and December 31, 2005, our available-for-sale investments were carried at estimated fair value which was determined based on the average of third-party broker quotes received. During the quarter ended September 30, 2006 we sold RMBS securities with an amortized cost of $439.0 million for cash proceeds (fair value) of $440.4 million. An impairment charge of $13.5 million was taken on these securities at June 30, 2006, in anticipation of the sale. The cash proceeds after repayment of related financings were redeployed into our new target asset classes. On August 3, 2006, we invested in “Kleros Real Estate CDO II, Ltd.” (Kleros II), a CDO securitization that provides financing for investments in mortgage-backed securities (MBS). Kleros II received commitments for $994.7 million of CDO notes, all of which were issued to investors as of September 30, 2006. Kleros II also issued $4.0 million of preference shares upon closing. We retained 100% of the common and preference shares of Kleros II, $11.0 million (representing 100%) of the Class D CDO notes, and $15.0 million (representing 100%) of the Class E CDO notes. As a result of the explicit interest that we have in this CDO entity, we have consolidated approximately $1.0 billion of assets and $968.7 million of CDO notes payable as of September 30, 2006.

The following table presents the components of our available-for-sale securities portfolio:

At September 30, 2006, our RMBS included agency securities with a fair value of $16.8 million.

Each quarter we review our securities to determine whether a decline in fair value below our amortized cost basis is other than temporary, as defined in SFAS 115. At September 30, 2006, we concluded that unrealized losses on our mortgage-backed securities did not represent other-than-temporary impairments. The unrealized losses are primarily a result of changes in interest rates and will not prohibit us from receiving our contractual interest and principal payments.

The unrealized losses on our RMBS at September 30, 2006, of $478,000 related to 11 agency securities with an amortized cost basis of $17.1 million and 19 non-agency securities with an amortized cost basis of $82.1 million. We do not believe these unrealized losses represent, individually or in the aggregate as of September 30, 2006, other-than-temporary impairments. The unrealized losses are primarily a result of changes in interest rates and will not prohibit us from receiving our contractual interest and principal payments. We have the ability to hold these securities for a period necessary to recover the amortized cost and, at September 30, 2006, had not determined a timeframe, if any, for the disposition of these securities.

The following table reflects the par value of the portfolio by remaining fixed interest periods for the investment securities portfolio at September 30, 2006. The floating rate mortgage-backed securities are backed by loans indexed off one-month LIBOR.

Note 4 – Investments in Loans

Residential Mortgage Loans

At September 30, 2006 and December 31, 2005, our residential mortgage loans, including our securitized loans, were carried at historical cost, net of unamortized premium or discount and fees. The balances by original fixed period are summarized in the following table:

The fair value of the mortgage loans at September 30, 2006 was $236.7 million. The difference between fair value and book value represents unrealized losses as a result of increases in interest rates, and will not prohibit us from receiving our contractual interest and principal payments.

At September 30, 2006, the average months to reset for the 3-, 5- and 7-year categories were 5, 58 and 53 months, respectively. The loan portfolio as a whole had an average remaining fixed period of 57 months.

At September 30, 2006, one loan with a balance of $109,000, or less than 1.0% of the aggregate loan balance, was 30 days past due in the residential loan portfolio, and one loan for $221,000, or less than 1.0% of the aggregate loan balance, was over 180 days past due and was in REO (real estate owned). At December 31, 2005, two loans totaling $600,000 (including the $221,000 loan referenced above), or 0.38% of the securitized loan balance, were 30 days past due, and one loan for $68,000 was in bankruptcy.

Commercial Mortgage Loans

Our commercial loans are carried on the balance sheet at historical cost, which, net of allowance for loan losses, approximates fair value, and are summarized as follows (in thousands):

Allowance for Loan Losses

We evaluate commercial loans for possible impairment under SFAS No. 114. The following is a discussion of each loan with a remaining principal balance at September 30, 2006:

Peerless Resort Development. The Peerless loan, which is collateralized by a development to consist of approximately 900 residential lots, matured on June 7, 2006, at which time all outstanding principal and interest became due and payable. While the borrowers made substantial progress on reducing the principal balance by $4.9 million during the six months ended June 30, 2006, they were unable to pay the loan in full at maturity, and we gave the borrowers notice of default.

During the quarter ended September 30, 2006, the borrowers continued to develop the property and market the lots for sale to potential home owners but were unable to make payments on the outstanding principal and interest balance. We assessed the loan for impairment, including a review of the estimated future cash flows from the development project and the underlying collateral value, and determined that the loan was impaired and that a provision of $2.2 million was required at September 30, 2006. Discussions with the borrowers are ongoing regarding the status of the development and the plans for repayment of the loan balance. During the three and nine months ended September 30, 2006, interest income of $630,000 and $1.6 million was recorded, of which $783,000 remains outstanding.

Rightstar Cemetery/Funeral Home. We have a participation interest (approximately 20%) in a loan collateralized by cemetery/funeral home properties in Hawaii. This loan has been in default since 2004, and during the second quarter of 2005, we determined that the loan was impaired and that the loan should be reserved in full. At September 30, 2006, the loan continued to be fully impaired. For the nine months ended September 30, 2006, no interest income was recorded on this loan.

We continue to incur legal fees of approximately $25,000 monthly related to the collection of this loan, which are expensed as incurred. Under terms of the Intercreditor Agreement, we may also be responsible for our respective portion of future expenses related to preservation of collateral. We anticipate that future expenditures related to the preservation of collateral will not be material.

On October 7, 2005, we filed suit against the other two participating creditors in the loan, Owens Mortgage Investment Fund and Vestin Mortgage, Inc., for violation of certain provisions under the Intercreditor Agreement. The outcome of this lawsuit cannot be determined at this time.

Coliseum Sport Facility. The Coliseum loan went into default during the first quarter of 2005, a court-ordered receiver was put in place and we were allowed to market the property for sale. On November 4, 2005, we received a signed contract for sale, subject to court approval. Using the contracted price, and accounting for carrying costs, commission and other transactions costs, we concluded that the net realizable value of the collateral securing the loan was less than the carrying value of the loan, and an impairment charge of $1.2 million was required for the period ended September 30, 2005. On January 31, 2006, the collateral was sold for net proceeds of $3.5 million, which approximated our loan balance. In March 2006, $3.4 million of the proceeds was released to us. The remaining $100,000 is still under court control; however, we anticipate that this balance will be released to us in the coming months. Although the collateral was sold, we retained all our rights and remedies under the original note agreement against the Guarantor as it relates to the deficiency arising from the sale of the loan collateral, including interest and legal fees and are pursuing collection of this deficiency.

In addition to a specific review of each commercial loan, we provide for loan losses by making a general assessment of the overall residential loan portfolio. Based on our review for the period ended September 30, 2006, no incremental provision was necessary.

Note 5 – Hedging

As of September 30, 2006, we had a portion of our interest rate risk hedged with interest rate swaps (designated as cash flow hedges), which also extended the duration of our short term borrowings. Total notional amount outstanding at September 30, 2006 was $452.9 million maturing as follows:

        As of September 30, 2006, five swaps were in a loss position totaling $9.4 million and seven swaps were in a gain position totaling $1.0 million. We have counterparty credit risk related to the swaps in a gain position. At September 30, 2006, our maximum net credit exposure to a single counterparty was $374,000. To mitigate this risk, we only enter into swap transactions with investment grade institutions.

During the quarter ended September 30, 2006, swaps with a notional balance of $292.1 million were terminated in conjunction with the sale of securities and repayment of reverse repurchase agreements. Since this transaction was part of our strategy to redeploy our assets into other target assets, it is probable that the forecasted transactions (variable rate interest payments) that were hedged with these swaps will not occur; therefore, the gain on the termination of these swaps of $8.2 million was recorded directly to earnings. Additionally, an ineffectiveness loss of $71,000 was recorded related to a hedging instrument on a CDO transaction.

Year-to-date, we terminated swaps with a notional amount of $946.4 million for a gain of $18.7 million, of which $17.7 was recorded directly to earnings and $1.0 million was recorded to other comprehensive income to be amortized over the remaining life of the hedged item.

Free-Standing Derivatives

We maintain arrangements with investment banks regarding TruPS-related CDO securitizations and warehouse facilities. Prior to the completion of a TruPS-related CDO securitization, investments are acquired by the warehouse providers in accordance with the warehouse facilities. Pursuant to the terms of the warehouse agreements, we receive the difference between the interest earned on the investments under the warehouse facilities and the interest charged by the warehouse facilities from the dates on which the respective securities are acquired. Under the warehouse agreements, we are required to deposit cash collateral with the warehouse provider and as a result, we bear the first dollar risk of loss, up to our warehouse deposit, if (i) an investment funded through the warehouse facility becomes impaired or (ii) a CDO is not completed by the end of the warehouse period, and in either case, if the warehouse facility is required to liquidate the securities at a loss. Upon the completion of a TruPS-related CDO securitization, the cash collateral held by the warehouse provider is returned to us. The terms of the warehouse facilities are generally nine months. These arrangements are deemed to be derivative financial instruments and are recorded by us at fair value each accounting period with the change in fair value recorded in earnings. These arrangements represent our only off-balance sheet arrangements. During the period from January 1, 2006 through September 30, 2006, the change in the fair value of our warehouse financing arrangement was $730,000 and was recorded as a component of net investment income in the accompanying consolidated statement of income. As of September 30, 2006, we had two warehouse agreements outstanding with investment banks that supported approximately $494 million of TruPS securities.

Note 6 – Debt

Junior Subordinated Notes

On March 15, 2005, Sunset Financial Statutory Trust I, a Delaware statutory trust (the Preferred Trust) and a wholly-owned subsidiary of the Company, completed a private offering of $20 million of trust preferred securities. The Preferred Trust used the proceeds of the private offering, together with our $619,000 investment in the Preferred Trust common securities, to purchase $20.6 million aggregate principal amount of our Junior Subordinated Notes with terms that mirror the terms of the trust preferred securities.

The trust preferred securities and the subordinated notes bear interest at 90-day LIBOR plus 4.15% (approximately 9.52% at September 30, 2006), payable quarterly in arrears, and generally may not be redeemed prior to March 30, 2010. The maturity date of subordinated notes is March 30, 2035.

The Preferred Trust is a variable interest entity pursuant to FIN No. 46(R) because the holders of the equity investment at risk do not have adequate decision making ability over the Preferred Trust’s activities. Because our investment in the Preferred Trust’s common securities was financed directly by the Preferred Trust as a result of its loan of the proceeds to us, that investment is not considered to be an equity investment at risk pursuant to FIN No. 46(R), and we are not the primary beneficiary of the Preferred Trust. Therefore, the financial statements of the Preferred Trust are not consolidated with our financial statements, and our financial statements present the subordinated notes issued to the Preferred Trust as a liability, and the investment in the Preferred Trust as an asset. As of September 30, 2006, no event had occurred that might have a significant adverse effect on the carrying value of the our $619,000 investment in the Preferred Trust.

Reverse Repurchase Agreements

We have arrangements to enter into reverse repurchase agreements with 14 financial institutions under facilities totaling $2.5 billion. Outstanding at September 30, 2006 was $304.5 million with a weighted average rate of 5.51% and a weighted average remaining maturity of 28 days. All maturity dates are in October 2006. Securities and securitized loans pledged as collateral on the reverse repurchase agreements had a carrying value and fair value of $324.1 million and $318.7 million, respectively, as of September 30, 2006.

As of September 30, 2006, we had amounts outstanding under repurchase agreements with four lenders with a maximum net exposure (the difference between the amount loaned to us and the estimated fair value of the security pledged by us as collateral) of $14.1 million to all four lenders, of which 49.5% was with one counterparty.

The following table summarizes the maturities of our reverse repurchase agreements (in thousands):

Trust Preferred Obligations

Trust preferred obligations finance subordinated debentures acquired by Trust VIEs that are consolidated by us for the portion of the total TruPS that are owned by entities outside of the consolidated group. These trust preferred obligations bear interest at either variable or fixed rates until maturity, generally 30 years from the date of issuance. The Trust VIE has the ability to prepay the trust preferred obligation at any time, without prepayment penalty, after five years. We do not control the timing or ultimate payment of the trust preferred obligations.

CDO Notes Payable

CDO notes payable represent notes payable issued by CDO entities used to finance the acquisition of MBS. Generally, CDO notes payable are comprised of various classes of notes payable, with each class bearing interest at variable or fixed rates.

On August 3, 2006, we invested in “Kleros Real Estate CDO II, Ltd.” (Kleros II), a CDO securitization that provides financing for investments in MBS. Kleros II received commitments for $994.7 million of CDO notes, all of which were issued to investors as of September 30, 2006. Kleros II also issued $4.0 million of preference shares upon closing. We retained 100% of the common and preference shares of Kleros II, $11.0 million (representing 100%) of the Class D CDO notes, and $15.0 million (representing 100%) of the Class E CDO notes.

The notes payable issued by Kleros II to third parties consist of 5 classes of notes bearing interest at spreads over 1-month LIBOR ranging from 22 to 65 basis points.

Note 7 – Stockholders’ Equity

During the nine-months ended September 30, 2006, there were no awards of restricted stock or stock options and 23,000 shares of restricted stock vested. For the three- and nine-month periods ended September 30, 2006, compensation expense of $70,000 and $146,000, respectively, was recognized related to previously issued restricted stock and stock options. For the three- and nine-month periods ended September 30, 2005, compensation expense of $6,000 and $117,000, respectively, was recognized related to previously issued restricted stock and stock options.

Accumulated other comprehensive loss at September 30, 2006 consisted of $7.1 million accumulated gain related to the mark to market of available-for-sale investment securities, $5.4 million accumulated loss related to the mark to market of interest rate swaps, and $543,000 accumulated net deferred loss on terminated effective cash flow hedges.

Note 8 – Earnings per Share

Basic earnings per share are computed based upon the weighted average number of common shares outstanding. Diluted earnings per share reflect the dilutive effect of stock options and restricted stock. A reconciliation of the basic and diluted weighted average shares is as follows:

Note 9 – Income Taxes

We elected to be taxed as a REIT commencing with the tax year ended December 31, 2004. In order to maintain our qualification as a REIT, we are required to distribute dividends to our stockholders in an amount at least equal to 90% of our REIT taxable income. For each of the first, second and third quarters of 2006, we declared and paid dividends of $315,000, or $0.03 per common share. During September 2006, we declared a pre-merger dividend of $5.3 million, or $0.50 per common share to holders of record at close of business on October 5, 2006, payable within 10 days following the closing of the merger.

The schedule below is provided to reconcile GAAP net income to estimated taxable income for the nine-month period ended September 30, 2006:

During the quarter ended September 30, 2006, we recorded a provision for income taxes of $150,000 related to the estimated taxable income on our taxable REIT subsidiaries. This amount represents an estimated consolidated effective tax rate of 2.0% for the three-months ended September 30, 2006. The difference between this rate and the statutory tax rate is attributable to income generated by qualified REIT subsidiaries and certain foreign TRS entities which are not subject to federal, state or local income tax.

Note 10 – Commitments and Contingencies

We are a party to various legal proceedings which arise in the ordinary course of our business.

Note 11 – Management Agreement

On April 27, 2006, we entered into an interim management agreement with Cohen under which Cohen assisted us in the implementation of the investment strategy outlined in the agreement, subject to approval by our board of directors, during the period prior to the consummation of our merger with AFT. The agreement is in effect until 90 days after the earlier of (i) the date on which the merger with AFT is consummated and (ii) the date of termination of the merger agreement. During the term of the agreement, we paid the manager a base management fee monthly in arrears, calculated as 1/12^th of equity (adjusted for transaction-related expenses) multiplied by 1.5%. For the period April 27 through September 30, 2006, fees for management services totaled $361,000, net of a $222,000 collateral management fee credit. On October 6, 2006, the interim management agreement was terminated and we assumed the long-term management agreement that was in place between AFT and Cohen.

Note 12 – Merger with Alesco Financial Trust and Pro Forma Financial Information

On October 6, 2006, we closed our merger with AFT following the approval of the merger by our stockholders. We acquired all of the outstanding common shares of AFT in exchange for shares of our common stock. In accordance with GAAP, the transaction is to be accounted for as a reverse acquisition, and therefore, AFT is the accounting acquirer. The merged company will pursue AFT’s investment strategy focused on TruPS, residential mortgage loans, leveraged loans, and MBS.

The aggregate purchase price was approximately $95.4 million, which consisted of common stock of $91.9 million and $3.5 million of transaction costs. The value of the 14,415,530 common shares issued in the merger was determined based on the average market price of our common stock over the 2-day period before and after the terms of the acquisition were announced.

The following table summarizes the unaudited pro forma consolidated balance sheet assuming the merger occurred on September 30, 2006.

Pro Forma Combined Balance Sheet for September 30, 2006

(In thousands)

The estimated fair value of Sunset’s net assets as of September 30, 2006 was calculated as follows:

The goodwill resulting from the transaction is calculated as follows:

The following table summarizes the unaudited pro forma consolidated income statement for the nine-month period ended September 30, 2006 assuming the merger with AFT occurred on January 1, 2006.

Pro Forma Condensed Combined Income Statement

(In thousands, except per share data)