Cohen & Co Inc. - Quarter Report: 2007 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended: September 30, 2007

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 November 5, 2007 there were 59,176,082 shares of common stock (par value $0.001 per share) of Alesco Financial Inc. outstanding.

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ALESCO FINANCIAL INC.

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PART I. FINANCIAL INFORMATION

Alesco Financial Inc.

Consolidated Balance Sheets

(Unaudited and in thousands, except share and per share information)

See accompanying notes.

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Alesco Financial Inc.

Consolidated Statements of Income/(Loss)

(Unaudited and in thousands, except share and per share information)

See accompanying notes.

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Alesco Financial Inc.

Consolidated Statements of Other Comprehensive Income/(Loss)

(Unaudited and in thousands)

See accompanying notes.

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Alesco Financial Inc.

Consolidated Statements of Cash Flows

(Unaudited and in thousands)

See accompanying notes.

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Alesco Financial Inc.

Notes to Consolidated Financial Statements

As of September 30, 2007

(Unaudited)

NOTE 1: THE COMPANY

Alesco Financial Trust was organized as a Maryland real estate investment trust on October 25, 2005 and commenced operations on January 31, 2006. On January 31, 2006, February 2, 2006, and March 1, 2006, Alesco Financial Trust completed the sale of 11,107,570 common shares of beneficial interest at an offering price of $10.00 per share in a private offering. Alesco Financial Trust received proceeds from this offering of $102.4 million, net of placement fees and offering costs.

On October 6, 2006, Alesco Financial Trust completed its merger with Alesco Financial Inc. (formerly Sunset Financial Resources, 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, upon the completion of the merger each share of beneficial interest of Alesco Financial Trust was converted into 1.26 shares of common stock of Sunset Financial Resources, Inc. (“Sunset”), which resulted in the issuance of 14,415,530 shares of common stock. In accordance with U.S. generally accepted accounting principles (“GAAP”) the transaction was accounted for as a reverse acquisition, and Alesco Financial Trust was deemed to be the accounting acquirer and all of Sunset’s assets and liabilities were required to be revalued as of the acquisition date. As used in these consolidated financial statements, the term “the Company”, “we”, “us” and “our” refer to the operations of Alesco Financial Trust from January 31, 2006 through October 6, 2006, and the combined operations of the merged company subsequent to October 6, 2006. “Sunset” refers to the historical operations of Sunset Financial Resources, Inc. through October 6, 2006, the merger date.

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 New York Stock Exchange (the “NYSE”) under the ticker symbol “SFO”. Sunset elected to be taxed as a real estate investment trust (“REIT”) for U.S. Federal income tax purposes and the Company intends to continue to comply with these tax provisions. On October 9, 2006, the Company began trading on the NYSE under the ticker symbol “AFN”. On November 27, 2006, the Company closed a public offering of 30,360,000 shares of the Company’s common stock, par value $0.001 per share, at a public offering price of $9.00 per share, net of placement fees and offering costs. On June 25, 2007, the Company closed a public offering of 8,000,000 shares of the Company’s common stock, par value $0.001 per share, at a public offering price of $9.25 per share, net of placement fees and offering costs. Additionally, the Company repurchased 3,410,600 shares of its common stock at $9.55 and 420,800 shares of its common stock at a weighted average price per share of $4.64 during the three-month periods ended June 30, 2007 and September 30, 2007, respectively.

The Company is a specialty finance company formed to invest primarily in certain target asset classes identified by Cohen Brothers, LLC (which does business as Cohen & Company) (“Cohen”) and its affiliates. The Company is externally managed and advised by Cohen & Company Management, LLC (the “Manager”), an affiliate of Cohen, pursuant to a management agreement (the “Management Agreement”). Since 2001, Cohen, a specialized research, investment banking and asset management firm, has provided financing to small and mid-sized companies in financial services, real estate and other sectors.

The Company’s objective is to generate attractive risk-adjusted returns and predictable cash distributions for its stockholders by investing primarily in the following target asset classes:

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The Company typically finances investments in these target asset classes on a short-term basis with on and off-balance sheet warehouse facilities and on a long-term basis with securitization vehicles, including collateralized debt obligations (“CDOs”) and collateralized loan obligations (“CLOs”).

The Company may also invest opportunistically from time to time in other types of investments within its Manager’s and Cohen’s areas of expertise and experience, subject to maintaining its qualification as a REIT and an exemption from regulation under the Investment Company Act of 1940, as amended.

NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared by management in accordance with GAAP. Certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures included are adequate to make the information presented not misleading. The unaudited interim consolidated financial statements should be read in conjunction with our audited financial statements as of and for the period from January 31, 2006 through December 31, 2006, included in our Annual Report on Form 10-K. See “Item 15—Exhibits and Financial Statement Schedules” included in our Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly our consolidated financial position and consolidated results of operations and cash flows are included. The results of operations for the interim periods presented are not necessarily indicative of the results for the full year.

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements reflect the accounts of the Company and its majority-owned and/or controlled subsidiaries and those entities for which the Company is 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 to which the Company does not have an economic interest are presented as minority interests in the consolidated financial statements. The creditors of each variable interest entity (“VIE”) consolidated within the Company’s consolidated financial statements have no recourse to the general credit of the Company. The Company’s maximum exposure to loss as a result of its involvement with each VIE is the capital or first-loss deposit that the Company has invested in the preference shares or debt of the CDO, CLO or other types of securitization structures. All significant intercompany accounts and transactions have been eliminated in consolidation.

When the Company obtains an explicit or implicit interest in an entity, the Company evaluates the entity to determine if the entity is a VIE, and, if so, whether or not the Company is deemed to be the primary beneficiary of the VIE in accordance with FIN 46R. The Company consolidates VIEs of which the Company is deemed to be the primary beneficiary or non-VIEs which the Company controls. The primary beneficiary of a VIE is the variable interest holder that absorbs the majority of the variability in the expected losses or potentially the residual returns of the VIE. When determining the primary beneficiary of a VIE, the Company considers its aggregate explicit and implicit variable interests as a single variable interest. If the Company’s variable interest absorbs the majority of the variability in the expected losses or the residual returns of the VIE, the Company is considered the primary beneficiary of the VIE. The Company reconsiders its determination of whether an entity is a VIE and whether the Company is the primary beneficiary of such VIE if certain events occur. If the Company determines that it is no longer the primary beneficiary of a VIE, the deconsolidation of the VIE is accounted for as a sale of the entity for no proceeds. In the case of non-VIEs or VIEs where the Company is not deemed to be the primary beneficiary and the Company does not control the entity, but has the ability to exercise significant influence over the entity, the Company accounts for its investment under the equity method.

The Company has 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, the Company is the primary beneficiary of the Trust VIEs because it holds, 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, through the Company’s on-balance sheet warehouse facilities or through the Company’s off-balance sheet

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warehouse facilities. Under the TruPS-related off-balance sheet warehouse agreements, the Company usually deposits cash collateral with an investment bank and bears the first dollar risk of loss, up to the Company’s collateral deposit, if an investment held under the warehouse facility is liquidated at a loss. This arrangement causes the Company 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 the Company’s consolidated 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.

Investments

The Company invests primarily in debt securities, residential and commercial mortgage portfolios, and leveraged loans and may invest in other types of real estate-related assets. The Company accounts for its investments in debt 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 designates 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 on quoted market prices from independent pricing sources, or when quoted market prices are not available because certain securities do not actively trade in the public markets, from internal pricing models. These internal pricing models include discounted cash flow analyses developed by management using current interest rates, specific issuer information and other market data for securities without an active market. Management’s estimate of fair value requires significant management judgment and is subject to a high degree of variability based upon market conditions, the availability of specific issuer information and management’s assumptions. Upon the sale of a security, the realized gain or loss is computed on a specific identification basis and is recorded as a component of earnings in the respective period.

The Company accounts for its investments in subordinated debentures owned by Trust VIEs that the Company consolidates as available-for-sale securities. These Trust VIEs have no ability to sell, pledge, transfer or otherwise encumber the company or the assets of the company until such subordinated debenture’s maturity. The Company accounts for investments in securities where the transfer meets the 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. The Company’s investments in security-related receivables represent interests in securities that were transferred to CDO securitization entities by transferors that maintain some level of continuing involvement.

The Company exercises judgment to determine whether an investment security has sustained an other-than-temporary decline in value. If the Company determines that an investment security has sustained an other-than-temporary decline in its fair value, the investment security is written down to its fair value by a charge to earnings, and the Company establishes a new cost basis for the investment. The Company’s evaluation of an other-than-temporary decline is dependent on specific facts and circumstances relating to the particular investment. Factors that the Company considers in determining whether an other-than-temporary decline in fair value has occurred include, but are not limited to: the estimated fair value of the investment in relation to its cost basis; the length of time the security has had a decline in estimated fair value below its amortized cost; the financial condition of the related entity and industry events; changes in estimated cash flows from the investment; external credit ratings and recent downgrades of such credit ratings; and the intent and ability of the Company to hold the investment for a sufficient period of time to allow for recovery in the fair value of the investment.

For subordinated MBS, the Company performs impairment analyses in accordance with Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF No. 99-20”), and management will record an impairment write-down if the investment is deemed to be impaired.

The Company accounts for its investments in residential and commercial mortgages and leveraged loans at amortized cost. 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 Statement of Financial Accounting Standards No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases” (“SFAS No. 91”).

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The Company maintains an allowance for residential and commercial mortgages and leveraged loan losses based on management’s evaluation of known losses and inherent risks in the portfolios, for example, historical and industry loss experience, economic conditions and trends, estimated fair values, the quality of collateral and other relevant quantitative and qualitative factors. Specific allowances for losses may be established for potentially impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loan’s expected cash flow, the loan’s estimated market price or the estimated fair value of the underlying collateral. The allowance is increased by charges to operations and decreased by charge-offs (net of recoveries).

Transfers of Financial Assets

The Company accounts for transfers of financial assets under SFAS No. 140 as either sales or financing arrangements. Transfers of financial assets that result in sale accounting are those in which (a) the transfer legally isolates the transferred assets from the transferor, (b) the transferee has the right to pledge or exchange the transferred assets and no condition both constrains the transferee’s right to pledge or exchange the assets and provides more than a trivial benefit to the transferor, and (c) the transferor does not maintain effective control over the transferred assets. If the transfer does not meet each of these criteria, the transfer is accounted for as a financing arrangement. Dispositions of financial assets that are treated as sales are removed from the Company’s accounts with any realized gain (loss) reflected in earnings during the period of sale. Dispositions of financial assets that are treated as financings are maintained on the balance sheet with proceeds received from the legal transfer reflected as secured borrowings and no gain or loss is recognized.

Revenue Recognition

The Company recognizes interest income from investments in debt and other securities, residential and commercial mortgages, and leveraged loans over the estimated life of the underlying financial instruments on an estimated yield to maturity basis.

In accordance with Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF No. 99-20”), the Company recognizes interest income from purchased interests in certain financial assets, including certain subordinated MBS, on an estimated effective yield to maturity basis. Management estimates the current yield on the amortized cost of the investment based on estimated cash flows after considering prepayment and credit loss experience. The adjusted yield is then applied prospectively to recognize interest income for the next quarterly period.

Derivative Instruments

The Company uses derivative financial instruments to attempt to hedge all or a portion of the interest rate risk associated with its borrowings. In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted (“SFAS No. 133”), the Company measures each derivative instrument (including certain derivative instruments embedded in other contracts) at fair value and records such amounts in its consolidated balance sheet as either an asset or liability. 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. For derivatives not designated as hedges, the changes in fair value are recorded in earnings.

Accounting for Off-Balance Sheet Arrangements

The Company may maintain certain warehouse financing arrangements with various investment banks that are accounted for as off-balance sheet arrangements. The Company receives 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. Under the warehouse agreements, the Company is typically required to deposit cash collateral with the warehouse provider and as a result, the Company bears 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 the collateral assets are maintained on the balance sheet of the warehouse providers. However, since the Company holds an implicit variable interest in many entities funded under its TruPS-related warehouse facilities, the Company often does consolidate the Trust VIEs while the TruPS they issue are held on the warehouse facilities. The Company records the cash collateral as warehouse deposits in its financial statements. The net amount earned from these warehouse facilities and any obligation associated with the warehouse arrangement are considered free-standing derivatives and are recorded at fair value in the financial statements with changes in fair value reflected in earnings in the respective period.

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Income Taxes

For tax purposes, Sunset is deemed to have acquired Alesco Financial Trust on October 6, 2006. Sunset has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and subsequent to the merger the Company continues to comply with these requirements. Accordingly, the Company generally will not be subject to U.S. federal income tax to the extent of its distributions to stockholders and as long as certain asset, income, distribution and share ownership tests are met. If the Company were to fail to meet these requirements, it would be subject to U.S. federal income tax, which could have a material adverse impact on its results of operations and amounts available for distributions to its stockholders. Management believes that all of the criteria to maintain the Company’s REIT qualification have been met for the applicable periods, but, there can be no assurances that these criteria will continue to be met in subsequent periods.

The Company maintains domestic taxable REIT subsidiaries (“TRSs”), which may be subject to U.S. federal, state and local income taxes. Current and deferred taxes are provided for on the portion of earnings/(losses) recognized by the Company with respect to its interest in domestic TRSs. 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. We evaluate the realizability of our deferred tax assets and recognize a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of our deferred tax assets will not be realized. When evaluating the realizability of our deferred tax assets, we consider estimates of expected future taxable income, existing and projected book/tax differences, tax planning strategies available, and the general and industry specific economic outlook. This realizability analysis is inherently subjective, as it requires management to forecast our business and general economic environment in future periods. Changes in estimate of deferred tax asset realizability, if any, are included in income tax expense on the consolidated income statements.

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 the Company’s income on a current basis, whether or not distributed. Upon distribution of any previously included income to the Company, no incremental U.S. federal, state, or local income taxes would be payable by the Company.

Recent Accounting Pronouncements

In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). SFAS No. 155 amends SFAS No. 133 and SFAS No. 140 and eliminates the guidance in SFAS No. 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets,” which provided that beneficial interests in securitized financial assets are not subject to SFAS No. 133. Under SFAS No. 155, an entity may irrevocably elect to measure a hybrid financial instrument that would otherwise require bifurcation at fair value in its entirety on an instrument-by-instrument basis. SFAS No. 155 clarifies which interest-only strips are not subject to the requirements of SFAS No. 133, establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, and amends SFAS No. 140 to eliminate the prohibition on a qualifying special purpose entity from holding certain derivative financial instruments. SFAS No. 155 is effective for all financial instruments that we acquire or issue after January 1, 2007. Management adopted SFAS No. 155 in the first quarter of 2007 and the adoption of SFAS No. 155 did not have a material effect on our consolidated financial statements.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), and we adopted the provisions of FIN 48 on January 1, 2007. We did not have any unrecognized tax benefits or expenses and there was no effect on our financial condition or results of operations as a result of adopting FIN 48. We are subject to federal, state and local tax examinations for all periods since the inception of Sunset in 2003. Our policy is that we recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, we did not have any accrued interest or penalties associated with any unrecognized tax benefits.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The statement also establishes a framework for measuring fair value by creating a three-level fair value hierarchy that ranks the quality and reliability of information used to determine fair value, and requires new disclosures of assets and liabilities measured at fair value based on their level in the hierarchy. Management is continuing to evaluate the impact that SFAS No. 157 may have on our financial position or results of operations.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 provides entities with an irrevocable option to report most financial assets and liabilities at fair value, with subsequent changes in fair value reported in earnings. The election can be applied on an instrument-by-instrument basis. SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate

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comparisons between entities that choose different measurement attributes for similar types of assets and liabilities, and will become effective for the Company on January 1, 2008. The Company anticipates that the adoption of SFAS No. 159 will allow the Company to recognize in its consolidated income statement the changes in the fair value of CDO notes payable that finance our investments in MBS, TruPS and subordinated debentures. The Company’s CDO financing typically results in match-funding between the assets and liabilities of the CDO. Management expects that upon the adoption of SFAS No. 159 the match-funded nature of the assets and liabilities will result in changes in fair value of our assets being significantly offset by changes in the fair value of our CDO notes payable liabilities. However, management continues to evaluate the impact that SFAS No. 159 may have on our reported financial position and results of operations.

NOTE 3: INVESTMENTS IN SECURITIES AND SECURITY-RELATED RECEIVABLES

The following table summarizes the Company’s investments in available-for-sale debt securities, as of September 30, 2007:

TruPS included above as available-for-sale debt securities include (a) investments in TruPS issued by Trust VIEs of which the Company is not the primary beneficiary and which the Company does not consolidate and (b) transfer of investments in TruPS to the Company that were accounted for as a sale pursuant to SFAS No. 140. Subordinated debentures included above represents the primary assets of Trust VIEs that the Company consolidates pursuant to FIN 46R.

The following table summarizes the Company’s investments in security-related receivables, as of September 30, 2007:

The Company’s investments in security-related receivables represents securities owned by CDO entities that are collateralized by TruPS and subordinated debentures owned by a consolidated subsidiary where the transfers are accounted for as financings under SFAS No. 140. These transactions are accounted for as financings due to certain constraints that limit further pledging or exchanging of the assets and the continuing involvement of investment banks with each of these transactions.

The following table summarizes ratings of our available-for-sale MBS investments included in our Kleros Real Estate CDOs (categorized based on fair value as of September 30, 2007 as rated by Standard & Poor’s (“S&P) as of October 30, 2007):

During the three-months ended September 30, 2007 and through October 30, 2007, 414 Kleros Real Estate MBS with an aggregate principal amount of $1.8 billion were downgraded by rating agencies and 40 Kleros Real Estate MBS with an aggregate principal amount of $166.8 million were placed on negative watch by rating agencies. These amounts represented 45.4% and 4.2%, respectively, of the aggregate principal amount of our Kleros Real Estate MBS portfolio at September 30, 2007. As a result of the recent rating agencies downgrade activity the Company has 210 Kleros Real Estate MBS with an aggregate principal amount of $847.1 million or 21.3% of the aggregate principal amount of our Kleros Real Estate MBS portfolio at September 30, 2007, that are below investment grade. Seventy-three percent of the Kleros Real Estate MBS that have been downgraded to date are collateralized by loans to subprime borrowers and second lien loans. As of September 30, 2007, the Company is not aware of any payment defaults in the Kleros Real Estate MBS portfolio.

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During the three-months and nine-months ended September 30, 2007, the Company recorded other-than-temporary impairments of $521.3 million and $590.2 million, respectively, in its consolidated Kleros Real Estate MBS portfolio. Additionally, during the three-months and nine-months ended September 30, 2007 the Company recorded $12.2 million and $17.8 million, respectively, of impairments on other non-consolidated CDO investments that are primarily collateralized by MBS. As of September 30, 2007, the Company had investments in other non-consolidated CDO investments with a fair value of $27.2 million, which is net of the $17.8 million of impairments mentioned above. The Company recorded other-than-temporary impairments primarily because of significant increases in the estimated cumulative default rates of the underlying collateral of the respective MBS, which resulted in significant decreases to the Company’s estimates of the future cash flows of the respective MBS. Other-than-temporary impairments are recorded within impairment on investments in the consolidated statement of income/(loss).

The Company recorded unrealized losses on available-for-sale MBS in the amount of $579.7 million in accumulated other comprehensive loss as of September 30, 2007. Included in the $579.7 million is $470.3 million of unrealized losses in the consolidated Kleros Real Estate CDOs mentioned below in excess of the Company’s equity investment. The unrealized losses related to 217 MBS with an aggregate principal amount of $294.6 million collateralized by loans to subprime borrowers and second lien loans. Forty-three MBS with an aggregate principal amount of $188.7 million were in a loss position for twelve months, which was the maximum length of time the investments were in an unrealized loss position. The unrealized losses as of September 30, 2007 were not deemed to be other-than-temporary impairments based upon the length of time and the extent to which the fair value has been less than cost, review of the current interest rate environment, the underlying credit rating of the issuers, anticipated volatility and illiquidity in the market, discounted cash flow analysis performed by the Company and our intent and ability to retain the investments for a period of time sufficient to allow for recovery in fair value, which may be maturity. The Company determined that these unrealized losses resulted from volatility in interest rates, widening of credit spreads and other qualitative factors relating to macro-credit conditions in the residential mortgage market. Additionally, as of September 30, 2007 management determined that the subordination levels below these MBS investments adequately protect our ability to recover our investment, and that our estimates of anticipated future cash flows from the MBS investments has not been adversely impacted by the deterioration in the credit worthiness of the specific MBS issuers.

During the nine-months ended September 30, 2007, the $579.7 million of unrealized losses on MBS and the $590.2 million of other-than-temporary impairments on MBS included $470 million of other-than-temporary impairments and $580 million of unrealized losses in excess of our $120 million economic exposure to these investments. Our maximum loss from investments in MBS is limited to the $120 million that the Company invested into the four Kleros Real Estate CDOs. The CDOs are governed by legal indentures that provide the Company with no rights to the MBS assets and provide the CDO noteholders with no recourse to the Company. The four Kleros Real Estate CDOs are consolidated in accordance with FIN 46R, which requires that the Company record the financial position and results of operations of the CDOs in its consolidated financial statements, without consideration that the Company’s maximum economic exposure to loss is $120 million. Upon the maturity or deconsolidation of the Kleros Real Estate CDOs, we anticipate that the Company would recognize a gain equal to the previously recognized losses in excess of $120 million.

As of September 30, 2007 the Company has recorded $658.5 million of unrealized losses on its available-for-sale TruPS portfolio in accumulated other comprehensive loss. The Company determined that these unrealized losses resulted from widening of credit spreads, volatility in interest rates, and other qualitative factors relating to macro-credit conditions. The unrealized losses as of September 30, 2007 were not deemed to be other-than-temporary impairments based upon the length of time and the extent to which the fair value has been less than cost, review of the current interest rate environment, the underlying credit rating of the issuers, anticipated volatility and illiquidity in the market, discounted cash flow analysis performed by the Company and our intent and ability to retain the investments for a period of time sufficient to allow for recovery in fair value, which may be maturity.

Proceeds from the sales of available-for-sale MBS were $988.7 million. The Company utilized a significant portion of the proceeds to pay down short-term financing related to these MBS during the nine-month period ended September 30, 2007. Included within loss on the sale of assets in the consolidated statement of income/(loss) are gross realized losses of 13.6 million during the nine-month period ended September 30, 2007. For purposes of determining realized losses, the cost of securities sold is based on specific identification.

All of the Company’s investments in TruPS, subordinated debentures and MBS collateralize debt issued through CDO entities, consolidated Trust VIEs, or warehouse credit facilities. The assets of the Company’s consolidated CDOs collateralize the debt of such entities and are not available to the Company’s general creditors. Similarly, the debt of such entities is not recourse to the Company.

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NOTE 4: INVESTMENTS IN RESIDENTIAL AND COMMERCIAL MORTGAGES AND LEVERAGED LOANS

The Company’s investments in residential and commercial mortgages and leveraged loans are accounted for at amortized cost. The following table summarizes the Company’s investments in residential and commercial mortgages and leveraged loans as of September 30, 2007:

The Company maintains an allowance for residential and commercial mortgages and leveraged loan losses based on management’s evaluation of known losses and inherent risks in the portfolios, which considers historical and industry loss experience, economic conditions and trends, estimated fair values and the quality of collateral and other relevant quantitative and qualitative factors. Specific allowances for losses are established for potentially impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loan’s expected cash flow, the loan’s estimated market price or the estimated fair value of the underlying collateral. The allowance is increased by charges to operations and decreased by charge-offs (net of recoveries). As of September 30, 2007, the Company maintained an allowance for loan losses of $11.4 million.

During the nine-month period ended September 30, 2007, the Company sold approximately $517.6 million of adjustable rate residential mortgages at a realized loss of $2.0 million. In connection with the sale of the assets and repayment of related financings, the Company terminated a portion of certain interest rate swap contracts and recorded a realized gain of $3.5 million in earnings.

During the three-months ended September 30, 2007, the Company reclassified 14 residential mortgage loans with a fair value of $5.8 million to real estate owned (REO). The Company records REO property at fair value within other assets in its consolidated balance sheet. During the three-months ended September 30, 2007, the Company recorded a charge-off of $1.5 million as a result of foreclosing on these properties.

As of September 30, 2007, approximately $1.1 billion of the carrying value of the Company’s residential mortgages was pledged as collateral for securitized mortgage debt. In addition, all of the carrying value of the Company’s leveraged loan portfolio is pledged as collateral for CDO notes payable.

As of September 30, 2007, 46.3% of the carrying value of the Company’s investment in residential mortgages was concentrated in residential mortgages collateralized by property in California.

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NOTE 5: INDEBTEDNESS

The following table summarizes the Company’s total indebtedness (includes recourse and non-recourse indebtedness) as of September 30, 2007:

Recourse indebtedness refers to indebtedness that is recourse to the general assets of the Company. As indicated in the table above, the Company’s consolidated financial statements include recourse indebtedness of $189.6 million as of September 30, 2007. Non-recourse indebtedness consists of indebtedness of consolidated VIEs which is recourse only to specific assets pledged as collateral to the lenders. The creditors of each consolidated VIE have no recourse to the general credit of the Company. The Company’s maximum exposure to loss as a result of its involvement with each VIE is the $557.5 million of capital that the Company has invested in the preference shares or debt of the CDO, CLO or other types of securitization structures. None of the indebtedness shown in the table above subjects the Company to potential margin calls for additional pledges of cash or other assets.

(a) Repurchase agreements

As of September 30, 2007, the Company is not financing any investments with short-term repurchase agreements that subject the Company to margin calls or potential recourse obligations in excess of posted first loss deposits.

(b) Trust preferred obligations

Trust preferred obligations finance subordinated debentures acquired by Trust VIEs that are consolidated by the Company 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. The Company does not control the timing or ultimate payment of the trust preferred obligations.

(c) CDO notes payable

CDO notes payable represent notes payable issued by CDO entities used to finance the acquisition of TruPS, MBS, and leveraged loans. Substantially all of the TruPS collateralizing CDO notes payable are obligations of banks, bank holding companies and insurance companies. The obligors under the leveraged loans come from a variety of industries. Generally, CDO notes payable are comprised of various classes of notes payable, with each class bearing interest at variable or fixed rates. The following summarizes CDO notes payable transactions during the nine-month period ended September 30, 2007:

TruPS CDO notes payable

On June 28, 2007, the Company closed “Alesco Preferred Funding XVI, Ltd.,” a CDO securitization that provides up to 30-year financing for banks or bank holding companies and insurance companies. Alesco Preferred Funding XVI, Ltd. received commitments for $482.8 million of CDO notes payable, all of which were issued to investors as of the closing date. Alesco Preferred Funding XVI, Ltd. also issued $26.0 million of preference shares upon closing. The Company retained $19.5 million of common and preference shares of Alesco Preferred Funding XVI, Ltd., excluding discounts.

The CDO notes payable issued by Alesco Preferred Funding XVI, Ltd. consist of four classes of notes bearing interest at spreads over 90-day LIBOR ranging from 32 to 225 basis points. One class of the fixed-rate notes bears interest at a fixed rate for an initial period of ten years and a floating rate for the remaining period based on 90-day LIBOR plus 78 basis points.

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On March 29, 2007, the Company closed “Alesco Preferred Funding XV, Ltd.,” a CDO securitization that provides up to 30-year financing for banks or bank holding companies and insurance companies. Alesco Preferred Funding XV, Ltd. received commitments for $642.0 million of CDO notes payable, all of which were issued to investors as of the closing date. Alesco Preferred Funding XV, Ltd. also issued $39.0 million of preference shares upon closing. The Company retained $28.8 million of common and preference shares of Alesco Preferred Funding XV, Ltd., excluding discounts.

The CDO notes payable issued by Alesco Preferred Funding XV, Ltd. consist of seven classes of notes bearing interest at spreads over 90-day LIBOR ranging from 28 to 255 basis points or at a fixed rate of 6.05%. One class of the fixed-rate notes bears interest at a fixed rate for an initial period of five years and a floating rate for the remaining period based on 90-day LIBOR plus 115 basis points.

MBS CDO notes payable

On February 28, 2007, the Company closed “Kleros Real Estate CDO IV, Ltd.,” a CDO securitization that provides financing for investments in MBS. Kleros Real Estate CDO IV, Ltd. received commitments for $970.0 million of CDO notes payable. Kleros Real Estate CDO IV, Ltd. also issued $12.0 million of preference shares upon closing. The Company retained 100% of the common and preference shares of Kleros Real Estate CDO IV, Ltd. and $9.0 million of both the Class D and Class E CDO notes payable, respectively.

The CDO notes payable issued by Kleros Real Estate CDO IV, Ltd. consist of six classes of notes bearing interest at spreads over one-month LIBOR ranging from 19 to 64 basis points.

Leveraged loans CDO notes payable

On March 15, 2007, the Company closed “Emporia Preferred Funding III, Ltd.,” a CDO securitization that provides financing for investments in leveraged loans. Emporia Preferred Funding III, Ltd. received commitments for $375.8 million of CDO notes payable, of which $314.6 million were issued to investors as of September 30, 2007. Emporia Preferred Funding III, Ltd. also issued $39.0 million of preference shares upon closing. The Company retained $31.0 million of common and preference shares of Emporia Preferred Funding III, Ltd., excluding discounts.

The CDO notes payable issued by Emporia Preferred Funding III, Ltd. consist of seven classes of notes bearing interest at spreads over 90-day LIBOR ranging from 26 to 370 basis points.

(d) Securitized Mortgage Debt

On June 29, 2007, the Company completed an on-balance sheet, term-secured financing of approximately $1.1 billion of residential mortgage loans. Upon the closing of this securitization transaction, the Company is no longer financing any residential mortgage loans with short-term repurchase agreement financing. In connection with this securitization, the Company entered into a Mortgage Loan Purchase Agreement, dated as of June 29, 2007 (the “MLPA”), with Structured Asset Mortgage Investments II Inc. (the “Depositor”), a wholly-owned subsidiary of The Bear Stearns Companies Inc. Pursuant to the MLPA, the Company transferred 2,572 conventional, first lien mortgage loans secured primarily by one- to four-family residential properties and individual condominium units (collectively, the “Mortgage Loans”) to the Depositor.

The Depositor established Bear Stearns ARM Trust 2007-2, a Delaware statutory trust (the “Issuing Entity”) pursuant to a Short Form Trust Agreement, dated as of June 26, 2007. The Depositor transferred the Mortgage Loans to the Issuing Entity pursuant to a Sale and Servicing Agreement, dated as of June 29, 2007. The Issuing Entity issued the Bear Stearns ARM Trust 2007-2, Mortgage-Backed Notes, Series 2007-2 as well as the notes issued pursuant to the Trust Agreement to the Depositor.

The Issuing Entity sold $1.0 billion of senior notes to third parties and the Company retained all of the $65.2 million of subordinated notes in the structure. The senior notes consist of eight classes of notes bearing interest ranging from 5.0% to 6.0%.

The Issuing Entity is a VIE pursuant to FIN 46R and the Company is the primary beneficiary due to its one-hundred percent ownership interest in the subordinated notes of the Issuing Entity (the issuing entity is not a QSPE). The Issuing Entity is included within the consolidated financial statements of the Company.

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(e) Warehouse Credit Facilities

As of September 30, 2007, the Company’s consolidated financial statements included $557.1 million of warehouse credit facility debt in the form of short term notes payable. Warehouse credit facility debt relates to on-balance sheet warehouse facilities typically entered into by a subsidiary of the Company that are utilized to finance the acquisition of TruPS and leveraged loans on a short-term basis until CDO notes payable are issued to finance the investments on a longer-term basis. The Company’s maximum economic exposure to loss on these warehouse credit facilities is limited to the amount of capital that the Company has invested pursuant to the terms of the arrangements. As of September 30, 2007, the Company has invested $50.0 million of capital in these financing arrangements, which includes $30 million relating to a TruPS facility and $20 million relating to two leverage loan facilities.

During the three-months ended September 30, 2007, the Company recognized a $2.7 million impairment of a first-loss warehouse deposit that was held by a consolidated VIE. The first-loss deposit related to a TruPS warehouse arrangement that the Company entered into during the first quarter of 2007. The Company contributed the first-loss deposit amount to a special purpose entity or VIE that in turn pledged the cash to an investment bank in connection with the warehouse arrangement. The VIE received notice that on September 29, 2007 it was in default on the terms of the warehouse arrangement and that the VIE and the Company no longer had decision making rights as it relates to the exit strategy of the assets accumulated in the warehouse. The stated maturity date of the warehouse agreement was September 29, 2007. As of September 29, 2007, the Company has deconsolidated this VIE from its consolidated financial statements because the Company is no longer the primary beneficiary of the VIE. The Company accounted for the deconsolidation of the VIE as a sale of the net assets of the entity and recorded a $10.3 million gain on disposition of a consolidated investment. Additionally, upon determining that the deconsolidation of the assets of the VIE will be accounted for as a sale, the Company recognized an $11.2 million realized loss on the disposition of TruPS assets included in the VIE. The net cash and economic impact of this transaction was the loss of $2.7 million, which includes the first-loss deposit and accrued but unpaid interest.

(f) Recourse Indebtedness

Revolving Credit Agreement

On March 27, 2007, the Company entered into a $40.0 million secured revolving credit agreement. The credit agreement matured on September 27, 2007. As of the maturity date, the Company no longer has any rights or obligations under this credit agreement.

Contingent Convertible Senior Notes

On May 15, 2007 and June 13, 2007, the Company sold $140 million aggregate principal amount of contingent convertible senior notes. The notes are senior, unsecured obligations of the Company and rank equally in right of payment with all of the Company’s existing and future unsubordinated, unsecured indebtedness. The notes are subordinated in right of payment to the Company’s existing and future secured indebtedness to the extent of such security, and structurally subordinated to any liabilities and other indebtedness of the Company’s subsidiaries. The notes will bear interest at an annual rate of 7.625%. The notes will mature on May 15, 2027.

The notes will be convertible prior to the maturity date into cash and, if applicable, shares of the Company’s common stock, par value $0.001 per share, under certain circumstances, at an initial conversion price per share of $11.70, which represents a conversion rate of approximately 85.4701 shares of common stock per $1,000 principal amount of notes. If converted, the holders of the notes will receive an amount in cash per note equal to the lesser of (i) $1,000 and (ii) the average of the “daily conversion values” for each of the twenty consecutive trading days of the conversion reference period. “Daily conversion value” means, with respect to any trading day, the product of (1) the applicable conversion rate and (2) the volume weighted average price of the Company’s common Stock on such trading day.

The Company may redeem all or part of the notes for cash (i) at any time prior to the date on which they mature to the extent necessary to preserve the Company’s qualification as a REIT for U.S. federal income tax purposes or (ii) on or after May 20, 2012, at a redemption price equal to 100% of the principal amount of the notes, plus accrued and unpaid interest and additional interest, if any, to, but excluding, the redemption date. The holders of the notes may require the Company to repurchase all or a portion of their notes for cash on May 15, 2012, May 15, 2017 and May 15, 2022 for a repurchase price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest and additional interest, if any, to, but excluding, the repurchase date.

Junior Subordinated Notes

On June 25, 2007, the Company completed the issuance and sale of $28.1 million in aggregate principal amount of TruPS issued by the Company’s unconsolidated subsidiary, Alesco Capital Trust I (the “Trust”). The TruPS mature on July 30, 2037 and may be called by the Company at par any time after July 30, 2012. The TruPS require quarterly distributions of interest by the Trust to the holders of the TruPS. Distributions will be payable quarterly at a fixed interest rate equal to 9.495% per annum through the

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distribution payment date on July 30, 2012 and thereafter at a floating interest rate equal to LIBOR plus 400 basis points per annum through July 30, 2037. The Trust simultaneously issued 870 shares of the Trust’s common securities to the Company for a purchase price of $870 thousand, which constitutes all of the issued and outstanding common securities of the Trust.

The Trust used the proceeds from the sale of the TruPS together with the proceeds from the sale of the Common Securities to purchase $29.0 million in aggregate principal amount of unsecured junior subordinated notes due July 30, 2037 issued by the Company. The Company is permitted to redeem the junior subordinated notes on or after July 30, 2012. If the Company redeems any amount of the junior subordinated notes, the Trust must redeem a like amount of the TruPS.

The Trust is a variable interest entity pursuant to FIN 46R because the holders of the equity investment at risk do not have adequate decision making ability over the Trust’s activities. Because the Company’s investment in the Trust’s common securities was financed directly by the Trust as a result of its loan of the proceeds to the Company, that investment is not considered to be an equity investment at risk pursuant to FIN 46R, and the Company is not the primary beneficiary of the Trust. The Trust is not consolidated by the Company and, therefore, the Company’s consolidated financial statements include the junior subordinated notes issued to the Trust as a liability, and the investment in the Trust’s common securities as an asset.

NOTE 6: DERIVATIVE FINANCIAL INSTRUMENTS

The Company may use derivative financial instruments to hedge all or a portion of the interest rate risk associated with its borrowings. The principal objective of such arrangements is to minimize the risks and/or costs associated with the Company’s operating and financial structure as well as to hedge specific anticipated transactions. The counterparties to these contractual arrangements are major financial institutions with which the Company and its affiliates may also have other financial relationships. In the event of nonperformance by the counterparties, the Company is potentially exposed to credit loss. However, because of the high credit ratings of the counterparties, the Company does not anticipate that any of the counterparties will fail to meet their obligations.

Cash Flow Hedges

The Company has entered into various interest rate swap contracts to hedge interest rate exposure relating to CDO notes payable and warehouse credit facilities that are used to finance investments in our target asset classes.

Generally, the Company designates interest rate swap contracts as hedges at inception and determines at each reporting period whether or not the interest rate hedge agreement is highly effective in offsetting interest rate fluctuations associated with the identified indebtedness. Certain of the Company’s interest rate swap contracts were not designated as interest rate hedges at inception, therefore the change in fair value during the period in which the interest rate swap contracts were not designated as hedges was recorded as an unrealized gain/(loss) on interest rate swap contracts in the consolidated statements of income/(loss).

Credit Default Swaps

As of September 30, 2007, the Company had $114 million notional amount of credit default swap (“CDS”) contracts that are referenced to certain MBS and CDOs that are trading in the public markets. The risk management objective of the CDS contracts is to potentially offset losses on our MBS portfolio. Under the terms of the CDS, the Company agrees to make periodic payments, usually ratably over the CDS term, in exchange for the agreement by the counterparty to pay an agreed upon value for a debt instrument of a specified issuer, should the issuer enter into an event of default as defined in each particular CDS contract during the CDS term. The Company records both realized and unrealized changes in fair value on the CDS contracts within net realized and unrealized gain/(loss) on credit default swaps in the consolidated statements of income/(loss).

Free-Standing Derivatives

The Company may maintain off-balance sheet arrangements with investment banks that allow for short term financing of collateral prior to financing the collateral through a long term CDO transaction. Prior to the completion of certain CDO securitizations, investments are acquired by the warehouse providers in accordance with the terms of the warehouse facilities. Pursuant to the terms of the warehouse agreements, the Company receives 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, the Company is required to deposit cash collateral with the warehouse provider and as a result, the Company typically bears the first dollar risk of loss, up to the Company’s 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 CDO securitization, the cash

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collateral held by the warehouse provider is returned to the Company. The terms of the warehouse facilities generally range from three to nine months. These arrangements are deemed to be derivative financial instruments and are recorded by the Company at fair value each accounting period with the change in fair value recorded in earnings. These arrangements represent the Company’s only off-balance sheet arrangements. As of September 30, 2007, we had approximately $1.8 million of cash collateral held by a warehouse provider pursuant to one off-balance sheet warehouse facility. During the three-months ended September 30, 2007, the Company recognized the $1.8 million as a loss on its off-balance sheet warehouse facility. The loss was due to the decline in fair value of the TruPS assets accumulated on the warehouse facility and the amount represents one-hundred percent of the Company’s first loss deposit and accrued but not paid earnings on the warehouse arrangement. The warehouse arrangement is with a third-party investment bank and there were $67.4 million of assets on the warehouse as of September 30, 2007. As of September 30, 2007, assets were no longer being accumulated in this facility, however the Company is working with the counterparty on the ultimate disposition of the assets. The Company’s maximum loss exposure is $1.8 million. The change in fair value is recorded within gain/(loss) on freestanding derivatives on the consolidated statement of income/(loss).

The table below summarizes the aggregate notional amount and estimated net fair value of the Company’s derivative instruments (amounts in thousands):

The following table summarizes by derivative instrument type the effect on income for the following periods (amounts in thousands):

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NOTE 7: EARNINGS PER SHARE

The following table presents a reconciliation of basic and diluted earnings per share for the following periods (dollars in thousands, except per share data):

The Company includes shares of restricted common stock issued and outstanding in its earnings per share computation as follows: shares of vested restricted common stock are included in basic weighted-average common shares and shares of unvested restricted common stock are included in the diluted weighted-average shares under the treasury stock method, unless anti-dilutive.

NOTE 8: MANAGEMENT AGREEMENT AND RELATED PARTY TRANSACTIONS

The Company’s Chairman of the Board and other officers serve as executive officers of Cohen, of which the Manager is an affiliate. The Manager handles the Company’s day-to-day operations, provides the Company with office facilities, and administers the Company’s business activities through the resources of Cohen. The Management Agreement was executed on January 31, 2006 between the Manager and Alesco Financial Trust and, upon the closing of the merger on October 6, 2006, the Company assumed the Management Agreement. The initial term expires on December 31, 2008 and shall be automatically renewed for a one-year term on each anniversary date thereafter unless two-thirds of the independent directors or the holders of at least a majority of the outstanding shares of common stock vote not to automatically renew the Management Agreement.

The Management Agreement provides, among other things, that in exchange for managing the day-to-day operations and administering the business activities of the Company, the Manager is entitled to receive from the Company certain fees and reimbursements, consisting of a base management fee, an incentive fee based on certain performance criteria, certain operating expenses as defined in the Management Agreement, and a termination fee if the Company decides to terminate the Management Agreement without cause or if the Manager terminates the Management Agreement due to the Company’s default. The base management fee and the incentive fee otherwise payable by the Company to the Manager pursuant to the Management Agreement are reduced by the Company’s proportionate share of the amount of any CDO and CLO collateral management fees that are paid to Cohen and its affiliates in connection with the CDOs and CLOs in which the Company invests, based on the percentage of equity it holds in such CDOs and CLOs.

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During the three-month period ended September 30, 2007 and the three-month period ended September 30, 2006, the Company incurred $1.9 million and $0.4 million in base management fees and $0.4 million and $0.4 million in incentive fees, respectively. During the same periods, the aggregate base management fees and incentive fees payable were reduced by collateral management fee credits of $2.3 million and $0.7 million, respectively. The Company recognized share-based compensation expense related to shares of restricted common stock granted to the officers of the Company and key employees of the Manager and Cohen of $0.4 million and $0.3 million during the three-month period ended September 30, 2007 and three-month period ended September 30, 2006, respectively.

During the nine-month period ended September 30, 2007 and the period from January 31, 2006 through September 30, 2006, the Company incurred $5.5 million and $1.1 million in base management fees and $0.5 million and $1.0 million in incentive fees, respectively. During the same periods, the aggregate base management fees and incentive fees payable were reduced by collateral management fee credits of $6.0 million and $1.1 million, respectively. The Company recognized share-based compensation expense related to shares of restricted common stock granted to the officers of the Company and key employees of the Manager and Cohen of $1.4 million and $0.8 million during the nine-month period ended September 30, 2007 and the period from January 31, 2006 through September 30, 2006, respectively. During the nine-month period ended September 30, 2007, the Company granted 1,457,460 shares of restricted common stock to employees of the Manager and Cohen under its 2006 Long-Term Incentive Plan.

During the three-month period ended September 30, 2007 and the three-month period ended September 30, 2006, the consolidated CDO entities that are included in the Company’s consolidated financial statements incurred collateral management fees that are payable to Cohen of $4.5 million and $1.6 million, respectively.

During the nine-month period ended September 30, 2007 and the period from January 31, 2006 through September 30, 2006, the consolidated CDO entities that are included in the Company’s consolidated financial statements incurred collateral management fees that are payable to Cohen of $11.2 million and $2.3 million, respectively. During the same periods, Cohen earned origination, structuring and placement fees of $16.7 million and $22.5 million, respectively, relating to services provided to warehouse facilities and CDOs that the Company is invested in. In addition, during the same periods, Cohen received $10.2 million and $7.1 million, respectively, from warehouse facilities and consolidated CDO entities as reimbursement for origination expenses paid to third parties.

Base management fees and incentive fees incurred, share-based compensation expense relating to shares of restricted common stock granted to the Manager, and collateral management fees paid to Cohen are included in related party management compensation on the consolidated statements of income/(loss). Expenses incurred by the Manager and reimbursed by the Company are reflected in the respective consolidated statement of income/(loss) non-investment expense category based on the nature of the expense.

During the nine-month period ended September 30, 2007, the Company entered into a warehouse risk-sharing agreement with a third party investment bank for short term investment purposes. The warehouse risk-sharing agreement terminated during the period as a result of the transfer of accumulated warehoused asset-backed securities to a CDO that was structured by Cohen and its affiliates. The Company did not purchase an interest in the CDO transaction, although in consideration of the benefits that Cohen and its affiliates received upon the closing of the asset-backed security CDO, Cohen paid a one-time capital commitment fee of $1.2 million to the Company for its services as first loss provider during the warehouse period.

During the nine-month period ended September 30, 2007, the Company entered into an agreement with Cohen that provided the Company with a guaranteed minimum return on its investment in an on-balance sheet TruPS warehouse facility. The agreement ensures that the Company earns a return on investment that is commensurate with the returns that the Company historically earned on off-balance sheet warehousing arrangements. Cohen receives certain benefits from the on-balance sheet warehousing structure upon the closing of a CDO transaction. During the three and nine-month periods ended September 30, 2007, the Company earned $0.8 million and $4.1 million, respectively, in accordance with the terms of the arrangement and recorded the amount in net investment income.

NOTE 9: COMMITMENTS AND CONTINGENCIES AND OTHER MATTERS

Commitments

In connection with the leveraged loan portfolio, the CDO vehicles consolidated by the Company committed to purchase interests in debt obligations of corporations, partnerships and other entities in the form of participations in leveraged loans, which obligate the CDO vehicle to acquire a predetermined interest in such leveraged loans at a specified price on a to-be determined settlement date. As of September 30, 2007, the consolidated CDO vehicles had committed to participate in funding approximately $15.0 million of leveraged loans. The CDO vehicles will use amounts currently included in restricted cash to fund these purchases.

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As of September 30, 2007, the consolidated CDO entities included within the Company’s consolidated financial statements have requirements to purchase $153.2 million of additional collateral assets in order to complete the accumulation of the required amount of collateral assets. Of this amount, $83.1 million has already been advanced to consolidated CDOs through CDO notes payable and is included within restricted cash on the consolidated balance sheet as of September 30, 2007.

Contingencies

The Company is party to various legal proceedings which arise in the ordinary course of business. The Company is not currently involved in any litigation nor to our knowledge, is any litigation threatened against us, the outcome of which would, in our judgment based on information currently available to us, have a material adverse effect on our financial position or results of operations.

During March 2007, the Company received $0.6 million of settlements relating to litigation that had been commenced by Sunset prior to the Company’s acquisition of Sunset. The litigation is related to commercial loans that were originated by Sunset. The settlement proceeds were recorded as a purchase price allocation adjustment relating to the Sunset acquisition.

NOTE 10: SUBSEQUENT EVENTS

On October 30, 2007, the Company completed “Alesco Preferred Funding XVII, Ltd.,” a CDO securitization that provides up to 30-year financing for banks or bank holding companies and insurance companies. Alesco Preferred Funding XVII, Ltd. received commitments for $372.7 million of CDO notes payable, all of which were issued to investors as of October 30, 2007. Alesco Preferred Funding XVII, Ltd. also issued $36.8 million of preference shares upon closing. The Company retained $27.6 million of common and preference shares of Alesco Preferred Funding XVII, Ltd.

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The following discussions under the headings “Overview,” “Operating Revenue,” “Operating Expenses,” “Our Portfolio and Recent Developments,” “Critical Accounting Policies,” “Liquidity and Capital Resources,” “Inflation,” “Quantitative and Qualitative Disclosures About Market Risk” and “Off-Balance Sheet Arrangements” applied to Alesco Financial Trust and continue to apply to us following the merger because we have adopted the investment strategy previously employed by Alesco Financial Trust. In accordance with U.S. generally accepted accounting principles, or GAAP, the transaction was accounted for as a reverse acquisition, and Alesco Financial Trust was deemed to be the accounting acquirer and all of Sunset’s assets and liabilities were required to be revalued as of the acquisition date. The terms, “the Company”, “we”, “us” and “our” refer to the operations of Alesco Financial Trust from January 31, 2006 through to October 6, 2006 and the combined operations of the merged company subsequent to October 6, 2006. “Sunset” refers to the historical operations of Sunset Financial Resources, Inc. through to the October 6, 2006 merger date.

Forward Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q, including without limitation statements regarding the objectives of management for future operations and statements containing the words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar expressions, constitute “forward-looking statements” within the meaning of the federal securities laws. Such forward-looking statements are subject to known and unknown risks, uncertainties and assumptions which may cause actual results, performance or achievements to differ materially from those anticipated or implied by the forward-looking statements. These risks include our failure to successfully execute our business plan, continued disruption in the U.S. credit markets generally and the mortgage loan and CDO markets particularly, our inability to gain access to additional financing, the limited availability of additional loan portfolios for future acquisition, our failure to maintain REIT status, the cost of capital, as well as the additional risks and uncertainties detailed in our periodic reports and registration statements filed with the Securities and Exchange Commission (“SEC”). We disclaim any obligation to update any such statements or publicly announce any updates or revisions to any of the forward-looking statements contained herein to reflect any change in our expectation with regard thereto or any change in events, conditions, circumstances or assumptions underlying such statements.

Management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On a regular basis, we evaluate these estimates, including asset impairment and provision for doubtful accounts. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.

Overview

We are externally managed and advised by our Manager, an affiliate of Cohen. Our objective is to generate attractive risk-adjusted returns and predictable cash distributions for our stockholders by investing primarily in the following target asset classes:

We typically finance our investments in these target asset classes on a short-term basis with on and off-balance sheet warehouse facilities and on a long-term basis with securitization vehicles, including CDOs and CLOs.

We may also invest opportunistically from time to time in other types of investments within the Manager’s and Cohen’s areas of expertise and experience, such as mezzanine real estate loans, participations in mortgage loans, corporate tenant leases and equity interests in real estate, subject to maintaining our qualification as a REIT and our exemption from regulation under the Investment Company Act of 1940, as amended.

The credit markets in the U.S. are currently suffering significant disruption. This disruption has been particularly severe in the residential mortgage lending sector, where available liquidity, including through CDOs and other securitizations, has declined precipitously during the three-months ended September 30, 2007 and remains depressed as of the date of this filing. This disruption directly impacts our business because our investment portfolio includes investments in MBS financed through CDO subsidiaries. The principal U.S. rating agencies have recently downgraded large amounts of MBS and debt securities of CDOs collateralized by MBS, including MBS that are in our portfolio. Since we finance our investments in MBS through the issuance of equity and debt securities of CDOs, our exposure to losses on our consolidated MBS portfolios is limited to our investments in such CDOs. As of September 30, 2007, the aggregate amount of our invested capital in CDOs collateralized by our consolidated $4.0 billion Kleros Real Estate MBS portfolio was $120.0 million, which has been completely written off in our income statement as of September 30, 2007. We also have invested $45 million of capital in other non-consolidated CDO investments that are primarily collateralized by MBS. As of September 30, 2007, we held non-consolidated CDO investments with a fair value of $27.2 million in our consolidated balance sheet. To date the disruption in the credit markets has not resulted in any material adverse impact to borrowers in our TruPS or leverage loan portfolios. Most of the companies that we lend to do not originate or hold material investments in sub-prime loans. While some banks and other companies impacted indirectly by the real estate lending sector are suffering from earnings volatility, we have not seen evidence that the recent credit market disruptions will result in a systematic credit threat.

We record our investments in MBS at fair value. During the three-months and nine-months ended September 30, 2007, we recorded a permanent impairment charge of approximately $521.3 million and $590.2 million, respectively, on our consolidated Kleros Real Estate MBS portfolio which is significantly in excess of our investment in the CDOs that own the investments. While the particular MBS that were written down have not experienced any payment defaults, we recorded a permanent impairment charge because of an increase in estimated cumulative defaults and a determination that we would not recover the carrying amount of certain MBS in our portfolio. This impairment charge is a direct charge against our earnings for the three-months and nine-months ended September 30, 2007 and was the primary reason why we recognized a net loss for the same periods. The impairment charge does not currently negatively impact our cash flow. However, as discussed below, the ratings agency downgrades of MBS in our Kleros Real Estate portfolio has adversely impacted our cash flow.

During the three-months and nine-months ended September 30, 2007, we also recorded unrealized losses of approximately $425.3 million and $580 million, respectively, in our Kleros Real Estate MBS portfolio. Unrealized losses are reflected in accumulated other comprehensive loss and, in the judgment of management, do not represent permanent impairments. We believe these unrealized losses occurred primarily because of interest rate volatility and the general deterioration of the macro-credit markets. Additionally, as of September 30, 2007 management determined that the subordination levels below these MBS investments adequately protect our ability to recover our investment, and that our estimates of anticipated future cash flows from the MBS investments has not been adversely impacted by the deterioration in the credit worthiness of the specific MBS issuers.

During the nine-months ended September 30, 2007, the $580 million of unrealized losses on MBS and the $590 million of other-than-temporary impairments on MBS included $470 million of other-than-temporary impairments and $580 million of unrealized losses in excess of our $120 million economic exposure to these investments. Our maximum loss from investments in MBS is limited to the $120 million that the Company invested into the four Kleros Real Estate CDOs. The CDOs are governed by legal indentures

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that provide the Company with no rights to the MBS assets and provide the CDO noteholders with no recourse to the Company. The four Kleros Real Estate CDOs are consolidated in accordance with FIN 46R, which requires that the Company record the financial position and results of operations of the CDOs in its consolidated financial statements, without consideration that the Company’s maximum economic exposure to loss is $120 million. Upon the maturity or deconsolidation of the Kleros Real Estate CDOs, we anticipate that the Company would recognize a gain equal to the previously recognized losses in excess of $120 million.

On September 4, 2007, we received written notice from the trustee of each of Kleros Real Estate CDO I, Ltd., or KRE I and Kleros Real Estate CDO II, Ltd., or KRE II, in accordance with the indenture of each of KRE I and KRE II, that on the September 4, 2007 payment date, we would not receive any cash flow distributions on the subordinated note and equity investments that we own in these transactions. On November 1, 2007, we received written notice from the trustee of each of Kleros Real Estate CDO III, Ltd., or KRE III and Kleros Real Estate CDO IV, Ltd., or KRE IV, in accordance with the indenture of each of KRE III and KRE IV, that on the November 1, 2007 payment date, we would not receive any cash flow distributions on the subordinated note and equity investments that we own in these transactions. The Kleros Real Estate CDOs provide long-term financing for our entire $4.0 billion Kleros Real Estate MBS portfolio. During the three-month period ended September 30, 2007, we had net investment income of $21.8 million or $0.37 per diluted common share, of which an aggregate of approximately $3.7 million or $0.06 per diluted common share was earned through our investments in the four Kleros Real Estate CDOs. Each of the Kleros Real Estate CDOs failed overcollateralization, or OC trigger tests which resulted in a change to the priority of payments to the debt and equity holders of the Kleros Real Estate CDOs. Upon the failure of an OC test, the indenture of each Kleros Real Estate CDO requires cash flows that would otherwise have been distributed to us to be used to sequentially paydown the outstanding principal balance of the most senior noteholders. The failure of the OC tests were due to cumulative ratings agency downgrades on certain MBS collateralizing the Kleros Real Estate CDOs.

The Kleros Real Estate transactions continue to generate taxable income for us despite the fact that we are not receiving cash distributions from these CDOs. Taxable income will continue to be recognized on each underlying MBS in the portfolio until a payment default occurs on the underlying MBS. The taxable income from these transactions continues to factor into our compliance with the REIT income test requirements and we must continue to distribute ninety percent of our taxable income to ensure continued qualification as a REIT. There can be no assurance that in the future other CDO investments will not fail OC tests or otherwise trigger contractual events that would limit the cash distributions received by us.

We will continue to review our MBS portfolio, as well as the other available-for-sale securities in our portfolio, to determine whether there have been additional temporary or other-than-temporary declines in their fair value, and there can be no assurance that we will not experience further declines in fair value given market conditions. Temporary declines, if any, would be recorded as losses within accumulated other comprehensive loss in our balance sheet and would have a negative impact on our book value, which we experienced during the three-months and nine-months ended September 30, 2007. Other than temporary declines, if any, would be recorded as an impairment charge in our consolidated statement of income and would have a negative impact on our net income, as we also experienced during the three-months and nine-months ended September 30, 2007. Our determinations of fair value are based upon many factors, as discussed further in Notes 2 and 3 of our consolidated financial statements as set forth herein. One factor is changes in the ratings of the securities. The ratings process is outside of our control and there can be no assurance that the rating agencies will not downgrade or place on negative watch additional securities in our portfolio. Any such rating agency action could contribute to declines in the fair value of the securities which could adversely affect our book value and/or our earnings.

During the second quarter of 2007, we began to purchase CDS contracts that are referenced to certain MBS and CDOs that are trading in the public markets. As of September 30, 2007, we had approximately $114.5 million notional amount of CDS contracts. We have purchased these swap contracts and may purchase additional swap contracts in the future with the objective of off-setting potential losses on MBS held in our consolidated portfolio. As discussed further below, we recorded unrealized gains on these swap contracts in the third quarter, but these gains only partially offset our MBS portfolio losses. There can be no assurance that these swap contracts will offset the losses that we may suffer on our MBS portfolio.

The disruption in the credit markets has increased the costs of securitizing assets. Increased securitization costs may cause us to realize lower returns on our equity for investments in future CDOs as compared with the returns that we have realized to date on

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completed CDOs that have lower financing costs. If securitization costs become unacceptably high, or if securitization financing becomes unavailable, for assets that have been purchased using short-term warehouse lines, we may not be willing or able to complete a securitization for such assets. In that event, we may potentially lose the cash that we had deposited with the warehouse lender. If we are unable to deploy our capital in high-yielding CDO investments quickly or at all, we would need to find alternative investments which may be lower yielding.

Set forth below is a discussion of the material aspects of our financial reporting.

Operating Revenue

The principal sources of our operating revenue are interest and dividend income on our investments, including debt and equity interests that we purchase in CDOs and CLOs, and the positive spread from the yield on assets held on our warehouse facilities, net of interest and other financing costs under those facilities. In the three and nine–month periods ended September 30, 2007, we generated net investment income of approximately $21.8 million and $57.6 million, respectively.

An important part of our operating strategy is to direct the acquisition through on and off-balance sheet warehouse facilities of assets that will ultimately be sold or contributed to CDOs, CLOs and other types of securitizations. As of September 30, 2007, we had $557.1 million of outstanding borrowings under on-balance sheet warehouse facilities that had $542.9 million of remaining available capacity and an investment in an off-balance sheet warehouse facility that had $67.4 million of assets on the warehouse facility and no remaining capacity. During the nine-month period ended September 30, 2007, we completed three CDO transactions and one CLO transaction that upon completion of the applicable ramp periods will be collateralized by approximately $2.6 billion of assets, of which a significant portion of the assets were included in warehouse facilities prior to securitization. We are typically required to post cash collateral to an investment bank for our off-balance sheet warehouse facilities and make contributions to special purpose entities for our on-balance sheet warehouse facilities. During a warehouse accumulation period, we generally earn all or a portion of the net positive cash flow derived from the assets acquired by our warehouse lenders or the special purpose entity, after payment to the warehouse lenders or noteholders’ of interest expense and other financing expenses. The cash collateral and equity contributions cover possible losses during the warehouse accumulation period, generally up to the amount of the cash pledged or equity contributed plus any net positive spread from the yield on assets held, should any of the assets need to be liquidated before being securitized through a CDO or CLO. Generally, we may have the right to purchase assets from the warehouse provider and special purpose entities in a liquidation in the event that a CDO or CLO is not formed or if an underlying security experiences a default or a decline in credit quality that may lead to a default. Typically our off-balance sheet warehouse facilities expire on the first to occur of the closing of a CDO or CLO or 180 days after the date of commencement of the facility. The maturity dates of our on-balance sheet warehouse facilities typically range from three to nine months. We account for our off-balance sheet warehouse facilities as “free-standing” derivatives. During the warehouse period, our participation under an off-balance sheet facility, consisting principally of the interest spread, is reflected in our financial statements as a non-hedge derivative, which is reflected at fair value, and any unrealized gain or loss is included in our results of operations. Our participation in on-balance sheet warehouse facilities results in interest income and interest expense and related financing costs being included in our consolidated financial statements. Upon the formation of a CDO or CLO collateralized by our targeted asset classes, it is generally our intention to purchase at least 51% of the equity and consolidate the underlying assets and liabilities onto our balance sheet; however, our guidelines do not require us to do so and we may elect to purchase less than a majority interest in these CDOs and CLOs.

It is possible that future warehouse facilities that we enter into will be structured on terms that are different from the terms of the warehouse facilities described above.

Additionally, we seek to finance our residential prime mortgage loans, leveraged loans and MBS assets on a long-term basis through securitizations and initially may finance these assets with short-term repurchase agreements. During the second quarter of 2007, we completed a securitization of substantially all of our existing residential mortgage loans by contributing the assets to a pass-through securitization entity (or trust) that issued debt securities in the capital markets collateralized by the mortgage loans held by the trust. The residential mortgage loans held by the trust are included in our consolidated financial statements.

As of September 30, 2007, the Company is not financing any investments with short-term repurchase agreements that subject the Company to margin calls or potential recourse obligations in excess of posted first loss deposits.

Operating Expenses

Our principal operating expenses are interest and other financing expenses relating to our CDO and warehouse facility financing strategies, base and incentive fees under the Management Agreement, director fees, professional fees, such as legal and accounting

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fees, and expenses resulting from grants of equity awards to our affiliates’ employees, executive officers, directors and other key personnel. Affiliates of our Manager provide ongoing collateral management services to CDOs and CLOs in which we invest under collateral management agreements. The collateral management fees are an administrative cost of and are paid by the CDO or CLO. Our pro rata share of these collateral management fees are credited against the base and incentive fees owed to our Manager, up to an amount equal to 100% of the base and incentive management fees payable under the Management Agreement, which we assumed from Alesco Financial Trust upon consummation of the merger. See “Item 1—Business—Management Agreement” included in our Annual Report on Form 10-K for the year ended December 31, 2006.

Our Portfolio and Recent Developments

The following table summarizes our allocation of capital and Adjusted Book Value, a non-GAAP measure, as of September 30, 2007 (amounts in thousands, except share and per share data):