Edgar Filing: FRIEDMAN BILLINGS RAMSEY GROUP INC

FRIEDMAN BILLINGS RAMSEY GROUP, INC.

Date: March 1, 2007

/S/ ERIC F. BILLINGS

Eric F. Billings

Chief Executive Officer

Form 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 000-50230

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

(Exact name of registrant as specified in its charter)


Virginia		54-1873198
(State or other jurisdiction of Incorporation or organization)		(I.R.S. Employer Identification No.)

1001 Nineteenth Street North,

Arlington, VA 22209

(Address of principal executive offices)(Zip Code)

(703) 312-9500

(Registrant’s telephone number, including area code)

Securities registered pursuant to section 12(b) of the act:


Title of each class of securities		Name of each exchange on which registered
Class A Common Stock, Par Value $0.01		New York Stock Exchange

Securities registered pursuant to section 12(g) of the act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act: Yes x No ¨

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

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

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

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


Large Accelerated Filer x		Accelerated Filer ¨		Non-Accelerated Filer ¨

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

The aggregate market value of the voting common equity stock held by non-affiliates of the registrant as of June 30, 2006, based on the last sale price reported on that date on the New York Stock Exchange, which was $10.97 per share, was approximately $1.8 billion. In determining this figure, the registrant has excluded all shares of Class A and Class B common stock beneficially owned by its directors and executive officers. By doing so, the registrant does not admit that such persons are affiliates within the meaning of Rule 405 of the Securities Act of 1933, as amended, or for any other purpose.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date:


Title		Outstanding
Class A Common Stock		161,462,148 shares as of January 31, 2007
Class B Common Stock		13,225,249 shares as of January 31, 2007

DOCUMENTS INCORPORATED BY REFERENCE


Document		Where Incorporated
1. Definitive proxy statement to be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K		Part III

TABLE OF CONTENTS


		Page
PART I

Cautions About Forward-Looking Information		1
Item 1.	Business	2
Item 1A.	Risk Factors	30
Item 1B.	Unresolved Staff Comments	65
Item 2.	Properties	65
Item 3.	Legal Proceedings	65
Item 4.	Submission of Matters to a Vote of Securities Holders	67

PART II		68

Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	68
Item 6.	Selected Consolidated Financial Data	70
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	72
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	109
Item 8.	Financial Statements and Supplementary Data	109
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	109
Item 9A.	Disclosure Controls and Procedures.	110
Item 9B.	Other Information	110

PART III		111

Item 10.	Directors, Executive Officers and Corporate Governance	111
Item 11.	Executive Compensation	111
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters	111
Item 13.	Certain Relationships and Related Transactions, and Director Independence	111
Item 14.	Principal Accounting Fees and Services	111

PART IV		112

Item 15.	Exhibits and Consolidated Financial Statement Schedules	112
Signatures		116
Index to Consolidated Financial Statements of Friedman, Billings, Ramsey Group, Inc.		F-1

CAUTIONS ABOUT FORWARD-LOOKING INFORMATION

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

•

the factors identified under the caption entitled “Risk Factors” beginning on page 30 of this Form 10-K;

•

the overall environment for interest rates;

•

prepayment speeds within the mortgage-backed securities market;

•

potential risk attributable to our mortgage-related or merchant banking investment portfolios;

•

credit and regulatory risks associated with the business of originating and holding residential mortgage loans which can result in losses on these assets;

•

the demand for public offerings of equity and debt securities;

•

activity in the secondary securities markets;

•

deterioration in the business environment in the specific sectors of the economy in which we focus or a decline in the market for securities of companies within these sectors;

•

competition among financial services firms and/or mortgage banking companies for business and personnel;

•

the high degree of risk associated with venture capital investments;

•

mutual fund and 401(k) pension plan inflows or outflows in the securities markets;

•

volatility of the securities markets;

•

available technologies;

•

malfunctioning or failure in our operations and infrastructure;

•

the effect of government regulation and of general economic conditions on our own business and on the business in the industry areas on which we focus our investment banking activities;

•

fluctuating quarterly operating results;

•

the availability of capital to us;

•

our ability to retain our key professionals;

•

risk from strategic investments or acquisitions and joint ventures or our entry into new business areas;

•

failure to maintain effective internal controls;

•

changes in laws and regulations and industry practices that may adversely affect our businesses; and

•

the loss of our exemption from registration as an investment company under the Investment Company Act of 1940, as amended.

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

ITEM 1. BUSINESS

Our Company

We are a real estate investment trust, or REIT, that, through our taxable REIT subsidiaries, operates investment banking, institutional brokerage and research and asset management businesses. At the parent REIT level, we invest as a principal in mortgage-backed securities (MBS), non-conforming residential mortgages and other mortgage related assets and make merchant banking investments. In addition, we also originate non-conforming residential mortgage loans through First NLC Financial Services, LLC (First NLC), one of our taxable REIT subsidiaries.

As of December 31, 2006, we beneficially owned approximately 72% of the outstanding shares of common stock of FBR Capital Markets Corporation (FBR Capital Markets), one of our taxable REIT subsidiaries, which is a holding company for our investment banking, institutional brokerage and research and asset management businesses. We formed FBR Capital Markets in June 2006. On July 20, 2006, FBR Capital Markets completed a private offering of common stock to institutional investors and a concurrent private placement to two affiliates of Crestview Partners (Crestview), a New York-based private equity firm. These transactions, which we collectively refer to as the 2006 private offering, resulted in the sale of 18,000,000 shares of FBR Capital Markets common stock. Cash proceeds to FBR Capital Markets, after deducting a placement fee payable to an affiliate of Crestview with respect to 5,172,813 shares of FBR Capital Markets common stock purchased by Crestview and other costs, were approximately $259.7 million. In connection with the 2006 private offering, we contributed to FBR Capital Markets our investment banking, institutional brokerage and research and asset management businesses, including the existing subsidiaries Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.), Friedman, Billings, Ramsey International, Ltd. (FBRIL), FBR Investment Management, Inc. (FBRIM) and FBR Fund Advisors, Inc. (FBR Fund Advisors).

Our investment banking, institutional brokerage and research, and asset management businesses and our non-conforming mortgage loan origination businesses are conducted through taxable REIT subsidiaries and pay income tax on their earnings at statutory corporate income tax rates. Our mortgage-related investment and merchant banking businesses are conducted at the parent REIT level, generating and distributing their earnings as dividends to shareholders before taxes. This structure provides shareholders a security that pays a dividend at the parent REIT level and, at the taxable REIT subsidiary level, offers the possibility for growth through the ability to retain and reinvest after-tax earnings. In 2005, we diversified our business and portfolio strategy further by acquiring First NLC, a non-conforming residential mortgage loan originator.

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

Available Information

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

Our Internet web site address is http://www.fbr.com. We make available free of charge through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), as well as the annual report to shareholders and Section 16 reports on Forms 3, 4 and 5 as soon as reasonably practicable after such documents are electronically filed with, or furnished to, the SEC. In addition, our Articles of Incorporation, Bylaws, Statement of Business Principles (our code of ethics), Corporate Governance Guidelines, and the charters of our Audit, Charitable Giving, Compensation, Nominating and Governance and Risk Policy and Compliance Committees are available on our Internet web site and are available in print, without charge, to any shareholder upon written request in writing c/o our Secretary at 1001 Nineteenth Street North, Arlington, Virginia 22209. Information on our web site should not be deemed to be a part of this report or incorporated into any other filings we make with the SEC.

Employees

As of December 31, 2006, we had 3,019 employees, of which 2,293 were employed at our First NLC subsidiary. Our employees are not subject to any collective bargaining agreement and we believe that we have excellent relations with our employees.

Financial Information by Segment

We operate in four business segments (each of which is described below): principal investing, capital markets (which includes investment banking and institutional brokerage and research operations), asset management and non-conforming residential mortgage loan origination.

At December 31, 2006, we had total assets of approximately $13.4 billion and shareholders’ equity of approximately $1.2 billion. These amounts were divided among our four business segments as follows:


	Assets		Equity Capital
Principal Investing	89.5	%	78.0	%
Capital Markets	2.2	%	12.2	%
Asset Management	0.3	%	2.6	%
Non-conforming Residential Mortgage Loan Origination	8.0	%	7.2	%

Financial information by business segment for the fiscal years ended December 31, 2006, December 31, 2005, and December 31, 2004, including the amount of net revenue contributed by each business segment in such periods, is set forth in Note 17 to our Consolidated Financial Statements and is incorporated herein by reference.

Principal Investing Business

The majority of our principal investing is in mortgage securities, whole mortgage loans and other mortgage assets. We also invest in merchant banking opportunities, including equity securities, mezzanine debt and senior loans. Some of our investments are in non-real estate related assets, subject to maintaining our REIT status. In 2005, we began to implement a broader strategy to expand the types of mortgage investments held in our REIT portfolio. Our acquisition of First NLC, completed in February 2005, has given us the ability to source self-originated non-conforming residential mortgage loans for our portfolio, in addition to loans purchased from third parties. Non-conforming residential mortgage loans are loans that do not meet the conforming loan underwriting standards of Fannie Mae, Freddie Mac and Ginnie Mae. See “—Mortgage Investing” below. Our mortgage-related investments include securities backed by residential mortgage loans that satisfy conforming loan underwriting standards of Fannie Mae, Freddie Mac and Ginnie Mae, non-conforming residential mortgage loans and securities backed by non-conforming residential mortgage loans.

We constantly evaluate the rates of return that can be achieved in each investment category and for each individual investment in which we participate. As a result of the significant decrease in short-term interest rates during 2002 and 2003 and the resulting shape of the yield curve, our MBS investments provided us with higher relative rates of return than most other investment opportunities we evaluated during that time. Increases in short-term interest rates during 2004, 2005 and 2006 reduced the rate of return on our MBS investments. There is no assurance that our past experience will be indicative of future results or that mortgage investments will provide higher rates of returns than other investment alternatives. We continue to believe that the mortgage sector offers attractive risk-adjusted returns and have broadened our investment activity to include non-conforming mortgage-related securities and non-conforming mortgage loans. We continuously evaluate investment opportunities against the returns available in each of our investment alternatives and attempt to allocate our assets and capital with an emphasis toward what we believe to be the highest risk-adjusted return available, consistent with retaining our REIT status. This strategy will cause us to have different allocations of capital in different environments.

Mortgage Investing

MBS

We invest directly in residential MBS guaranteed as to principal and interest by Fannie Mae, Freddie Mac or Ginnie Mae (referred to as agency-backed MBS). The market value of these securities however is not guaranteed by these companies. We also invest in MBS issued by private organizations (referred to as private-label MBS). These pools of mortgage loans, together with our other real estate-related assets, represent qualifying REIT assets under the federal tax code.

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

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

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

MBS portfolio to not greater than 12:1, although, from time to time leverage may increase or decrease due to changes in the value of the underlying portfolio investments and the timing and amount of re-investments.

Our agency-backed MBS consist of MBS backed by Fannie Mae, Freddie Mac and Ginnie Mae. For a detailed discussion regarding the interest rate sensitivity of our MBS portfolio and how we manage interest rate risk, see “—Our Hedging & Interest Rate Risk Management” below.

•

Fannie Mae MBS: Federal National Mortgage Association, better known as “Fannie Mae,” is a privately owned, federally chartered corporation organized and existing under the Federal National Mortgage Association Charter Act. Fannie Mae provides funds to the mortgage market primarily by purchasing home mortgage loans from local lenders, thereby replenishing their funds for additional lending. Fannie Mae guarantees to registered holders of Fannie Mae certificates that it will distribute amounts representing scheduled principal and interest (at the rate provided by the Fannie Mae certificate) on the mortgage loans in the pool underlying the Fannie Mae certificate, whether or not received, and the full principal amount of any mortgage loan foreclosed or otherwise finally liquidated, whether or not the principal amount is actually received by Fannie Mae. The obligations of Fannie Mae under its guarantees are solely those of Fannie Mae and are not backed by the full faith and credit of the United States. If Fannie Mae were unable to satisfy its obligations, the distributions made to us would consist solely of payments and other recoveries on the underlying mortgage loans, and accordingly, monthly distributions to us would be adversely affected by delinquent payments and defaults on the mortgage loans. The securities issued by Fannie Mae have an implied “AAA” rating.

•

Freddie Mac MBS: Federal Home Loan Mortgage Corporation, better known as “Freddie Mac,” is a privately owned government-sponsored enterprise created pursuant to Title III of the Emergency Home Finance Act of 1970. Freddie Mac’s principal activities currently consist of the purchase of mortgage loans or participation interests in mortgage loans and the resale of the loans and participations in the form of guaranteed MBS. Freddie Mac guarantees to holders of Freddie Mac certificates the timely payment of interest at the applicable pass-through rate and ultimate collection of all principal on the holder’s pro rata share of the unpaid principal balance of the underlying mortgage loans, but does not guarantee the timely payment of scheduled principal on the underlying mortgage loans. The obligations of Freddie Mac under its guarantees are solely those of Freddie Mac and are not backed by the full faith and credit of the United States. If Freddie Mac were unable to satisfy its obligations, the distributions made to us would consist solely of payments and other recoveries on the underlying mortgage loans, and accordingly, monthly distributions to us would be adversely affected by delinquent payments and defaults on those mortgage loans. The securities issued by Freddie Mac have an implied “AAA” rating.

•

Ginnie Mae MBS: Government National Mortgage Association, better known as “Ginnie Mae,” is a wholly owned corporate instrumentality of the United States within the Department of Housing and Urban Development. Title III of the National Housing Act of 1934 (the Housing Act) authorizes Ginnie Mae to guarantee the timely payment of principal and interest on certificates that represent an interest in a pool of mortgages insured by the Federal Housing Administration under the Housing Act or partially guaranteed by the Veteran’s Administration under the Servicemen’s Readjustment Act of 1944 and other loans eligible for inclusion in mortgage pools underlying Ginnie Mae certificates. Section 306(g) of the Housing Act provides that “the full faith and credit of the United States is pledged to the payment of all amounts that may be required to be paid under any guaranty under this subsection.” An opinion, dated December 12, 1969, of an Assistant Attorney General of the United States provides that under section 306(g) of the Housing Act, Ginnie Mae certificates of the type that we may purchase are authorized to be made by Ginnie Mae and “would constitute general obligations of the United States backed by its full faith and credit.”

•

Privately-issued MBS: Privately-issued MBS are MBS that are not issued by one of the agencies referred to above and that are backed by a pool of single-family residential mortgage loans. These certificates are issued by originators of, investors in, and other owners of residential mortgage loans, including savings and loan associations, savings banks, commercial banks, mortgage banks, investment

banks and special purpose “conduit” subsidiaries of these institutions. While agency MBS are backed by the express obligation or guarantee of Fannie Mae, Freddie Mae, or Ginnie Mae as described above, privately-issued MBS are generally covered by one or more forms of private (i.e., non-governmental) credit enhancement. These credit enhancements provide an extra layer of loss coverage in the event that losses are incurred upon foreclosure sales or other liquidations of underlying mortgaged properties in amounts that exceed the equity holder’s equity interest in the property. Forms of credit enhancement include limited issuer guarantees, reserve funds, private mortgage guaranty pool insurance, over-collateralization and subordination. Subordination is a form of credit enhancement frequently used and involves the issuance of classes of senior and subordinated MBS to allocate losses on the underlying mortgage loans. Typically, one or more classes of senior MBS are created which are rated in one of the two highest rating levels by one or more nationally recognized rating agencies and which are supported by one or more subordinated MBS that bear losses on the underlying mortgage loans prior to the classes of senior MBS.

Non-conforming Residential Mortgage Loans

We invest directly in non-conforming residential mortgage loans which consist of mortgage loans that do not satisfy conforming loan underwriting guidelines of Fannie Mae, Freddie Mac and Ginnie Mae because of higher loan-to-value ratios, the nature or absence of income documentation, limited credit histories, high levels of consumer debt, past credit difficulties or other factors. Non-conforming residential mortgage loans also include loans to more creditworthy borrowers where the size of the loan exceeds underwriting guidelines of Fannie Mae, Freddie Mac and Ginnie Mae. We purchase non-conforming residential mortgage loans from third party originators and we also invest in securities backed by pools of non-conforming residential mortgage loans. We may also invest in loans originated by First NLC. See “Mortgage Loan Origination—Mortgage Banking” below.

During 2006, we did not deploy additional capital to invest in this asset class. As of September 30, 2006, we made a determination in evaluating our mortgage investments and strategy to reclassify the mortgage loan portfolio held at the parent-REIT level. As a result of this change, we recorded our investment in this portfolio at the lower of cost or market. During 2006, we recognized a $149.8 million non-cash mark-to-market write-down in the value of this mortgage loan portfolio. The write-down of the mortgage loan portfolio signals our decision not to hold that portfolio to maturity and an intention to redeploy the capital invested in that portfolio more rapidly than if the portfolio were held to maturity.

The non-conforming residential mortgage market has recently encountered difficulties which may adversely affect the liquidity, fair value and profitability of our non-conforming residential mortgage loan portfolio. These difficulties include:

•

An increase in delinquencies and losses with respect to residential mortgage loans generally have increased and may continue to increase in the sub-prime sector. In recent months residential property values in many states have declined or remained stable, after extended periods during which those values appreciated. A continued decline or a lack of increase in those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to second homes and investor properties, and with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable rate mortgage loans. Moreover, with respect to hybrid mortgage loans after their initial fixed rate period, and with respect to mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an increase in prevailing market interest rates.

•

An increase in the yield required by sub-prime mortgage loan investors to compensate for heightened uncertainty with respect to future credit losses. This higher yield is a result of increasing delinquencies and losses and the recently experienced serious financial difficulties and, in some cases, bankruptcy of several residential mortgage loan originators that originate sub-prime loans.

These difficulties have resulted in a declining market for non-conforming residential mortgage loans as well as from claims for repurchases of mortgage loans previously sold under provisions that require repurchase in the event of early payment defaults and for breaches of other representations regarding loan quality and a decline in value of a mortgage loan investment portfolios for the reasons specified above.

Net Interest Margin (NIM) Securities

We invest directly in net interest margin (NIM) securities that are short-term and investment grade-rated by either Moody’s or Standard & Poor’s. Generally, a NIM represents an interest in some or all of the excess cash flows of a securitization of non-conforming mortgage loans. Specifically, a typical non-conforming mortgage loan securitization generates excess spread due to the fact that the securitization is backed by mortgage loans which bear interest rates in excess of the interest rates on the securities offered in such securitization. Additionally, excess cash flow in a typical non-conforming mortgage loan securitization is generated by prepayment premiums. The excess spread, after satisfaction of any realized losses, required overcollateralization (O/C) of the securitization, servicing and trustee fees, and prepayment premiums, are part of the residual assets of the securitization trust.

A NIM represents a right to receive some or a portion of such excess cash flows. A NIM is quite sensitive to increases in losses on the underlying securitization as such losses have a major impact on the excess spread. Additionally, losses may require the application of excess spread to maintain required O/C levels. Such loss severities may be mitigated through the use of mortgage insurance at the underlying loan level. Mortgage insurance also reduces the required O/C levels thereby providing greater stability to the NIM. A NIM is also highly sensitive to rates of prepayment on the underlying loans with a higher prepayment speed resulting in a more rapid decline in the collateral balance thereby reducing excess spread. Prepayment premiums counteract prepayment speed. The inclusion of prepayment premiums in a NIM structure offsets declines in excess spread which may occur in a declining interest rate environment when prepayment rates increase.

Our Use of Leverage

We may reduce the amount of equity capital we have invested in MBS or other mortgage assets by funding a portion of those investments with repurchase agreements, commercial paper or other borrowing arrangements. To the extent that revenue derived from those assets exceeds our interest expense and other costs of the financing, our net income will be greater than if we had not borrowed funds and had not invested in the assets. Conversely, if the revenue from our MBS and other mortgage assets does not sufficiently cover the interest expense and other costs of the financing our net income will be less or our net loss will be greater than if we had not borrowed funds.

We borrow funds to invest in residential mortgage assets by entering into repurchase agreements or, in the case of MBS, issuing commercial paper or entering into securitization financing arrangements. Under repurchase agreements, assets are sold to a third party with the commitment to repurchase the same assets at a fixed price on an agreed future date. The repurchase price reflects the purchase price plus an agreed upon market rate of interest. These repurchase agreements are accounted for as debt, secured by the underlying assets. In August 2003, we formed Georgetown Funding, LLC (Georgetown Funding), which is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes in the asset-backed commercial paper market and entering into reverse repurchase agreements with us and our affiliates. We serve as administrator for Georgetown Funding’s commercial paper program and all of Georgetown Funding’s transactions are conducted with FBR. Through our administration agreement and repurchase agreements, we are the primary beneficiary of Georgetown Funding and consolidate this entity for financial reporting purposes. The

commercial paper notes issued by Georgetown Funding are collateralized by the MBS we own and are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. Through our master repurchase agreement with Georgetown Funding, we are able to finance up to $12 billion of MBS.

In October 2004, we formed Arlington Funding LLC (Arlington Funding), which is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by non-conforming mortgages and providing warehouse financing in the form of reverse repurchase agreements to us and our affiliates and to mortgage originators with which we have a relationship. We serve as administrator for Arlington Funding’s $5 billion commercial paper program and provide collateral as well as guarantees for commercial paper issuances. The commercial paper notes issued by Arlington Funding are collateralized by non-conforming mortgage loans owned by various third party originators as well as non-conforming residential mortgage loans owned by First NLC. Through these arrangements, we are the primary beneficiary of Arlington Funding and consolidate this entity for financial reporting purposes. The extendable commercial paper notes issued by Arlington Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. The agreements with First NLC allow us to finance up to $1 billion of non-conforming residential mortgage loans owned by First NLC through commercial paper issued by Arlington Funding.

We finance non-conforming residential mortgage loans purchased for our portfolio initially with warehouse debt utilizing repurchase agreements. Securitized loans remain on our consolidated statement of financial condition as an asset while the securitization debt is accounted for as a liability on our consolidated statement of financial condition in the case that the transaction is not considered a sale.

Our Hedging and Interest Rate Risk Management

To the extent consistent with our election to qualify as a REIT, we follow an interest rate risk management program intended to protect our portfolio of MBS, mortgage-related investments and mortgage loans against the effects of major interest rate changes. Generally, our interest rate risk management program is formulated with the intent to ameliorate the potential adverse effects resulting from differences in the amount and timing of rate adjustment to our assets verses those affecting our corresponding liability. Our agency-backed MBS hedging strategy includes an element of reliance on coupon repricing of assets in addition to hedging our liability cost.

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

•

structuring some borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate MBS, mortgage-related investments and mortgage loans; and

•

structuring some borrowing agreements relating to adjustable-rate MBS, mortgage-related investments and mortgage loans to have a range of different maturities and interest rate adjustment periods (although substantially all will be less than one year).

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

We purchase from time-to-time interest rate swaps, interest rate collars, interest rate caps or floors, and similar financial instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the yield on our assets during a period of rising interest rates or to mitigate prepayment risk. It is not our policy to use derivatives to speculate on interest rates. These derivative instruments have an active

secondary market and are intended to provide income and cash flow to offset potential reduced interest income and cash flow under certain interest rate environments. Certain of our interest rate management activities qualify for hedge accounting in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted. We report the derivative financial instruments and any related margin accounts on our consolidated balance sheets at their fair value. We may hedge as much of the interest rate risk as our management determines is in our best interests, given the cost of the hedging transactions and the need to maintain our status as a REIT. This determination may result in our electing to bear a level of interest rate or prepayment risk that could otherwise be hedged when management believes, based on all relevant facts, that the cost of hedging exceeds the level of risk that management believes is present.

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

We may elect to conduct a portion of our hedging operations through one or more subsidiary corporations, each of which we would elect to treat as a “taxable REIT subsidiary.” To comply with the asset tests applicable to us as a REIT, we could own 100% of the voting stock of such subsidiary, provided that the value of the stock that we own in all such taxable REIT subsidiaries does not exceed 20% of the value of our total assets at the close of any calendar quarter. A taxable subsidiary would not elect REIT status and may or may not distribute any net profit after taxes to us and its other stockholders. Any dividend income we receive from the taxable subsidiaries (combined with all other income generated from our assets, other than qualified REIT real estate assets) must not exceed 25% of our gross income.

We believe that we maintain a cost-effective asset/liability management program to provide a level of protection against interest rate and prepayment risks. However, no strategy can completely insulate us from interest rate changes and prepayment risks. Further, as noted above, the federal income tax requirements that we must satisfy to qualify as a REIT limit our ability to hedge our interest rate and prepayment risks. We monitor carefully, and may have to limit, our asset/liability management program to assure that we do not realize excessive hedging income, or hold hedging assets having excess value in relation to total assets, which could result in our disqualification as a REIT, the payment of a penalty tax for failure to satisfy certain REIT tests under the Internal Revenue Code, provided the failure was for reasonable cause. In addition, asset/liability management involves transaction costs which increase dramatically as the period covered by the hedging protection increases. Therefore, we may be unable to hedge effectively our interest rate and prepayment risks. See “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies—Hedging Activities” below.

Prepayment Risk Management

We seek to minimize the effects of faster or slower than anticipated prepayment rates through structuring a diversified portfolio with a variety of prepayment characteristics, investing in mortgage loans with prepayment

prohibitions and penalties, investing in certain mortgage structures which have prepayment protections, and balancing assets purchased at a premium with assets purchased at a discount. We monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.

Merchant Banking

Our merchant banking investment strategy is to invest in companies that compete in industries where we have investment expertise and a contextual understanding of industry dynamics. We rely on the investment banking group of Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.), which is the principal operating subsidiary of FBR Capital Markets, to provide us with potential investment opportunities. As a result, although all of our investment decisions are driven by a fundamental value-oriented approach and not as part of a strategy to generate investment banking business for our affiliate, almost all of our investments are in companies that are also investment banking clients of our affiliate. We are long-term investors but do not seek to control the companies in which we invest. In most cases, we intend to hold our merchant banking investments for greater than 12 months. Because of our broker-dealer affiliation, many of our investments in companies that are our investment banking clients are subject to lock-up restrictions which limit our ability to sell securities for a period of time.

Subject to maintaining our qualification as a REIT, we invest from time to time in equity securities that may or may not be related to the real estate business. We follow a fundamental value-oriented investment approach and focus on the anticipated future cash flows to be generated by the underlying business, discounted by an appropriate rate to reflect both the risk of achieving those cash flows and the alternative uses for the capital to be invested. We also consider factors such as: strength of management; liquidity of the investment; underlying value of the assets owned by the issuer; and prices of similar or comparable securities and/or companies.

Upon completion of FBR Capital Markets’ private offering in July 2006, FBR Capital Markets began evaluating merchant banking investments along with us in potential or existing investment banking clients. FBR Capital Markets and our company intend to allocate each merchant banking investment opportunity 50% to FBR Capital Markets and 50% to our company, subject to the approval of each of our investment committees. In addition, allocations will also be subject, in our case, to the maintenance of our REIT qualification, and, in the case of both FBR Capital Markets and our company, the maintenance of our respective exemptions from the registration requirements of the Investment Company Act of 1940, as amended.

As of December 31, 2006, we had invested in approximately $143.4 million of equity securities of various companies. See, “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Principal Investing—Merchant Banking” below.

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

During 2006, we made a determination in evaluating our merchant banking portfolio to recognize as “other than temporary impairments” the amounts by which the fair value of certain of our merchant banking investments were below their respective cost bases. In 2006, we recognized a $79.7 million non-cash write-down of equity positions in our merchant banking portfolio, the majority of which involve companies doing business in the sub-prime mortgage sector.

Mortgage Loan Origination—Mortgage Banking

On February 16, 2005, we completed the acquisition of First NLC, a non-conforming residential mortgage loan originator, for approximately $100.8 million, paid with a combination of cash and shares of our common stock. First NLC originates, underwrites and funds mortgage loans secured primarily by single-family residences, and then sells these loans to institutional loan purchasers. Loans are originated primarily based upon the borrower’s willingness and ability to repay the loan and the adequacy of the collateral. First NLC currently is licensed, or otherwise exempted from licensing requirements, to originate loans in 45 states across the United States. Through First NLC and its subsidiaries we originate mortgage loans through both wholesale and retail channels, through which we originated approximately $6.0 billion in 2005 and $7.5 billion in 2006. First NLC’s loan origination platform provides us with the ability to originate, price, portfolio and sell non-conforming mortgage loan assets based on market conditions. See “Item 1A—Risk Factors—Risks Related to our Non-Conforming Residential Mortgage Loan Origination Business.”

As discussed above in “Non-Conforming Mortgage Loans,” the non-conforming residential mortgage loan market has recently been adversely affected by increased delinquencies, losses and declining real estate values in certain markets. These changes in the market for non-conforming mortgage loans have already affected the profitability of the loans originated by First NLC. We believe that First NLC’s 2006 cost to originate of 191 basis points and early payment default rate of 2.3% are relatively low for the industry. However, the increasing frequency of early payment defaults and an increase in the expected severity of these defaults due to industry-wide concerns caused First NLC to incur an operating loss of $18 million in 2006. Although First NLC continues to strengthen lending standards, the potential adverse impact on origination volume and the need to reduce expenses may continue to impact First NLC’s ability to operate profitability. In the current market we cannot predict when First NLC will return to profitability.

Capital Markets Business

FBR Capital Markets, a taxable REIT subsidiary holding company, is a full-service investment banking, institutional brokerage and research and asset management firm that has a customer-focused and innovative approach to its clients’ needs. We formed FBR Capital Markets in June 2006 to be the holding company for our investment banking, institutional brokerage and research and asset management businesses. In connection with the 2006 private offering described above, we caused FBR TRS Holdings, Inc., a taxable REIT subsidiary holding company, to contribute to FBR Capital Markets all of the outstanding capital stock of FBR Capital Markets Holdings, Inc. and FBR Asset Management Holdings, Inc. FBR Capital Markets Holding is the parent company of the following existing subsidiaries: Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.) and Friedman, Billings, Ramsey International, Ltd. (FBRIL). FBR Asset Management Holdings, Inc. is the parent company of FBR Investment Management, Inc. (FBRIM) and FBR Fund Advisors, Inc. (FBR Fund Advisors). As a result of the contribution transaction, we retain an approximate 72% ownership interest in FBR Capital Markets. As a result, FBR Capital Markets is a controlled subsidiary of ours and we will continue to consolidate FBR Capital Markets for financial reporting purposes.

FBR Capital Markets has filed a shelf registration statement on Form S-1 with the United States Securities and Exchange Commission (SEC) to register for resale the shares of its common stock that were sold in the 2006 private offering. When the registration statement is declared effective by the SEC, FBR Capital Markets will be a public reporting company and we expect its common stock to trade on the Nasdaq Global Market. FBR Capital Markets will remain a controlled subsidiary of ours after it becomes public.

In connection with the 2006 private offering, we entered into various agreements and arrangements with FBR Capital Markets, including among others, a management services agreement. Pursuant to the management services agreement, we provide FBR Capital Markets with its executive management team. Each of the members of FBR Capital Markets’ executive management team serves as an executive officer of our company. The board of directors of FBR Capital Markets Corporation consists of nine members. Three of the FBR Capital Markets directors, Eric F. Billings, J. Rock Tonkel, Jr. and Richard J. Hendrix, also serve as executive officers of our

company and of FBR Capital Markets. Mr. Billings, the Chairman and Chief Executive Officer of our company and of FBR Capital Markets, also serves as a member of our board of directors. In addition to the three inside directors, the FBR Capital Markets board of directors has six outside directors, four of whom will qualify as “independent” directors in accordance with the Nasdaq Marketplace Rules once FBR Capital Markets becomes a public company. Biographical information with respect to the six outside directors serving on the board of directors appears below.


Andrew M. Alper		Mr. Alper is an independent member of the FBR Capital Markets board of directors, a position he has held since January 2007. Mr. Alper currently serves as Chairman and Managing Member of EQA Partners, L.P., a commodity pool limited partnership engaged in a global macro strategy and currency trading. Mr. Alper served as President of New York City’s Economic Development Corporation and Chairman of New York City’s Industrial Development Agency from February 2002 to June 2006. Prior to joining New York City’s government in February 2002, Mr. Alper was a Partner and Managing Director of Goldman, Sachs & Co., or Goldman Sachs. In his 21 year career with Goldman Sachs, Mr. Alper served in various positions, including co-head of the Investment Banking Division’s Financial Institutions Group and Chief Operating Officer of the Investment Banking Division. He currently serves as Vice Chairman of the Board of Trustees of the University of Chicago and is a member of the Visiting Committee of the University of Chicago Graduate School of Business. Mr. Alper also is a trustee of Columbia Grammar and Preparatory School and the Mount Sinai Medical Center in Manhattan.

Richard M. DeMartini		Mr. DeMartini is a Managing Director of Crestview Partners, a position he has held since 2006. Mr. DeMartini retired as President of Bank of America’s Asset Management Group in December 2004. He was also a member of the Risk and Capital Committee and the Operating Committee at Bank of America. Prior to joining Bank of America in 2001, Mr. DeMartini served as Chairman and Chief Executive Officer of the International Private Client Group at Morgan Stanley Dean Witter. He also was a member of the Morgan Stanley Dean Witter Management Committee. Mr. DeMartini’s career at Morgan Stanley Dean Witter spanned more than 26 years and included roles as President of Individual Asset Management and President of Dean Witter & Company, Inc. and Chairman of Discover Card. He has been a member of the investment community since joining Dean Witter in 1975. He has served as Chairman of the Board of The Nasdaq Stock Market, Inc. and Vice Chairman of the Board of the National Association of Securities Dealers, Inc. Mr. DeMartini currently serves as a trustee of the Cancer Research Institute.

Thomas J. Hynes, Jr.		Mr. Hynes is President and Chief Executive Officer of Meredith & Grew Incorporated, a Boston-based real estate services firm. Mr. Hynes has been employed by Meredith & Grew Incorporated since 1965, during which time he has held various offices. Mr. Hynes also serves as Chairman of the Massachusetts Business Roundtable, a non-profit, nonpartisan, statewide public affairs organization that represents Massachusetts’ leading industry and business enterprises, and as a director of the John F. Kennedy Library Foundation. From October 1996 to January 2006, Mr. Hynes served as a director of Prentiss Properties Trust (NYSE: PP), a publicly-traded REIT that was acquired by Brandywine Realty Trust in January 2006.


Richard A. Kraemer		Mr. Kraemer served as Chairman of the Board of Directors of Saxon Capital Inc., a publicly-traded mortgage REIT from 2001 through December 2006. Mr. Kraemer also serves as a trustee of American Financial Realty Trust (NYSE: AFR), a publicly-traded REIT, and has held such position since 2002. Mr. Kraemer serves on the audit committee and is chairman of the finance committee of the board of trustees of American Financial Realty Trust. He also serves as a director of Urban Financial Group, Inc., a position he has held since 2001. From 1996 to 1999, Mr. Kraemer was Vice Chairman of Republic New York Corporation, a publicly-traded holding company for Republic National Bank. From 1993 to 1996, Mr. Kraemer was Chairman and Chief Executive Officer of Brooklyn Bancorp, a publicly-traded holding company for Crossland Federal Savings Bank.

Thomas S. Murphy, Jr.		Mr. Murphy is a Managing Director of Crestview, a position he has held since 2004. Mr. Murphy retired from Goldman Sachs in 2003 where he was the co-founder and head of the Financial Sponsors Group. Mr. Murphy was a Partner and Managing Director of Goldman Sachs. The Financial Sponsors Group was responsible for Goldman Sachs’ investment banking activities with private equity firms around the world. These activities included acquisitions, divestitures, initial public offerings, bank and high yield financings and principal investments. He serves on the boards of trustees of The Taft School, The Inner-City Scholarship Fund and The Madison Square Boys and Girls Clubs.

Arthur J. Reimers		Since his retirement from Goldman Sachs in 2001, Mr. Reimers has served as an independent financial and business consultant. From 1981 to 2001, Mr. Reimers served in various capacities at Goldman Sachs, including, among others, as a Partner and Managing Director of the Investment Banking Division, co-head and founder of the Investment Banking Division’s Healthcare Department from 1996 to 1998 and co-head of the Financial Advisory Group (London) from 1991 to 1996. Mr. Reimers also serves as Chairman of the Board of Directors of Rotech Healthcare, Inc. (Nasdaq: ROHI), a publicly-traded healthcare company, a position he has held since March 2002. Mr. Reimers serves as a member of Rotech’s audit, compensation and nominating and corporate governance committees. He also serves as a director of Bear Naked, Inc., a private food company. From 2003 to 2005, Mr. Reimers served as a director of NeighborCare, Inc. (Nasdaq: NCRX), a publicly-traded healthcare company that was acquired by Omnicare, Inc. in July 2005. Mr. Reimers is also a member of the management advisory board of New Mountain Capital, L.L.C., a private equity firm, and is a senior advisor to the New Mountain Vantage Fund, a public equity investment fund. Mr. Reimers serves on the board of trustees of the Boys & Girls Club of Greenwich and The Miami University Foundation Board, where he chairs the investment committee.

Our investment banking professionals, backed by their industry knowledge and our strong distribution platform, seek to establish and maintain relationships with our corporate clients and to provide them with capital raising and strategic advisory services. We provide these services in the following broad industry sectors that we believe offer significant business opportunities: consumer, diversified industrials, energy and natural resources, financial institutions, healthcare, insurance, real estate and technology, media and telecommunications. We have continued to strengthen our business by adding coverage of new industry sectors in both institutional brokerage and investment banking, adding new products and services that benefit from our knowledge of each sector and building a wider customer base.

As an investment bank with a merchant banking capability, we believe it is important for us to be involved with companies early in their formation in order to establish relationships that will provide us with ongoing revenues as these companies’ corporate finance and financial advisory needs grow. We seek to provide our corporate clients with the financing and advisory services that they will need at all stages of their corporate lifecycle.

Investment Banking

Capital Raising. We have developed a strong market presence, primarily in a lead-managing role, as a top-tier underwriter of equity securities in the United States. We maintain leading market share in the Rule 144A equity market as a function of our distribution capability and experienced, client-focused investment bankers. During 2005, we were the lead or sole book-running manager of 39 equity offerings and co-managed 32 other equity offerings, raising proceeds of approximately $18.2 billion. During 2006, we were the lead or sole book-running manager of 32 equity offerings and co-managed 14 other equity offerings raising aggregate proceeds of approximately $12.0 billion.

We base our decision to underwrite an offering of a client’s securities on company and industry fundamentals, management’s track record, historical financial results and financial projections all backed by extensive due diligence. We underwrite for corporate clients that we believe will be able to execute long-term strategies that deliver significant returns to investors. We offer a wide range of financial products designed to serve the needs of our investment banking clients, including initial offerings, follow-on and secondary offerings, equity-linked offerings, public debt offerings, asset backed securitizations, and private placements of debt and equity. We seek to introduce companies desiring to raise capital to investors that we believe will be long-term investors.

Strategic Advisory Services. Our strategic advisory practice builds on our capital markets expertise and focuses on helping clients to assess strategic alternatives, including advice on M&A, mutual conversions, financial restructuring, and strategic partnering transactions. In addition, we provide valuation advice, fairness opinions, market comparable valuation analysis, advice on dividend policies, evaluations of stock repurchase programs, and other advice and services as appropriate. On February 8, 2007, we announced that we had acquired certain assets and a team of more than two dozen investment banking professionals from Legacy Partners Group, LLC, an independent investment banking and advisory firm, specializing in providing merger and acquisition advisory services and raising private capital. We believe this is a significant step in implementing our strategy to build out our capital markets platform.

We believe that our activities and reputation have created a network of relationships that enables us to quickly identify and execute mutually beneficial business combinations. We work with our corporate clients to develop strategies and ideas customized to meet their needs and objectives by utilizing our thorough knowledge of our target industries and the relationships that we have developed over the years. Our in-depth research, secondary market experience, and innovative thought processes enable us to recommend and evaluate value creating strategies for our clients.

Institutional Brokerage and Research

We focus on providing research and institutional sales and trading services to equity and high-yield investors in the United States, Europe and elsewhere. We execute securities transactions for institutional investors such as banks, mutual funds, insurance companies, hedge funds, money managers and pension and profit-sharing plans. Institutional investors normally purchase and sell securities in large quantities, which requires the special market making and trading expertise that we provide.

Institutional Brokerage. Our institutional brokerage professionals are distinguished by their in-depth understanding of the companies and industries in which we focus. Our traders and salespeople are required to develop detailed knowledge and relationships and strive to consistently provide exceptional trade execution and sales and trading services to our client base of more than 700 institutional investor accounts. Many of our

institutional clients have been long-standing investors in transactions that we have brought to the capital markets and have continued a close relationship with us as they have grown in size and assets under management.

Our sales professionals work closely with our research analysts and our trading desk to provide the most up-to-date information to our institutional clients. Our sales, trading and research professionals work together to maintain regular contact with the specialized portfolio managers and buy-side analysts of each institutional client. Our trading professionals facilitate trading in equity and high-yield securities. We make markets in Nasdaq and other securities, trade-listed securities and service the trading desks of major institutions in the United States, Europe and elsewhere.

Research. We understand the importance of research and the role quality research plays in the institutional brokerage process, particularly for accounts that do not maintain a large in-house research team. Our research analysts perform independent research on over 580 companies to help our clients understand the dynamics that drive the sectors and companies they cover. We seek to differentiate ourselves through originality of perspective, depth of insight and our ability to uncover industry trends. Our unique viewpoint has helped us develop relationships with investor clients in both our primary distribution and secondary trading businesses.

Our research analysts operate under three guiding principles: (i) to provide objective, independent analysis of securities, their issuers, and their place in the capital markets; (ii) to identify undervalued investment opportunities in the capital markets, and (iii) to communicate effectively the fundamentals of these investment opportunities to potential investors. To achieve these objectives, we believe that industry specialization is necessary and, as a result, we organize our research staff along industry lines. Each industry team works together to identify and evaluate industry trends and developments. Within industry groups, analysts are further subdivided into specific areas of focus so that they can maintain and apply specific industry knowledge to each investment opportunity they address.

After initiating coverage on a company, our analysts seek to maintain a long-term relationship with that company and a long-term commitment to ensure that new developments are effectively communicated to our sales force and institutional investors. Our research team analyzes major trends, publishes original research on new areas of growth, provides fundamental, company-specific coverage and works with our institutional clients to identify and evaluate public equity investment opportunities.

The majority of our non-REIT revenues have historically been generated from the investment banking, institutional brokerage and research and asset management businesses that were contributed to FBR Capital Markets in July 2006.

Asset Management Business

Our asset management subsidiaries are subsidiaries of FBR Capital Markets and also are taxable REIT subsidiaries. Since 1989, we have managed hedge funds and other alternative asset management products. Since 1996, we have expanded these specialized asset management capabilities, adding private equity, and venture capital funds and public mutual funds, both equity and fixed income, as part of our strategy to diversify our asset management product offerings.

Our asset management business currently offers three main services: mutual funds, alternative asset management and private wealth advisory. We are focused on expanding our asset management business and strive, where appropriate, to utilize our intellectual capital, relationships and other resources, to achieve this goal. We believe our overall asset management business provides us with a unique opportunity to leverage our strengths to grow our asset management business.

Mutual Funds. We entered into the mutual funds business in 1997. At December 31, 2006, our mutual funds had over $1.95 billion of assets under management. Our mutual fund offerings include the FBR Pegasus Fund, the FBR Small Cap Financial Fund, the FBR Large Cap Financial Fund, the FBR Small Cap Fund, the FBR Gas

Utility Index Fund, the FBR Small Cap Technology Fund and the FBR Large Cap Technology Fund. We also manage a money-market fund, the FBR Fund for Government Investors. We provide advisory and administration services to the funds, for which we receive total fees at an annual rate ranging from 0.40% to 0.90% of net assets, depending on the fund.

Alternative Asset Management Group—Hedge, Private Equity and Venture Capital Funds. Our alternative asset management group currently manages hedge funds, including funds of funds, as well as private equity and venture capital funds. At December 31, 2006, our alternative asset management group had approximately $136.9 million in assets under management on which our base management fees of 1.0% to 2.3% are calculated. In addition to base management fees, these funds provide the potential for incentive income if certain benchmarks are met.

We seek to expand our presence in these and related alternative asset segments by using our industry knowledge to identify strategies and managers, within our company and externally. We also intend to invest our own capital in certain of these strategies. By doing so, we believe we can grow our alternative asset management business.

Private Wealth Advisory Services. Our private wealth advisory practice intends to capture a larger market share of the increasing number of high net worth individuals in the U.S. Our primary private wealth advisory focus is on understanding each client’s complete financial profile. This knowledge is the foundation of our ability to create comprehensive investment strategies specifically tailored to each client. We rely on a “building blocks approach” in constructing effective, risk-managed investment strategies for our clients. These strategies can include access to elite, “best of breed” managers, alternative investments, including our investment banking transactions, and other proprietary FBR investment ideas. We are confident that providing clients access to FBR’s differentiated, proprietary investment ideas and strategies is attractive and sets FBR apart from other banks, brokerages and trust companies. In addition, we believe that our access to distinctive proprietary investments will also be attractive to potential new private wealth manager hires, as we seek to expand our practice. As of December 31, 2006, our private wealth advisory professionals oversaw the management of more than $259.9 million in assets for our clients.

Accounting, Administration and Operations

Our accounting, administration and operations personnel are responsible for financial controls, internal and external financial reporting, human resources and personnel services, office operations, information technology and telecommunications systems, the processing of securities transactions, and corporate communications. With the exception of payroll processing, which is performed by an outside service bureau, and customer account processing, which is performed by our clearing brokers, most data processing functions are performed internally. We believe that future growth will require implementation of new and enhanced communications and information systems and training of our personnel to operate such systems.

Compliance, Legal, Risk Management and Internal Audit

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

Competition

As a full-service investment banking, institutional brokerage and asset management firm, all aspects of our business are intensely competitive. Our competitors are other brokerage firms, investment banking firms, merchant banks and financial advisory firms. We compete with some of our competitors nationally and with others on a regional, product or business line basis. Many of our competitors have substantially greater capital and resources than we do and offer a broader range of financial products. We believe that the principal factors affecting competition in our business include client relationships, reputation, the abilities of our professionals, market focus and the relative quality and price of our services and products.

We have experienced intense price competition in some of our businesses, in particular discounts in large block trades and trading commissions and spreads. The ability to execute trades electronically, through the Internet and through other alternative trading systems, has increased the pressure on trading commissions and spreads. We believe that this trend toward alternative trading systems will continue. In addition, the trend, particularly in the equity underwriting business, toward multiple book runners and co-managers has increased the competitive pressure in the investment banking industry, and may lead to lower average transaction fees. We may experience competitive pressures in these and other areas in the future as some of our competitors seek to increase market share by reducing prices.

In our asset management business, we compete with many of the same firms as we do in the investment banking and brokerage businesses as well as with venture capital firms, large mutual fund companies, commercial banks and smaller niche players including private hedge funds. We believe that our unique perspective on the industries we serve affords an opportunity to grow our assets under management and intend to invest our own capital alongside that of our fund investors.

In our mortgage loan origination business, we compete with large non-conforming mortgage loan originators. Our competitors in the mortgage loan origination business may have greater resources than our company and may have greater success in recruiting and retaining qualified professionals and in originating non-conforming residential mortgage loans.

Competition is also intense for the recruitment and retention of qualified professionals. Our ability to continue to compete effectively in our businesses will depend upon our continued ability to attract new professionals and retain and motivate our existing professionals.

In addition to competing for customers and investments, we compete with other companies in the financial services, investment and mortgage banking and brokerage industries to attract and retain experienced and productive investment professionals. See “Item 1A—Risk Factors—General Risks Related to Our Business” below.

In acquiring mortgage-related assets, including MBS, and in originating non-conforming residential mortgage loans, we compete with specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders, governmental bodies, broker-dealers, mortgage REITs and other entities. Many of our mortgage competitors are significantly larger than us, have access to greater capital and other resources and may have other advantages over us. In addition, there are numerous mortgage REITs with asset acquisition objectives similar to ours, and other mortgage REITS with similar strategies may be organized in the future. The effect of the existence of additional REITs may be to increase competition for the available supply of mortgage-related assets, including MBS, suitable for purchase.

For a further discussion of the competitive factors affecting our business, see “Item 1A—Risk Factors—General Risks Related to Our Business and—Risks Related to Our Principal Investing Activities.”

Risk Management

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

•

Market risk. Market risk is the risk to our earnings or capital resulting from adverse changes in the values of assets resulting from movement in market interest rates, equity prices or foreign exchange rates, as well as market expectations concerning the underlying assets.

•

Credit risk. Credit risk is the risk of loss due to an individual customer’s or institutional counterparty’s unwillingness or inability to pay its obligations.

•

Operations risk. Operations risk is the risk of loss resulting from systems failure, inadequate controls, human error, fraud or unforeseen catastrophes.

•

Liquidity risk. Liquidity risk is the risk that we may be unable to meet our obligations as they come due because of our inability to liquidate assets or obtain funding. Liquidity risk also includes the risk of having to sell assets at a loss to generate liquid funds.

•

Regulatory risk. Regulatory risk is the risk of loss, including fines or penalties, from failing to comply with federal, state or local laws, rules and regulations pertaining to financial services activities, including the loss of our REIT qualification.

•

Legal risk. Legal risk is the risk of loss, disruption or other negative effect on our operations or condition that arises from unenforceable contracts, lawsuits, adverse judgments, or adverse governmental or regulatory proceedings, or the threat thereof.

•

Reputational risk. Reputational risk is the risk that negative publicity regarding our practices, whether true or not, will cause a decline in the customer base, resulting in costly litigation, or reduce our revenues.

•

Equity Ownership Risk. Equity ownership risk arises from making equity investments that create an ownership interest in portfolio companies, and is a combination of credit, market, operational, liquidity, compliance and reputation risks. We have a corporate-wide risk management program approved by our Board of Directors. This program sets forth various risk management policies, provides for a risk management committee and assigns risk management responsibilities. The program is designed to focus on the following:

•

identifying, assessing and reporting on corporate risk exposures and trends;

•

establishing and revising as necessary policies, procedures and risk limits;

•

monitoring and reporting on adherence with risk policies and limits;

•

developing and applying new measurement methods to the risk process as appropriate; and

•

approving new product developments or business initiatives.

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

Regulation

Overview

In the United States, a number of federal regulatory agencies are charged with the integrity of the securities and other financial markets and with protecting the interests of customers participating in those markets.

We are subject to regulation by several federal agencies. The Securities and Exchange Commission (SEC) is the federal agency that is primarily responsible for the regulation of broker-dealers and investment advisers doing

business in the United States. The Federal Reserve Board promulgates regulations applicable to securities credit (margin) transactions involving broker-dealers and certain other institutions in the United States. Much of the regulation of broker-dealers has been delegated to self-regulatory organizations (SROs), principally the NASD (and its subsidiaries NASD Regulation, Inc. and the Nasdaq Stock Market (Nasdaq)), and the national securities exchanges. These organizations, which are subject to oversight by the SEC, govern the industry, monitor daily activity and conduct periodic examinations of member broker-dealers. While FBR & Co. and our other broker-dealer subsidiaries are not members of the New York Stock Exchange (NYSE), our business is impacted by the NYSE’s rules.

Securities firms are also subject to regulation by state securities commissions in the states in which they are required to be registered. FBR & Co. is registered as a broker-dealer with the SEC and in all 50 states, Puerto Rico and the District of Columbia, and is a member of, and subject to regulation by the NASD and the Municipal Securities Rulemaking Board. FBR Investment Services, Inc., (FBRIS) is registered as a broker-dealer with the SEC and in all 50 states, Puerto Rico and the District of Columbia; it is a member of the NASD.

The mortgage lending industry is highly regulated. First NLC, our mortgage loan origination subsidiary, is subject to extensive regulation and supervision by various federal, state, and local government authorities. First NLC is licensed or exempt from licensing requirements by the relevant state banking or consumer credit agencies to originate first and second mortgage loans in 45 states. Additionally, MHC I, Inc. (MHC), our qualified REIT subsidiary through which we may acquire mortgage loans, is also subject to regulation and supervision by various federal, state and local government authorities. MHC currently is licensed or exempt from licensing requirements by relevant regulatory entities to acquire first and second mortgage loans in 49 states and the District of Columbia.

We and our operating subsidiaries are also subject to the USA PATRIOT Act (PATRIOT Act), which requires financial institutions to adopt and implement policies and procedures designed to prevent and detect money laundering. FBR and its subsidiaries have adopted a comprehensive anti-money laundering compliance program that we believe is in compliance with the PATRIOT Act.

Regulation of FBR Capital Markets’ Broker-Dealer Subsidiaries

Our capital markets business, as well as the financial services industry generally, is subject to extensive regulation in the United States and elsewhere. As a matter of public policy, regulatory bodies in the United States and the rest of the world are charged with safeguarding the integrity of the securities and other financial markets and with protecting the interests of customers participating in those markets. In the United States, the SEC is the federal agency responsible for the administration of the federal securities laws. Our broker-dealer subsidiaries, FBR & Co. and FBRIS, are registered as broker-dealers with the SEC and the NASD and in all 50 states, Puerto Rico and the District of Columbia. Accordingly, each of FBR & Co. and FBRIS is subject to regulation and oversight by the SEC and the NASD, a self-regulatory organization which is itself subject to oversight by the SEC and which adopts and enforces rules governing the conduct, and examines the activities, of its member firms, including FBR & Co. and FBRIS. State securities regulators also have regulatory or oversight authority over FBR & Co. and FBRIS. Our business may also be subject to regulation by non-U.S. governmental and regulatory bodies and self-regulatory authorities in other countries where we operate.

In general, broker-dealers are subject to regulations that cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers’ funds and securities, capital structure, record-keeping, the financing of customers’ purchases and the conduct and qualifications of directors, officers and employees. In particular, as a registered broker-dealer and member of various self-regulatory organizations, FBR & Co. and FBRIS are subject to the SEC’s uniform net capital rule, Rule 15c3-1. Rule 15c3-1 specifies the minimum level of net capital a broker-dealer must maintain and also requires that a significant part of its assets be kept in relatively liquid form. The SEC and various self-regulatory organizations impose rules that require notification when net capital falls below certain predefined criteria, limit

the ratio of subordinated debt to equity in the regulatory capital composition of a broker-dealer and constrain the ability of a broker-dealer to expand its business under certain circumstances. Additionally, the SEC’s uniform net capital rule imposes certain requirements that may have the effect of prohibiting a broker-dealer from distributing or withdrawing capital and requiring prior notice to the SEC for certain withdrawals of capital. The SEC has adopted rule amendments that establish alternative net capital requirements for broker-dealers that are part of a consolidated supervised entity. As a condition to its use of the alternative method, a broker-dealer’s ultimate holding company and affiliates (referred to collectively as a consolidated supervised entity) must consent to group-wide supervision and examination by the SEC. If we elect to become subject to the SEC’s group-wide supervision, we will be required to report to the SEC computations of our capital adequacy.

Compliance with regulatory net capital requirements could limit those operations that require the intensive use of capital, such as underwriting and trading activities, and also could restrict our ability to withdraw capital from our affiliated broker-dealers, which in turn could limit our ability to pay dividends, repay debt and redeem or repurchase shares of our outstanding capital stock.

We believe that at all times FBR & Co. and FBRIS have been in compliance in all material respects with the applicable minimum net capital rules of the SEC and the NASD.

A failure of a U.S. broker-dealer to maintain its minimum required net capital would require it to cease executing customer transactions until it came back into compliance, and could cause it to lose its NASD membership, its registration with the SEC or require its liquidation. Further, the decline in a broker-dealer’s net capital below certain early warning levels, even though above minimum net capital requirements, could cause material adverse consequences to the broker-dealer and to us.

FBR & Co. and FBRIS are also subject to Risk Assessment Rules imposed by the SEC which require, among other things, that certain broker-dealers maintain and preserve certain information, describe risk management policies and procedures and report on the financial condition of certain affiliates whose financial and securities activities are reasonably likely to have a material impact on the financial and operational condition of the broker-dealers. Certain Material Associated Persons (as defined in the Risk Assessment Rules) of the broker-dealers and the activities conducted by such Material Associated Persons may also be subject to regulation by the SEC. In addition, the possibility exists that, on the basis of the information it obtains under the Risk Assessment Rules, the SEC could seek authority over our unregulated subsidiaries either directly or through its existing authority over our regulated subsidiaries.

The research areas of investment banks have been and remain the subject of increased regulatory scrutiny. In 2002 and 2003, acting in part pursuant to a mandate contained in the Sarbanes-Oxley Act of 2002, the SEC, the NYSE and the NASD adopted rules imposing heightened restrictions on the interaction between equity research analysts and investment banking personnel at member securities firms. In addition, in 2003 and 2004, several securities firms in the United States reached a settlement with certain federal and state securities regulators and self-regulatory organizations to resolve investigations into their equity research analysts’ alleged conflicts of interest. Under this settlement, the firms have been subject to certain restrictions and undertakings. As part of this settlement, restrictions have been imposed on the interaction between research and investment banking departments, and these securities firms are required to fund the provision of independent research to their customers. In connection with the research settlement, we have also subscribed to a voluntary initiative imposing restrictions on the allocation of shares initial public offerings to executives and directors of public companies. In 2004, the SEC proposed amendments to Regulation M that would further affect the manner in which securities are distributed and allocated in registered public offerings, and the NYSE and NASD have proposed similar rulemaking in this area. We cannot fully predict the practical effect that such restrictions or measures will have on our business, and the SEC, the NYSE and the NASD may adopt additional and more stringent rules with respect to offering procedures and the management of conflicts of interest in the future.

The SEC staff has conducted studies with respect to “soft dollar” practices (i.e., arrangement under which an investment adviser directs client brokerage transactions to a broker in exchange for research products or other services in addition to brokerage services) in the brokerage and asset management industries. In July 2006 the SEC proposed interpretative guidance regarding the scope of permitted brokerage and research services in connection with soft dollar practices and solicited further public comment regarding soft dollar practices involving third party providers of research. The July 2006 interpretative guidance may affect our institutional brokerage business and future changes in laws of regulations may cause our institutional brokerage customers to revisit or alter the manner in which they pay for brokerage and research services.

The effort to combat money laundering and terrorist financing is a priority in governmental policy with respect to financial institutions. The USA PATRIOT Act of 2001, as amended, or the PATRIOT Act, contains anti-money laundering and financial transparency laws and mandates the implementation of various new regulations applicable to broker-dealers and other financial services companies, including standards for verifying client identification at account opening, and obligations to monitor client transactions and report suspicious activities. Through these and other provisions, the PATRIOT Act seeks to promote the identification of parties that may be involved in terrorism or money laundering. Anti-money laundering laws outside the United States contain some similar provisions. The obligation of financial institutions, including us, to identify their customers, watch for and report suspicious transactions, respond to requests for information by regulatory authorities and law enforcement agencies, and share information with other financial institutions, has required the implementation and maintenance of internal practices, procedures and controls which have increased, and may continue to increase, our costs, and any failure with respect to our programs in this area could subject us to serious regulatory consequences, including substantial fines, and potentially other liabilities.

Certain of our businesses are subject to compliance with laws and regulations of U.S. federal and state governments, non-U.S. governments, their respective agencies and/or various self-regulatory organizations or exchanges relating to the privacy of client information, and any failure to comply with these regulations could expose us to liability and/or reputational damage. Additional legislation, changes in rules promulgated by the SEC and self-regulatory organizations or changes in the interpretation or enforcement of existing laws and rules, either in the United States or elsewhere, may directly affect the mode or our operation and profitability. The U.S. and non-U.S. government agencies and self-regulatory organizations, as well as state securities commissions in the United States, are empowered to conduct administrative proceedings that can result in censure, fine, the issuance of cease-and-desist orders or the suspension or expulsion of a broker-dealer or its directors, officers or employees. Occasionally, FBR & Co. has been subject to investigations and proceedings, and sanctions have been imposed for infractions of various regulations relating to its activities.

Our broker-dealer business is also subject to regulation by various foreign governments and regulatory bodies. FBR & Co. is registered with and subject to regulation by the Ontario Securities Commission in Canada. Friedman, Billings, Ramsey International, Ltd. (FBRIL), our United Kingdom brokerage subsidiary, is subject to regulation by the Financial Services Authority in the United Kingdom pursuant to the United Kingdom Financial Services Act of 1986. Foreign regulation may govern all aspects of the investment business, including regulatory capital, sales and trading practices, use and safekeeping of customer funds and securities, record-keeping, margin practices and procedures, registration standards for individuals, periodic reporting and settlement procedures.

In the event of non-compliance by us or one of our subsidiaries with an applicable regulation, governmental regulators and one or more of the SROs may institute administrative or judicial proceedings that may result in censure, fine, civil penalties (including treble damages in the case of insider trading violations), the issuance of cease-and-desist orders, the deregistration or suspension of the non-compliant broker-dealer, the suspension or disqualification of officers or employees or other adverse consequences. The imposition of any such penalties or orders on us or our personnel could have a material adverse effect on our operating results and financial condition.

Regulation of Asset Management Subsidiaries

Three of our asset management subsidiaries are registered as investment advisers with the SEC. As investment advisers registered with the SEC, they are subject to the requirements of the Investment Advisers Act of 1940 (the “Advisors Act”) and the SEC’s regulations thereunder. These requirements relate to, among other things, limitations on the ability of investment advisers to charge performance-based or non-refundable fees to clients, record-keeping and reporting requirements, disclosure requirements, limitations on principal transactions between an adviser or its affiliates and advisory clients, as well as general anti-fraud prohibitions. They may also be subject to certain state securities laws and regulations. The state securities law requirements applicable to registered investment advisers are in certain cases more comprehensive than those imposed under the federal securities laws. In addition, two of our asset management subsidiaries, FBR Fund Advisers, Inc. and Money Management Advisors, Inc., and the mutual funds they manage, are subject to the requirements of the Investment Company Act of 1940 (the “1940 Act”) and the SEC’s regulations thereunder.

In connection with much of our asset management activities, we, and the private investment vehicles that we manage, are relying on certain exclusions and exemptions from registration under the 1940 Act, and under certain state securities laws and the laws of various foreign countries. Failure to comply with the initial and continuing requirements of any such exemptions could have a material adverse effect on the manner in which we and these vehicles carry on their activities, including penalties similar to those listed above for broker-dealers.

Regulation of Mortgage Loan Origination and Acquisition Subsidiaries

The volume of new or modified laws, rules, and regulations applicable to our mortgage loan origination business has increased in recent years and individual municipalities have also begun to enact laws, rules, and regulations that restrict or otherwise affect mortgage loan origination and acquisition activities. The laws, rules, and regulations of each of these jurisdictions are different, complex, and, in some cases, in direct conflict with each other. It may become increasingly difficult to identify applicable requirements comprehensively, to interpret laws, rules, and regulations accurately, to program our information systems properly, and to train our personnel effectively with respect to all of these laws, rules, and regulations. Therefore, the risk of non-compliance with these laws, rules, and regulations may be increased.

Our mortgage lending activities are subject to the provisions of various federal laws and their implementing regulations, including the Equal Credit Opportunity Act of 1974, or ECOA, as amended, the Federal Truth-in-Lending Act (TILA), and Regulation Z thereunder, Home Ownership and Equity Protection Act (HOEPA), the Fair Credit Reporting Act of 1970, as amended (FCRA), the Real Estate Settlement Procedures Act (RESPA) and Regulation X thereunder, the Fair Debt Collection Practices Act, the Home Mortgage Disclosure Act (HMDA) and Regulation C thereunder, the Fair Housing Act and Regulation X thereunder, the Gramm-Leach-Bliley privacy legislation, the Fair and Accurate Credit Transactions Act (FACT) the Telemarketing and Consumer Fraud and Abuse Prevention Act, the Telephone Consumer Protection Act, the CAN-SPAM Act and the Soldiers and Sailors Civil Relief Act.

Specifically, TILA was enacted to require lenders to provide consumers with uniform, understandable information with respect to the terms and conditions of loan and credit transactions. Among other things, TILA gives consumers a three-business day right to rescind certain refinance loan transactions. FCRA establishes procedures governing the use of consumer credit reports and also requires certain disclosures when adverse action is taken based on information in such a report. FACT provides new protections for consumer information, particularly with respect to identity theft.

HOEPA imposes additional disclosure requirements and substantive limitations on certain “high cost” mortgage loan transactions. Our policy is not to originate HOEPA—covered loans.

ECOA, which is implemented by Regulation B, prohibits creditors from discriminating against applicants on the basis of race, color, sex, age, religion, national origin or marital status, if all or part of the applicant’s income

is derived from a publicly assisted program or if the applicant has in good faith exercised any right under the Consumer Credit Protection Act. ECOA also requires disclosures when adverse action is taken on an application, and prohibits creditors from requesting certain types of information from loan applicants. The Federal Fair Housing Act also contains anti-discrimination restrictions. HMDA requires us to collect and file with the Department of Housing and Urban Development information on our loan applications and originations.

RESPA mandates certain disclosures concerning settlement fees and charges and mortgage servicing transfer practices. It also prohibits the payment or receipt of kickbacks or referral fees in connection with the performance of settlement services.

The Gramm-Leach-Bliley Act imposes requirements on all financial institutions, including lenders, with respect to their collection, disclosure and use of nonpublic personal information and requires them to implement and maintain appropriate safeguards to protect the security of that information. This act also permits the states to enact more demanding privacy rules.

In addition, we are subject to applicable state and local laws and the rules and regulations of various state and local regulatory agencies in connection with originating, purchasing, processing, underwriting, securitizing, and servicing mortgage loans.

These rules and regulations, among other things:

•

impose licensing obligations on us;

•

establish eligibility criteria for mortgage loans;

•

prohibit discrimination;

•

require us to devote substantial resources to loan-by-loan analysis of points, fees, benefits to borrowers, and other factors set forth in laws, which often differ depending on the state, and in some cases the city or county, in which the mortgaged property is located;

•

require us to adhere to certain procedures regarding credit reports and personal information on loan applicants;

•

regulate assessment, collection, foreclosure and claims handling, investment and interest payments on escrow balances, and payment features;

•

mandate certain truth-in-lending and other disclosures and notices to borrowers; and

•

may fix maximum interest rates, fees, and mortgage loan amounts.

Compliance with these laws is complex and labor intensive. We have ceased, or may cease in the future, to do business in certain jurisdictions in which we believe compliance requirements cannot be assured at a reasonable cost with the degree of certainty that we require, and we may cease doing business in additional jurisdictions where we, or our counterparties, make similar determinations with respect to anti-predatory lending laws. Failure to comply with legal requirements in jurisdictions where we do business can lead to, among other things, loss of approved licensing status, demands for indemnification or mortgage loan repurchases, certain rights of rescission for mortgage loans, class action lawsuits, administrative enforcement actions, and civil and criminal penalties.

Any person or group that acquires more than 10%, or in some cases 5%, of our share of Class A common stock will become subject to certain state licensing regulations requiring such person or group periodically to file certain financial and other information disclosures. If any person or group holding more than 10%, or in some cases 5%, of our shares of Class A common stock fails to meet a state’s criteria, or refuses to adhere to such filing requirements, our existing licensing arrangements could be jeopardized and we could lose its authority to conduct business in that state. The loss of required licenses or authority to conduct business in a state could have a material adverse effect on our results of operations, financial condition and business.

In recent years, federal and several state and local laws, rules, and regulations have been adopted, or have come under consideration, that are intended to eliminate certain lending practices, often referred to as “predatory” lending practices, that are considered to be abusive. Many of these laws, rules, and regulations restrict commonly accepted lending activities and would impose additional costly and burdensome compliance requirements on us. These laws, rules, and regulations impose certain restrictions on loans with points and fees or APRs that meet or exceed specified thresholds. Some of these restrictions expose a lender to risks of litigation and regulatory sanction regardless of how carefully a loan is underwritten. In addition, an increasing number of these laws, rules, and regulations seek to impose liability for violations on the purchasers of mortgage loans, regardless of whether a purchaser knew of or participated in the violation. We may be subject to liability if we purchase mortgage loans that violate these predatory lending laws.

The continued enactment of these laws, rules, and regulations may prevent us from making or acquiring certain loans and may cause us to reduce the APR or the points and fees we charge on the mortgage loans that we originate. The difficulty of managing the compliance risks presented by these laws, rules, and regulations may decrease the availability of warehouse financing and the overall demand for the purchase of our originated or acquired mortgage loans. These laws, rules, and regulations have increased, and may continue to increase, our cost of doing business as it has been, and may continue to be, required to develop systems and procedures to ensure that it does not violate any aspect of these new requirements.

In addition, many of these state laws, rules, and regulations are not applicable to the mortgage loan operations of national banks and federal savings associations, and their operating subsidiaries, or of federal credit unions. Therefore, the mortgage loan operations of these institutions are at a competitive advantage to us since they do not have to comply with many of these laws.

We seek to avoid originating or acquiring loans that meet or exceed the Annual Percentage Rate (APR) or “points and fees” threshold of these laws, rules, and regulations. If we decide to relax certain self-imposed restrictions on originating or acquiring mortgage loans subject to these laws, rules and regulations, we will be subject to greater risks for actual or perceived non-compliance with the laws, rules and regulations, including demands for indemnification or mortgage loan repurchases from the parties to whom we sell mortgage loans, difficulty in obtaining credit to fund our operations, class action lawsuits, increased defenses to foreclosure of individual mortgage loans in default, individual claims for significant monetary damages and administrative enforcement actions. Any of the foregoing could significantly harm our business, cash flow, financial condition, liquidity and results of operations.

Additional legislation and regulations, including those relating to the activities of financial holding companies, broker-dealers and investment advisers, changes in rules promulgated by the SEC, NASD or other United States, states or foreign governmental regulatory authorities and SROs or changes in the interpretation or enforcement of existing laws and rules may adversely affect our manner of operation and our profitability. Our businesses may be materially affected not only by regulations applicable to us as a financial market intermediary, but also by regulations of general application. For example, the volume of our underwriting, merger and acquisition, securities trading and asset management activities in any year could be affected by, among other things, existing and proposed tax legislation, antitrust policy and other governmental regulations and policies (including the interest rate policies of the Board) and changes in interpretation or enforcement of existing laws and rules that affect the business and financial communities.

Regulatory Developments

In recent years, federal and state legislators and regulators adopted a variety of new or expanded regulations, particularly in the areas of privacy and consumer protection. We summarize these regulations below.

Privacy

The federal Gramm-Leach-Bliley financial reform legislation imposes additional obligations on us to safeguard the information we maintain on our borrowers. Also, several states are considering even more stringent privacy legislation. California has passed legislation known as the California Financial Information Privacy Act and the California On-Line Privacy Protection Act. Both pieces of legislation impose additional notification obligations on us and place additional restrictions upon information sharing with non-affiliated third parties. The more stringent information provisions of these laws are not preempted by existing federal laws. In addition, the California Information Safeguard Law AB1950 imposes the obligation on businesses to establish procedural and electronic safeguards to protect customer personal information. If other states choose to follow California and adopt a variety of inconsistent state privacy legislation, our compliance costs could substantially increase.

Fair Credit Reporting Act

The Fair Credit Reporting Act provides federal preemption for lenders to share information with affiliates and certain third parties and to provide pre-approved offers of credit to consumers. Changes to the Fair Credit Reporting Act, made with the adoption of the Fair and Accurate Credit Transaction Act, include modifications to the right to receive credit reports, the reporting of negative information, the rights of identity theft victims, the issuance of risk-based credit pricing notices, the responsibilities of creditors and other furnishers of credit information and the disclosure of credit scores. Some provisions of the Fair and Accurate Credit Transaction Act will only become effective after federal agencies issue final regulations. Some of the provisions of the Fair and Accurate Credit Transaction Act have not yet become effective because federal agencies have not yet issued final regulations. All of these new provisions impose additional regulatory and compliance costs on us and reduce the effectiveness of its marketing programs.

Home Mortgage Disclosure Act

In 2002, the Federal Reserve Board adopted changes to Regulation C promulgated under the Home Mortgage Disclosure Act. Among other things, these regulations require lenders to report pricing data on loans with annual percentage rates that exceed the yield on treasury bills with comparable maturities by 3%. A significant portion of the mortgage loans originated by us are subject to these reporting requirements.

The expanded reporting does not provide for additional loan information such as credit risk, debt-to-income ratio, loan-to-value (LTV), documentation-level or other salient loan features. As a result, lenders remain concerned that the reported information may lead to increased litigation as the information could be misinterpreted by third parties.

Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003

The CAN-SPAM Act of 2003 applies to businesses, such as ours, that use electronic mail for advertising and solicitation. This law, generally administered by the Federal Trade Commission, preempts state laws to the contrary, and establishes, among other things, a national uniform standard that gives consumers the right to stop unwanted emails. The law imposes requirements for the header caption in emails, as well as return email addresses, and consumers are granted the right to ‘opt out’ from receiving further emails from the sender. In addition, certain rules apply to “dual-purpose” e-mails where a commercial message is included with transactional or relationship e-mail. These provisions impose additional regulatory and compliance costs on us and reduce the effectiveness of our marketing programs.

Telephone Consumer Protection Act and Telemarketing Consumer Fraud and Abuse Prevention Act

These laws, enacted in 1991 and 1994, respectively, are designed to restrict unsolicited advertising using the telephone and facsimile machine. Since they were enacted, however, telemarketing practices have changed significantly due to new technologies that make it easier to target potential customers while at the same time

making it more cost effective to do so. The Federal Communications Commission, or the FCC, and the Federal Trade Commission have responsibility for regulating various aspects of these laws, such as regulating unwanted telephone solicitations and the use of automated telephone dialing systems, prerecorded or artificial voice messages, and telephone facsimile machines. In 2003, both agencies adopted ‘do-not-call’ registry requirements, which, in part, mandate that companies such as us maintain and regularly update lists of consumers who have chosen not to be called. These requirements also mandate that we do not call consumers who have chosen to be on the list. The FCC requires that telemarketers access the “do-not-call” list at least once every 31 days. Over 25 states have also adopted similar laws, with which we also comply. As with other regulatory requirements, these provisions impose additional regulatory and compliance costs on us and reduce the effectiveness of our marketing programs.

Predatory Lending Legislation

The United States Congress periodically considers legislation, such as the Ney-Lucas Responsible Lending Act introduced in 2003, which, among other provisions, would limit fees that a lender is permitted to charge, including prepayment fees, restrict the terms lenders are permitted to include in their loan agreements and increase the amount of disclosure required to be given to potential borrowers. We cannot predict whether or in what form Congress or the various state and local legislatures may enact legislation affecting our business. We are evaluating the potential impact of these initiatives, if enacted, on our lending practices and results of operations. As a result , we are unable to predict whether federal, state or local authorities will require changes in our lending practices in the future, including reimbursement of fees charged to borrowers, or will impose fines. These changes, if required, could adversely affect our profitability, particularly if we make such changes in response to new or amended laws, regulations or ordinances in states where we originate a significant portion of our mortgage loans.

The Home Ownership and Equity Protection Act of 1994, or HOEPA, identifies a category of mortgage loans and subjects them to more stringent restrictions and disclosure requirements. In addition, liability for violations of applicable law for loans covered by HOEPA extends not only to the originator, but also to the purchaser of the loans. HOEPA generally covers loans with either (i) total points and fees upon origination in excess of the greater of eight percent of the loan amount or a dollar threshold adjusted annually in January in accordance with the Consumer Price Index ($528 for 2006 and $547 for 2007), or (ii) an APR of more than eight percentage points higher than United States Treasury securities of comparable maturity on first mortgage loans, and 10 percentage points above Treasuries of comparable maturity for junior mortgage loans.

Our policy is not to originate or acquire mortgage loans covered by HOEPA because of the higher legal risks as well as the potential negative perception of originating mortgage loans that are considered to be “high cost” under federal law.

Several federal, state and local laws and regulations have been adopted or are under consideration that are intended to eliminate so-called “predatory” lending practices. Many of these laws and regulations go beyond targeting abusive practices by imposing broad restrictions on certain commonly accepted lending practices, including some of our practices. In addition, some of these laws impose liability on assignees of mortgage loans such as loan buyers, lenders and securitization trusts. Such provisions deter loan buyers from purchasing loans covered by the applicable law. For example, the Georgia Fair Lending Act that took effect in October 2002 resulted in First NLC’s withdrawal from the Georgia market, until the law was amended in early 2003, because lenders and loan buyers refused to finance or purchase loans covered by that law. The enactment of similar laws in late 2003 in New Jersey and New Mexico, and in 2004 in Massachusetts, has resulted in significant interruption in the secondary market, with some participants no longer purchasing home loans originated in those states, and some not purchasing just those loans covered by these new laws. During 2006, Ohio, Rhode Island, and Tennessee passed legislation intended to eliminate “predatory” lending practices in these states. Our policy is not to make loans that are deemed high cost under these laws, and remain able to finance or sell those loans we do make.

Finally, states continue to adopt laws requiring loan officer licensing. Many of these laws contain pre-licensing educational and testing requirements, and others contain post licensing continuing education requirements of anywhere from 6 to 12 hours per year. The definition of what constitutes a loan officer also varies among states, such that in some states only associates who deal directly with the public must be licensed, while in a few other states employees who also process loans must be licensed.

These decisions and new laws impose additional regulatory and compliance costs on us and reduce the effectiveness of our marketing programs. There can be no assurance that other similar laws, rules or regulations will not be adopted in the future. Adoption of these laws and regulations could have a material adverse impact on our business by substantially increasing the costs of compliance with a variety of inconsistent federal, state and local rules, or by restricting our ability to charge rates and fees adequate to compensate us for the risk associated with certain mortgage loans. Adoption of these laws could also have a material adverse effect on our mortgage loan origination volume, especially if our lenders and secondary market buyers elect not to finance or purchase mortgage loans covered by the new laws.

Nontraditional Mortgage Products

During 2006, the federal mortgage banking agencies issued final Guidance addressing certain concerns that the Agencies had about the proliferation of “nontraditional mortgage products,” loosely defined as any mortgage where the borrower is able to defer repayment of principal for a period of time—in other words, interest only-loans and Pay Option ARMs. The Guidance notes that financial institutions are increasingly combining these loans with other practices, such as making simultaneous second-lien mortgages and allowing reduced documentation in evaluating the applicant’s creditworthiness. The Guidance acknowledges that innovations in mortgage lending can benefit some consumers, but that these layering practices can present unique risks that institutions must appropriately measure, monitor and control. It recognizes that many of the risks associated with nontraditional mortgage loans exist in other adjustable-rate mortgage products, but the Agencies share an elevated concern with nontraditional products due to the lack of principal amortization and potential accumulation of negative amortization. The Agencies are also concerned that these products and practices are being offered to a wider spectrum of borrowers, including some who may not otherwise qualify for traditional fixed-rate or other adjustable-rate mortgage loans, and who may not fully understand the associated risks.

The Guidance directs financial institutions to consider the effect of payment shock in underwriting by evaluating whether the borrower will be able to make the higher monthly payments once the loan begins amortizing. At the very least, underwriting criteria must “include an evaluation of [the borrower’s] ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule.” Lenders are directed to “avoid the use of loan terms and underwriting practices that may result in the borrower having to rely on the sale or refinancing of the property once amortization begins.” In addition, the Guidance notes that lenders often underwrite nontraditional mortgage products with less stringent or no income and asset verification requirements as compared to traditional “full” underwriting. Although it does not outright prohibit reduced income or asset verification programs in connection with nontraditional mortgages, the Guidance cautions lenders against “over-reliance on credit scores as a substitute for income verification in the underwriting process” in connection with these products. The Guidance expresses the greatest concern about risk layering in connection with nontraditional mortgage programs “that target subprime borrowers through tailored marketing, underwriting standards, and risk selection.”

Since the final Guidance by the federal mortgage banking agencies was issued, the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators have issued guidance for state-licensed mortgage lenders and brokers, such as First NLC, which is substantially similar to the final Guidance issued by the federal mortgage banking agencies. By December 20, 2006, approximately 19 state regulatory agencies had adopted such guidance. While not specifically applicable to loans originated by us, the guidance and related banking regulations are instructive of the regulatory climate relating to low and no documentation loans, such as the stated income and no documentation loan products, and nontraditional

mortgage products, such as interest-only and Payment Option ARMs, made by us. Our ability to finance the origination of our nontraditional mortgage loans and sell such loans to third parties potentially could be impaired if our financing sources or mortgage buyers are required or choose to incorporate prohibitions or requirements from certain anti-predatory lending practices into their eligibility criteria, even if the laws do not specifically apply to us.

Ameriquest Settlement

ACC Capital Holdings Corporation and several of its residential lending subsidiaries, including Ameriquest Mortgage Company (collectively “Ameriquest”), agreed to a $325 million nationwide settlement with the state attorneys general of forty-nine states and the District of Columbia to resolve claims that Ameriquest engaged in predatory lending practices. The Settlement Agreement, which was effective March 15, 2006, also enjoins Ameriquest from engaging in unfair or deceptive acts or practices and imposes new origination-related requirements upon Ameriquest. These new requirements include, among others, (1) providing detailed oral and written disclosures (in addition to those required under applicable state and federal law), (2) limiting refinances of Ameriquest loans, (3) prohibiting an employee compensation system that is tied to loan fees or closing costs, (4) implementing training courses for employees, (5) using independent loan closers, (6) limiting prepayment penalty periods on variable rate mortgages, and (7) implementing an internal monitoring program to ensure compliance with the Settlement Agreement. These requirements are generally more restrictive than existing consumer credit laws that address the same topics. The effect that this settlement will have on the industry and the extent to which certain of these requirements become industry best practices remains unclear.

Efforts to Avoid Abusive Lending Practices

In an effort to prevent the origination of mortgage loans containing unfair terms or involving predatory practices, we have adopted many policies and procedures, including the following:

Product Policies

•

Our policy is not to originate “high cost loans” as defined by HOEPA and/or state law.

•

We do not make mortgage loans containing single premium credit life, disability or accident insurance.

•

We do not make or purchase mortgage loans containing, negative amortization, mandatory arbitration clauses or interest rate increases triggered by borrower default.

•

We offer mortgage loans with and without prepayment penalties. When a borrower opts for a mortgage loan with a prepayment charge, the borrower benefits from a lower interest rate and/or pays lower upfront fees.

•

Prepayment penalties do not extend beyond three years from the origination date. On fixed rate mortgage loans, the maximum prepayment penalty term is three years. Prepayment penalties on adjustable rate mortgage loans do not extend beyond the first adjustment date.

Loan Processing and Underwriting Policies

•

We only approve mortgage loan applications that evidence a borrower’s ability to repay the mortgage loan.

•

We consider whether the mortgage loan terms are in the borrower’s best interests and documents its belief that the mortgage loan represents a tangible benefit to the borrower.

•

We do not resolicit borrowers within 12 months of loan origination.

•

We price mortgage loans commensurate with risk.

•

We use a credit grading system to help ensure consistency of grading.

•

We do not ask appraisers to report a predetermined value or withhold disclosure of adverse features.

•

We employ electronic and manual systems to protect against adverse practices like “property flipping.” Mortgage loan origination systems are designed to detect red flags such as inflated appraisal values, unusual multiple borrower activity or rapid mortgage loan turnover.

Customer Interaction and Education

•

We market mortgage loans with a view to encouraging a wide range of applicants strongly representative of racial, ethnic and economic diversity of the markets it serves throughout the nation.

•

Our mortgage loan applicants receive a brochure to educate them on the mortgage loan origination process, explain basic mortgage loan terms, help them obtain a mortgage loan that suits their needs and advise them on how to find a loan counselor approved by the U.S. Department of Housing and Urban Development, or HUD.

•

We distribute a Fair Lending Policy to all newly hired employees and hold them accountable for treating borrowers fairly and equally.

•

We monitor broker performance and strive to hold brokers accountable for fair and equal treatment of borrowers.

•

We conduct periodic randomly selected satisfaction surveys of customers who receive mortgage loans through a mortgage broker.

Evaluation and Compliance

•

We subject a significant statistical sampling of our mortgage loans to a quality assurance review of borrower qualification, validity of information, and verified property value determination.

•

Our fair lending officer currently provides an independent means of reporting or discussing fair lending concerns.

•

We periodically engage independent firms to review internal controls and operations to help ensure compliance with accepted federal and state lending regulations and practices.

•

We adhere to high origination standards in order to sell our mortgage loan products in the secondary mortgage market. We treat all customer information as confidential and consider it to be nonpublic information. We maintain systems and procedures designed to ensure that access to nonpublic consumer information is granted only to legitimate and valid users.

•

We believe that our commitment to responsible lending is good business.

•

We strive to promote highly ethical standards throughout our industry.

We plan to continue to review, revise and improve our practices to enhance our fair lending efforts and support the goal of eliminating predatory lending practices in the industry.

Recent Developments

On February 6, 2007, we appointed J. Rock Tonkel, Jr., previously President and Head of Investment Banking, as our President and Chief Operating Officer, where he will oversee our principal investment portfolio and our First NLC subsidiary. Richard J. Hendrix, previously our President and Chief Operating Officer, will be responsible, as President and Chief Operating Officer of FBR Capital Markets Corporation, for our investment banking, institutional brokerage and research, and asset management businesses. Messrs. Tonkel and Hendrix will continue to report to Eric F. Billings, Chairman and Chief Executive Officer of both our company and FBR

Capital Markets and, together with Mr. Billings, both will continue to be members of our Office of the Chief Executive. Mr. Tonkel remains an executive officer of FBR Capital Markets and Mr. Hendrix remains an executive officer of our company.

On February 9, 2007, we acquired certain assets and a team of more than two dozen investment banking professionals from Legacy Partners Group, LLC, an independent investment banking and advisory firm, specializing in providing merger and acquisition advisory services and raising private capital. We believe this is a significant step in implementing our strategy to build out our capital markets platform.

ITEM 1A. RISK FACTORS

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

The following discussion concerns some of the risks associated with our business. These risks are interrelated, and you should treat them as a whole. Additional risks and uncertainties not presently known to us or not identified below, may also materially and adversely affect the value of our common stock and our ability to distribute dividends.

General Risks Related to our Business

We may fail to realize the anticipated benefits of our acquisition of First NLC in February 2005, which could have an adverse effect on our earnings and in turn negatively affect the value of our common stock and our ability to make distributions to our shareholders.

We expect to realize financial and operating benefits including improved returns on invested capital in non-conforming residential mortgage loans originated by First NLC. However, we cannot predict with certainty when these benefits will occur, or the extent to which they actually will be achieved, if at all. The ongoing management oversight of First NLC will also require substantial attention from management. The diversion of management attention and any difficulties associated with managing First NLC could have a material adverse effect on our operating results and on the value of our common stock.

We may not be able to manage our growth efficiently, which may adversely affect our results and may, in turn, negatively affect the market price of our common stock and our ability to make distributions to our shareholders.

Over the last several years, we have experienced significant growth in our business activities, in the number of our employees and in our equity and assets. Our growth has required, and our growth will continue to require, increased investment in management and professionals, personnel, financial and management systems and controls and facilities, which could cause our operating margins to decline from historical levels, especially in the absence of revenue growth. In addition, as is common in the industry, our broker-dealer and mortgage loan origination subsidiaries will continue to be highly dependent on the effective and reliable operation of communications and information systems and business continuity plans. We believe that our anticipated future growth will require implementation of new and enhanced communications and information systems and training of our personnel to operate these systems. In addition, the scope of procedures for assuring compliance with applicable laws and regulations and NASD rules has changed as the size and complexity of our business has changed. As we continue to grow, we will continue to implement additional formal compliance procedures to reflect our growth. Any difficulty or significant delay in the implementation or operation of existing or new systems, compliance procedures or the training of personnel could adversely affect the market price of our common stock and our ability to pay dividends.

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

Eric F. Billings has significant influence over our operations through his ownership of our common stock, which, as of January 31, 2007, represents approximately 12.2% of the total voting power of our common stock. In addition, Mr. Billings serves as one of our directors and as our Chief Executive Officer. Mr. Billings also serves as a member of the board of directors and as Chairman and Chief Executive Officer of FBR Capital Markets. Mr. Billings and all of our other executive officers, directors and nominees, as a group, control, as of January 31, 2007, approximately 15.5% of our total voting power. The extent of the influence that Mr. Billings and our other officers, directors and nominees have over us may have the effect of discouraging offers to acquire control of our company and may preclude holders of our common stock from receiving any premium above market price for their shares that may be offered in connection with any attempt to acquire control of our company without the approval of Mr. Billings.

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

Any negative changes in the public’s perception of the prospects for companies in the REIT, the mortgage-backed securities, the merchant banking, or non-conforming mortgage loan origination industries, or in the investment banking, securities brokerage, asset management, or financial services industries could depress our stock price regardless of our results.

The following factors could contribute to the volatility of the price of our Class A common stock:

•

actual or unanticipated variations in our quarterly results;

•

changes in our level of dividend payments;

•

new products or services offered by us and our competitors;

•

changes in our financial estimates by securities analysts;

•

conditions or trends in the investment or financial services industries in general;

•

changes in interest rate environments and the mortgage market that cause our borrowing costs to increase, our reported yields on our mortgage-backed securities to decrease or that cause the value of our mortgage-backed securities to decrease;

•

increased defaults under non-conforming residential mortgage loans originated by First NLC and held in our portfolio;

•

announcements by us of significant acquisitions, strategic partnerships, investments or joint ventures;

•

changes in the market valuations of the companies in which we make principal investments;

•

negative changes in the public’s perception of the prospects of investment or financial services or non-conforming residential mortgage loan originating companies;

•

changes in the regulatory environment in which our business operates;

•

general economic conditions such as a recession, or interest rate or currency rate fluctuations;

•

any obstacles in continuing to qualify as a REIT, including changes in law applicable to REITs;

•

additions or departures of our key personnel; and

•

additional sales of our securities.

Many of these factors are beyond our control.

We may experience significant fluctuations in quarterly operating results due to the volatile nature of the investment banking and securities business and the sensitivity of our principal investing business to changes in interest rates and fluctuations in the stock market and we may therefore fail to meet profitability or dividend expectations, which may, in turn, affect the market price of our Class A common stock and our ability to pay dividends to our stockholders.

Our revenues and operating results may fluctuate from quarter to quarter and from year to year due to a combination of factors, including:

•

the number and size of underwriting and merger and acquisition transactions completed by our investment banking group, and the level and timing of fees received from those transactions;

•

changes in the earnings from our mortgage-backed securities and other principal investments resulting from market volatility, changes in interest rates and volatility in mortgage loan prepayment rates;

•

changes in the market valuations of the investments of our managed funds and of the companies in which we have made principal investments;

•

changes in earnings from non-conforming residential mortgage loans originated by First NLC or purchased from third parties and held in our portfolio resulting from increased borrower defaults;

•

access to public markets or other exit strategies for companies in which we have made an investment as principal;

•

the recognition of profits or losses on principal investments or with respect to warrants or other equity-linked securities received in connection with capital-raising activities;

•

the level of institutional and retail brokerage transactions and the level of commissions received from those transactions;

•

the timing of recording of asset management fees and special allocations of income, if any;

•

the level of residential real estate activity and its effect on our mortgage loan originations;

•

variations in expenditures for personnel, consulting and legal expenses, and expenses of establishing new business units, including technology expenses; and

•

other variations in expenditures, including marketing and sponsorship.

Any one of these factors could adversely affect the market price of our common Class A stock and our ability to pay dividends to our stockholders.

An increase in market interest rates may have an adverse effect on the market price of our common stock.

One of the factors that investors may consider in deciding whether to buy or sell our common stock is our dividend rate as a percentage of our share price, relative to market interest rates. If market interest rates increase, prospective investors may desire a higher dividend rate on our common stock or seek securities paying higher dividends or interest. For instance, if interest rates rise without an increase in our dividend rate, the market price of our common stock could decrease because potential investors may require a higher yield on our common stock as market rates on interest-bearing securities, such as bonds, rise.

We cannot assure you that we will be able to maintain or increase our current dividend rate.

As a REIT, we must distribute annually at least 90% of our REIT taxable income to our shareholders, other than any net capital gain and excluding the retained earnings of our taxable REIT subsidiaries. We currently anticipate that our taxable REIT subsidiaries will retain most or all of their earnings and profits, which would make these earnings and profits unavailable for distribution to our shareholders. As a result, we may need to generate sufficient taxable income outside of our taxable REIT subsidiaries to maintain our current dividend rate. There can be no assurance that we will be able to generate sufficient taxable income to maintain this dividend rate or maintain our tax status as a REIT.

Loss of our 1940 Act exemption would adversely affect us and negatively affect the market price of our Class A common stock and the ability to pay dividends to our stockholders.

We believe that we currently are not, and we intend to continue operating our company so that we will not become, regulated as an investment company under the 1940 Act, because we are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Specifically, we have invested, and intend to continue investing, at least 55% of our assets in mortgage loans or mortgage-backed securities that represent the entire ownership in a pool of mortgage loans and at least an additional 25% of our assets in mortgages, mortgage-backed securities, securities of REITs, and other real estate-related assets.

If we fail to qualify for this exclusion from regulation under the 1940 Act, we could be required to restructure our activities. For example, if the market value of our investments in equity securities were to increase by an amount that resulted in less than 55% of our assets being invested in mortgage loans or mortgage-backed securities that represent the entire ownership in a pool of mortgage loans, we might have to sell equity securities in order to qualify for exclusion from regulation under the 1940 Act. The sale could occur under adverse market conditions. Each of our subsidiaries also qualifies for an exemption from regulation as an investment company under the 1940 Act.

Failure to procure adequate capital and funding would adversely affect our results and may, in turn, negatively affect the market price of our Class A common stock and our ability to pay dividends to our stockholders.

We depend upon the availability of adequate funding and capital for our operations. For example, we invest in mortgage-backed securities funded by short-term borrowings. In addition, our broker-dealer and financial services subsidiaries are dependent on the availability of adequate capital to satisfy applicable regulatory capital requirements. As a REIT, we are required to distribute annually at least 90% of our taxable income, other than any net capital gain and excluding taxable REIT subsidiary earnings, to our shareholders and are therefore not able to retain our earnings for new investments. However, our taxable REIT subsidiaries are able to retain (and likely will continue to retain) earnings for investment in new capital, subject to the various REIT requirements. We have historically satisfied our capital needs from equity contributions, internally generated funds and loans from third parties. We cannot assure you that any, or sufficient, funding or capital will continue to be available to us in the future on terms that are acceptable to us. In the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the market price of our Class A common stock and our ability to pay dividends.

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

Our businesses are dependent on the highly skilled, and often highly specialized, individuals we employ. Retention of specialists to manage our sub-prime mortgage originator subsidiary and our mortgage-backed securities portfolio, research analysts, private equity specialists, sales and trading personnel, investment banking personnel, asset management personnel, and technology, lending, management and administrative professionals are particularly important to our prospects. Competition for the recruiting and retention of employees may increase elements of our compensation costs. We cannot assure you that, in order to support our growth plans, we will be able to recruit and hire a sufficient number of new employees with the desired qualifications in a timely manner. We regularly review our compensation policies, including stock incentives. Nonetheless, our incentives may be insufficient in light of competition for experienced professionals in the investment industry, particularly if the value of our stock declines or fails to appreciate sufficiently to be a competitive source of a portion of professional compensation. Increased compensation costs could adversely affect the amount of cash available for distribution to shareholders and our failure to recruit and retain qualified employees could materially and adversely affect our future operating results.

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

We generally do not have employment agreements with our senior officers and other key professionals. The loss of professionals, particularly a senior professional with a broad range of contacts in one of our businesses, could materially and adversely affect our operating results. Our investment banking strategy is to establish relationships with prospective corporate clients in advance of any transaction, and to maintain these relationships by providing advisory services to corporate clients in equity, debt and merger and acquisition transactions. These relationships depend in part upon the individual employees who represent us in our dealings with our clients. From time to time, other companies in the investment industry have experienced losses of professionals in all areas of the investment business. The level of competition for key personnel includes competition from non-brokerage U.S. and foreign financial services companies, commercial banks, other investment banks and venture capital firms, all of which may target or increase their efforts in some of the same industries that we serve. In particular, we face competition for experienced research analysts, sales and trading personnel, and investment bankers of the type on which our business is highly dependent. We cannot assure you that losses of key personnel will not occur.

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

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

In addition, our clearing brokers provide elements of our principal disaster recovery system. We cannot assure you that we, our clearing brokers or our mortgage brokers will not suffer any systems failure or interruption, including one caused by a hurricane, earthquake, fire, other natural disaster, power or telecommunications failure, act of God, act of war, terrorist attack, pandemic or other emergency situation, or that we or our clearing brokers’ back-up procedures and capabilities in the event of any such failure or interruption will be adequate. The occurrence of any failures or interruptions could significantly harm our business.

We may not be able to keep up with rapid technological change, which may adversely affect the market price of our Class A common stock and our ability to pay dividends.

There are significant technical and financial risks in the development of new services and products or enhanced versions of existing services and products. We cannot assure you that we will be able to:

•

develop or obtain the necessary technologies;

•

effectively use new technologies;

•

adapt our services and products to evolving industry standards;

•

develop, introduce and market in a profitable manner our services and products; or

•

enhance or create new services and products.

If we are unable to develop and introduce enhanced or new services or products quickly enough to respond to market or customer requirements, or if we or our services and products do not achieve market acceptance, our

business, financial condition and operating results will be materially adversely affected and our cash available for distribution to stockholders may be negatively impacted.

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

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

Risks Related to Investment Banking, Institutional Brokerage, Sales and Trading, Asset Management and Other Fee-Based Financial Services Businesses Operated by us through our Taxable REIT Subsidiaries

We may be adversely affected by the general risks of the financial services and investment banking business.

Through taxable REIT subsidiaries, including FBR & Co. (the primary broker-dealer subsidiary of FBR Capital Markets), we operate investment banking, trading, brokerage, asset management and other fee-based financial services businesses. The financial and investment business is, by its nature, subject to numerous and substantial risks, particularly in volatile or illiquid markets and in markets influenced by sustained periods of low or negative economic growth. As a financial services and investment banking firm, we and our operating results may be adversely affected by a number of factors, which include:

•

the risk of losses resulting from the ownership or underwriting of securities;

•

the risks of trading securities for our own account (i.e., principal activities) and for our customers;

•

reduced cash inflows from investors into asset management businesses;

•

the risk of losses from lending, including to small, privately-owned companies;

•

counterparty failure to meet commitments;

•

customer default and fraud;

•

customer complaints;

•

employee errors, misconduct and fraud (including unauthorized transactions by traders);

•

failures in connection with the processing of securities transactions;

•

litigation and arbitration;

•

the risks of reduced revenues in periods of reduced demand for public offerings or reduced activity in the secondary markets; and

•

the risk of reduced fees and commissions we receive for selling securities on behalf of our customers (i.e., underwriting spreads).

Any one of these factors could adversely affect the market price of our Class A common stock and our ability to pay dividends.

We depend on relatively few industries to generate a significant percentage of our revenue, which may limit our revenues and net income and may adversely affect our operating results and negatively impact the market price of our common stock.

We are dependent on revenues related to securities issued by companies in specific industry sectors. The consumer, diversified industrials, energy and natural resources, financial institutions, healthcare, insurance, real estate and TMT sectors account for the majority of our investment banking, asset management, institutional trading and research activities. Therefore, any downturn in the market for the securities of companies in these industry sectors, or factors affecting such companies, could adversely affect our operating results and financial condition. Additionally, the frequency and size of securities offerings can vary significantly from industry to industry due to economic, legislative, regulatory and political factors.

Underwriting and other capital raising transactions, strategic advisory engagements and related trading activities in our core sectors represent a significant portion of our businesses. This concentration of activity exposes us to the risk of substantial declines in revenues in the event of downturns in our core sectors. For example, total public equity capital raised in our core sectors fell from $111.6 billion in 2004 to $103.2 billion in 2005, a decrease of 7.5%. The total number of public equity offerings in our core sectors also fell significantly, from 685 transactions in 2004 to 566 transactions in 2005, a decrease of 17.4%. Any future downturns in our core sectors could result in a decrease in the size or number of transactions we complete, which would reduce our investment banking revenues.

We also derive a significant portion of our revenues from institutional sales and trading transactions related to the securities of companies in these sectors. Our revenues from such institutional sales and trading transactions may decline when underwriting activities in these industry sectors decline, the volume of trading on Nasdaq or the NYSE declines, or when industry sectors or individual companies report results below investors’ expectations.

Our financial results may fluctuate substantially from quarter to quarter, which may impair our stock price.

We have experienced, and expect to experience in the future, significant quarterly variations in our revenues and results of operations. These variations may be attributed in part to the fact that our investment banking revenues are typically earned upon the successful completion of a transaction, the timing of which is uncertain and beyond our control. In most cases we receive little or no payment for investment banking engagements that do not result in the successful completion of a transaction. As a result, our business is highly dependent on market conditions as well as the decisions and actions of our clients and interested third parties. For example, our investment banking revenues for the third quarter of 2006 totaled $12.7 million, down from $89.1 million in the third quarter of 2005. In addition, a client’s securities offering may be delayed or terminated because of adverse market conditions, failure to obtain necessary regulatory approvals or unexpected financial or other problems in the client’s business. If the parties fail to complete an offering in which we are participating as an underwriter or placement agent, we will earn little or no revenue from the transaction. This risk may be intensified by our focus on early-stage companies in certain sectors, as the market for securities of these companies may experience significant variations in the number and size of equity offerings as well as the after-market trading volume and prices of newly issued securities. Recently, more companies initiating the process of an initial public offering are simultaneously exploring M&A exit opportunities. Our investment banking revenues would be adversely affected in the event that an initial public offering for which we are acting as an underwriter is preempted by the company’s sale if we are not engaged as a strategic advisor in such sale.

As a result, we are unlikely to achieve steady and predictable earnings on a quarterly basis, which could in turn adversely affect the price of our common stock. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Executive Summary.”

Our failure to acquire or internally develop the infrastructure needed to offer a complete range of M&A services could negatively affect the growth of our business.

Our ability to expand our M&A business depends upon acquiring a platform from which to offer a complete range of M&A services or by expanding and enhancing the investment banking services we presently offer. We intend to incur increased costs to expand this business. Our failure to acquire or hire additional M&A professionals to offer additional M&A services or our failure to successfully integrate such M&A services into our existing business could have an adverse impact on our business. Furthermore, our failure to expand our M&A services capabilities to satisfy anticipated near-term demand in our core sectors may harm our growth prospects.

Pricing and other competitive pressures may impair the revenues and profitability of our institutional brokerage business.

We derive a significant portion of our revenues from our institutional brokerage business. Along with other firms, we have experienced intense price competition in this business in recent years. In particular, the ability to execute trades electronically and through alternative trading systems has increased the pressure on trading commissions and spreads. We expect pricing pressures in the business to continue. Decimalization in securities trading, introduced in 2000, has also reduced revenues and lowered margins within the equity sales and trading divisions of many firms, including ours. We believe we may experience competitive pressures in these and other areas in the future as some of our competitors seek to obtain market share by competing on the basis of price or use their own capital to facilitate client trading activities. In addition, we face pressure from our larger competitors, which may be better able to offer a broader range of complementary products and services to clients in order to win their trading business. If we are unable to compete effectively in these areas, the revenues from our sales and trading business may decline, and our business and results of operations may be adversely affected. Our research and institutional brokerage business may be adversely affected by changes in laws and regulations and industry practices.

Changes in laws and regulations governing our institutional brokerage and research activities could also adversely affect our institutional brokerage and research business. For example, in July 2006, the SEC published interpretive guidance regarding the scope of permitted brokerage and research services in connection with “soft dollar” practices (i.e., arrangements under which an investment adviser directs client brokerage transactions to a broker in exchange for research products or services in addition to brokerage services) and solicited further public comment regarding soft dollar practices involving third party providers of research. The July 2006 SEC interpretive guidance may affect our institutional brokerage and research business and laws or regulations may prompt institutional brokerage customers to revisit or alter the manner in which they pay for research or brokerage services.

Changes in industry practices may also adversely affect our results of operations. Historically, our clients have paid us for research through commissions on trades. Recently, Fidelity Investments has entered into arrangements with certain financial institutions of which it is a client, pursuant to which Fidelity Investments agreed to pay separately for trading and research services, a process known as “unbundling.” Previously, Fidelity Investments had, like other fund managers, paid for research from those financial institutions through the commissions that it had paid to those financial institutions for trading services. As a result, the financial institutions that have entered into unbundling arrangements with Fidelity Investments will charge lower commissions per trade but will receive separate compensation for research that they provide to Fidelity Investments. Currently, we are not a party to any unbundling arrangements. However, we cannot assure you that we will not be a party to any unbundling arrangements in the future. It is uncertain whether unbundling arrangements will become an industry trend, and if so, to what extent. Furthermore, we cannot predict the consequences on our business of these arrangements, nor can we predict the impact on our business if unbundling develops as an industry trend. If unbundling becomes prevalent, we cannot assure you that our institutional brokerage clients will also pay us separately for our research, or if they do, that our revenues from these clients will remain the same. If our clients wish to purchase sales and trading and research services separately, we cannot assure you that we will be able to market our services on that basis as effectively as some of our competitors, and our business consequently could be adversely affected.

We face strong competition from larger firms, some of which have greater resources and name recognition, which may impede our ability to grow our business.

The brokerage and investment banking industries are intensely competitive and we expect them to remain so. We compete on the basis of a number of factors, including client relationships, reputation, the abilities of our professionals, market focus and the relative quality and price of our services and products. We have experienced intense price competition in some of our businesses, in particular discounts in large block trades and trading commissions and spreads. In addition, pricing and other competitive pressures in investment banking, including the trends toward multiple book runners, co-managers and multiple financial advisors handling transactions, have continued and could adversely affect our revenues, even as the volume and number of investment banking transactions have started to increase. We believe we may experience competitive pressures in these and other areas in the future as some of our competitors seek to obtain market share by competing on the basis of price.

Many of our competitors in the brokerage and investment banking industries have a broader range of products and services, greater financial and marketing resources, larger customer bases, greater name recognition, more senior professionals to serve their clients’ needs, greater global reach and more established relationships with clients than we have. These larger and better capitalized competitors may be better able to respond to changes in the brokerage and investment banking industries, to compete for skilled professionals, to finance acquisitions, to fund internal growth and to compete for market share generally.

The scale of our competitors has increased in recent years as a result of substantial consolidation among companies in the brokerage and investment banking industries. In addition, a number of large commercial banks, insurance companies and other broad-based financial services firms have established or acquired underwriting or financial advisory practices and broker-dealers or have merged with other financial institutions. These firms have the ability to offer a wider range of products than we do, which may enhance their competitive position. They also have the ability to support investment banking with commercial banking, insurance and other financial services in an effort to gain market share, which has resulted, and could further result, in pricing pressure in our businesses. In particular, the ability to provide financing has become an important advantage for some of our larger competitors and, because we do not provide such financing, we may be unable to compete as effectively for clients in a significant part of the brokerage and investment banking market.

If we are unable to compete effectively with our competitors, our business, financial condition and results of operations will be adversely affected.

Our capital markets and strategic advisory engagements are singular in nature and our failure to capture repeat business from existing clients may harm our operating results.

Our investment banking clients generally retain us on a short-term, engagement-by-engagement basis in connection with specific capital markets or mergers and acquisitions transactions, rather than on a recurring basis under long-term contracts. As these transactions are typically singular in nature and our engagements with these clients may not recur, we must continuously seek out new engagements when our current engagements are successfully completed or are terminated. As a result, high activity levels in any period are not necessarily indicative of continued high levels of activity in any subsequent period. If we are unable to generate a substantial number of new engagements that generate fees from the successful completion of transactions, our business and results of operations would likely be adversely affected.

Larger and more frequent capital commitments in our trading, underwriting and other businesses increases the potential for us to incur significant losses.

There is a trend toward larger and more frequent commitments of capital by financial services firms in many of their activities. For example, in order to win business, investment banks are increasingly committing to purchase large blocks of stock from publicly traded issuers or significant shareholders, instead of the more traditional marketed underwriting process, in which marketing is typically completed before an investment bank commits to purchase securities for resale. With the increased capital available to us from our 2006 private offering, we may undertake more block trades in the future. As a result, we will be subject to increased risk as we commit greater amounts of capital to facilitate primarily client-driven business and, therefore, may suffer losses even when economic and market conditions are generally favorable for others in the industry.

Although we have historically not engaged in proprietary trading, we may engage in proprietary trading in the future to maintain trading positions in the fixed income and equity markets. We may enter into large transactions in which we commit our own capital as part of our client trading activities. The number and size of these large transactions may materially affect our results of operations in a given period. We may also incur significant losses from our trading activities due to market fluctuations and volatility in our results of operations. To the extent that we own assets, i.e., have long positions, in any of those markets, a downturn in the value of those assets or in those markets could result in losses. Conversely, to the extent we have sold assets we do not own, i.e., have short positions, in any of those markets, an upturn in those markets could expose us to potentially large losses as we attempt to cover our short positions by acquiring assets in a rising market.

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

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

FBR & Co., which is a domestic registered broker-dealer, is subject to the net capital requirements of the SEC and various self-regulatory organizations of which it is a member. These requirements typically specify the minimum level of net capital a broker-dealer must maintain and also mandate that a significant part of its assets be kept in relatively liquid form. FBRIL, which is a registered broker-dealer in the United Kingdom, is also subject to the capital requirements of the United Kingdom Financial Services Authority, or FSA. Any failure to comply with these net capital requirements could impair our ability to conduct our core business as a brokerage firm.

Furthermore, FBR & Co. and FBRIL are subject to laws that authorize regulatory bodies to block or reduce the flow of funds from them to us. As a holding company, we will depend on dividends, distributions and other payments from our subsidiaries to fund our obligations, including debt obligations. As a result, regulatory actions could impede access to funds that we need to make payments on our obligations, including debt obligations.

Our risk management policies and procedures may leave us exposed to unidentified or unanticipated risk, which could harm our business.

Our risk management strategies and techniques may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk.

We are exposed to the risk that third parties that owe us money, securities or other assets will not perform their obligations. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure, breach of contract or other reasons. We are also subject to the risk that our rights against third parties may not be enforceable in all circumstances. Although we regularly review credit exposures to specific clients and counterparties and to specific industries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to detect or foresee. In addition, concerns about, or a default by, one institution could lead to significant liquidity problems, losses or defaults by other institutions, which in turn could adversely affect us. If any of the variety of instruments, processes and strategies we utilize to manage our exposure to various types of risk are not effective, we may incur losses.

Strategic investments or acquisitions and joint ventures may result in additional risks and uncertainties in our business.

We intend to grow our core businesses through both internal expansion and through strategic investments, acquisitions or joint ventures. To the extent we make strategic investments or acquisitions or enter into joint ventures, we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls and to integrate relationships with customers and business partners. In the case of joint ventures, we are subject to additional risks and uncertainties in that we may be dependent upon, and subject to liability, losses or reputational damage relating to, systems, controls and personnel that are not under our control. In addition, conflicts or disagreements between us and our joint venture partners may negatively impact our businesses.

To the extent that we pursue business opportunities outside the United States, we will be subject to political, economic, legal, operational and other risks that are inherent in operating in a foreign country, including risks of possible nationalization, expropriation, price controls, capital controls, exchange controls and other restrictive governmental actions, as well as the outbreak of hostilities. In many countries, the laws and regulations applicable to the securities and financial services industries are uncertain and evolving, and it may be difficult for us to determine the exact requirements of local laws in every market. Our inability to remain in compliance with local laws in a particular foreign market could have a significant and negative effect not only on our businesses in that market but also on our reputation generally. We are also subject to the enhanced risk that transactions we structure might not be legally enforceable in the relevant jurisdictions.

We have potential conflicts of interest with our executive officers and employees which could result in decisions that are not in your best interests.

From time to time, our executive officers and employees may invest in private or public companies in which we, or one of our affiliates, is or could potentially be an investor or for which we carry out investment banking assignments, publish research or act as a market maker. In addition, we have in the past and will likely in the future organize businesses, such as our hedge, private equity and venture capital funds, in which our employees may acquire minority interests or profit interests. There are risks that, as a result of such investment or profit interest, an executive officer or employee may have incentives to take actions that would conflict with our best interests. We believe that we have in place compliance procedures and practices designed to monitor the activities of our executive officers and employees in this regard, but we cannot guarantee that these procedures and practices will be effective.

Our business is dependent on cash inflows to mutual funds and other pooled investment vehicles, which could result in our experiencing operating losses if cash flows slow, and negatively impact cash available for distribution to shareholders.

A slowdown or reversal of cash inflows to mutual funds and other pooled investment vehicles could lead to lower underwriting and brokerage revenues for us since mutual funds and other pooled investment vehicles purchase a significant portion of the securities offered in public offerings underwritten by FBR & Co. and subsequently traded in the secondary markets. Demand for new equity offerings has been driven in part by institutional investors, particularly large mutual funds and hedge funds, seeking to invest on behalf of their investors. Our brokerage business is particularly dependent on the institutional market. The public may redeem mutual funds as a result of a decline in the market generally or as a result of a decline in mutual fund net asset values. To the extent that a decline in cash inflows into mutual funds reduces demand by fund managers for initial public or secondary offerings, FBR and our business and results of operations could be materially adversely affected. Moreover, a slowdown in investment activity by mutual funds may have an adverse effect on the securities markets generally. Such environments may adversely affect the market price of our Class A common stock and our ability to pay dividends.

Significantly expanded corporate governance and public disclosure requirements may result in fewer initial public offerings and distract existing public companies from engaging in capital market transactions which may reduce the number of investment banking opportunities available to pursue.

Highly-publicized financial scandals in recent years have led to investor concerns over the integrity of the U.S. financial markets, and have prompted Congress, the SEC, the NYSE and Nasdaq to significantly expand corporate governance and public disclosure requirements. To the extent that private companies, in order to avoid becoming subject to these new requirements, decide to forgo initial public offerings, our equity underwriting business may be adversely affected. In addition, provisions of the Sarbanes-Oxley Act of 2002 and the corporate governance rules imposed by self-regulatory organizations have diverted many companies’ attention away from capital market transactions, including securities offerings and acquisition and disposition transactions. In particular, companies that are or are planning to be public are incurring significant expenses in complying with the SEC and accounting standards relating to internal control over financial reporting, and companies that disclose material weaknesses in such controls under the new standards may have greater difficulty accessing the capital markets. These factors, in addition to adopted or proposed accounting and disclosure changes, may have an adverse effect on our business.

Financial services firms have been subject to increased scrutiny over the last several years, increasing the risk of financial liability and reputational harm resulting from adverse regulatory actions.

Firms in the financial services industry have been operating in a difficult regulatory environment. The industry has experienced increased scrutiny from a variety of regulators, including the SEC, the NYSE, the NASD and state attorneys general. Penalties and fines sought by regulatory authorities have increased substantially over the last several years. This regulatory and enforcement environment has created uncertainty with respect to a number of transactions that had historically been entered into by financial services firms and that were generally believed to be permissible and appropriate. We may be adversely affected by changes in the interpretation or enforcement of existing laws and rules by these governmental authorities and self-regulatory organizations. We also may be adversely affected as a result of new or revised legislation or regulations imposed by the SEC, other United States or foreign governmental regulatory authorities or self-regulatory organizations that supervise the financial markets. Among other things, we could be fined, prohibited from engaging in some of our business activities or subject to limitations or conditions on our business activities. Substantial legal liability or significant regulatory action against us could have material adverse financial effects or cause significant reputational harm to us, which could seriously harm our business prospects.

In addition, financial services firms are subject to numerous conflicts of interests or perceived conflicts. The SEC and other federal and state regulators have increased their scrutiny of potential conflicts of interest. We have adopted various policies, controls and procedures to address or limit actual or perceived conflicts and regularly seek to review and update our policies, controls and procedures. However, appropriately dealing with conflicts of interest is complex and difficult and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with conflicts of interest. Our policies and procedures to address or limit actual or perceived conflicts may also result in increased costs, additional operational personnel and increased regulatory risk. Failure to adhere to these policies and procedures may result in regulatory sanctions or client litigation. For example, the research areas of investment banks have been and remain the subject of heightened regulatory scrutiny which has led to increased restrictions on the interaction between equity research analysts and investment banking personnel at securities firms.

Our exposure to legal liability is significant, and damages that we may be required to pay and the reputational harm that could result from legal action against us could materially adversely affect our businesses.

We face significant legal risks in our businesses and, in recent years, the volume of claims and amount of damages sought in litigation and regulatory proceedings against financial institutions have been increasing. These risks include potential liability under securities or other laws for materially false or misleading statements made in connection with securities offerings and other transactions, potential liability for “fairness opinions” and other

advice we provide to participants in strategic transactions and disputes over the terms and conditions of complex trading arrangements. We are also subject to claims arising from disputes with employees for alleged discrimination or harassment, among other things.

As a brokerage and investment banking firm, we depend to a large extent on our reputation for integrity and high-caliber professional services to attract and retain clients. As a result, if a client is not satisfied with our services, it may be more damaging in our business than in other businesses. Moreover, our role as advisor to our clients on important underwriting or mergers and acquisitions transactions involves complex analysis and the exercise of professional judgment, including rendering “fairness opinions” in connection with mergers and other transactions. Therefore, our activities may subject us to the risk of significant legal liabilities to our clients and aggrieved third parties, including shareholders of our clients who could bring securities class actions against us. Our investment banking engagements typically include broad indemnities from our clients and provisions to limit our exposure to legal claims relating to our services, but these provisions may not protect us or may not be enforceable in all cases. As a result, we may incur significant legal and other expenses in defending against litigation and may be required to pay substantial damages for settlements and adverse judgments. Substantial legal liability or significant regulatory action against us could have a material adverse effect on our results of operations or cause significant reputational harm to us, which could seriously harm our business and prospects.

Employee misconduct could harm us and is difficult to detect and deter.

There have been a number of highly publicized cases involving fraud or other misconduct by employees in the financial services industry in recent years, and we run the risk that employee misconduct could occur at our company. For example, misconduct by employees could involve the improper use or disclosure of confidential information, which could result in regulatory sanctions and serious reputational or financial harm. It is not always possible to deter employee misconduct and the precautions we take to detect and prevent this activity may not be effective in all cases, and we may suffer significant reputational harm for any misconduct by our employees.

Risks Related to our Principal Investing Activities

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

A substantial portion of our assets are investments in mortgage-backed securities and other investment securities. Most of those assets are classified for accounting purposes as “available-for-sale.” Changes in the market values of those assets will be directly charged or credited to stockholders’ equity. As a result, a decline in market value of our MBS portfolio and other investment securities may reduce the book value of our assets. Moreover, if the decline in value of an available-for-sale security is other than temporary, such decline will reduce earnings, as will a decline in the value of securities not classified as available-for-sale for accounting purposes.

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

Use of leverage could adversely affect our operations, particularly with respect to our mortgage-related assets portfolio and negatively affect cash available for distribution to our stockholders.

Using debt to finance the purchase of mortgage-backed securities and other investment securities and origination and acquisition of mortgage loans will expose us to the risk that margin calls will be made and that

we will not be able to meet those margin calls. To meet margin calls, we may sell the applicable mortgage-related securities or mortgage loans and such sales could result in realized losses, and negatively affect cash available for distribution to our shareholders.

While it is not our current policy to leverage our equity securities or loan investments, if we were to leverage these investments, this leverage could expose us to the risk that margin calls will be made and that we will not be able to meet them. A leveraged company’s income and net assets will tend to increase or decrease at a greater rate than if borrowed money were not used.

We enter into repurchase agreements to finance our MBS and other mortgage related investments, which can amplify the effect of a decline in value resulting from an interest rate increase. For example, assume that we finance $96 million of MBS through repurchase agreements to acquire $100 million of 8% mortgage-backed securities. If prevailing interest rates increase from 8% to 9%, the value of the mortgage-backed securities may decline to a level below the amount required to be maintained under the terms of the repurchase agreements. If the mortgage-backed securities were then sold, we would have to transfer additional assets to secure the borrowings.

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

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

A significant risk associated with our portfolio of mortgage-related assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates were to increase significantly, the market value of these mortgage-backed securities would decline and the weighted average life of the investments would increase. We have realized a loss in 2005, and could realize a loss in the future if the mortgage-backed securities were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on the repurchase agreements we enter into in order to finance the purchase of mortgage-backed securities. See “Item 1—Business—Recent Developments.”

Market values of mortgage-backed securities may decline without any general increase in interest rates for a number of reasons, such as increases in defaults, increases in voluntary prepayments and widening of credit spreads.

In addition, changes in interest rates may impact some our merchant banking equity investments in non-conforming mortgage loan originators and other companies whose business models are sensitive to interest rates.

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

As our repurchase agreements and other short-term borrowing instruments mature, we will be required either to enter into new repurchase agreements or to sell a portion of our mortgage-related assets or other investment securities. An increase in short-term interest rates at the time that we seek to enter into new

repurchase agreements would reduce the spread between our returns on our mortgage-related assets and the cost of our borrowings. This change in interest rates would adversely affect our returns on our mortgage-related assets portfolio, which might reduce earnings and, in turn, cash available for distribution to our stockholders.

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

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

Despite Fannie Mae, Freddie Mac or Ginnie Mae guarantees of principal and interest related to the agency-backed MBS we own, those guarantees do not protect us against prepayment risks.

Rapid changes in the values of our mortgage-backed securities and other real estate assets may make it more difficult for us to maintain our REIT status or exemption from the 1940 Act.

If the market value or income potential of our mortgage-backed securities and mezzanine loans declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT status or exemption from the 1940 Act. If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of many of our non-real estate assets. We may have to make investment decisions that we otherwise would not make absent the REIT and 1940 Act considerations.

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

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

•

interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

•

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

•

the duration of the hedge may not match the duration of the related liability;

•

the amount of income that a REIT may earn from hedging transactions to offset interest rate losses is limited by federal tax provisions governing REITs;

•

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and

•

the party owing money in the hedging transaction may default on its obligation to pay.

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

Our assets may include mezzanine or senior unsecured loans that may have greater risks of loss than secured senior loans and if those losses are realized, it could adversely affect our earnings, which could adversely affect our cash available for distribution to our stockholders.

Our assets may include mezzanine or senior unsecured loans that involve a higher degree of risk than long-term senior secured loans. First, the loans may not be secured by mortgages or liens on assets. Even if secured, these loans may have higher loan-to-value ratios than a senior secured loan. Furthermore, our right to payment and the security interest may be subordinated to the payment rights and security interests of the senior lender. Therefore, we may be limited in our ability to enforce our rights to collect these loans and to recover any of the loan balance through a foreclosure of collateral.

Our loans may have an interest only payment schedule, with the principal amount remaining outstanding and at risk until the maturity of the loan. In this case, a borrower’s ability to repay its loan may be dependent upon a liquidity event that will enable the repayment of the loan.

In addition to the above, numerous other factors may affect a company’s ability to repay its loan, including the failure to meet its business plan, a downturn in its industry or negative economic conditions. A deterioration in a company’s financial condition and prospects may be accompanied by deterioration in the collateral for the loan. Losses in our loans could adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders.

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

Leverage may have material adverse consequences to the companies to which we may make loans in connection with our Merchant Banking business and to us as an investor in these companies. These companies may be subject to restrictive financial and operating covenants. The leverage may impair these companies’ ability to finance their future operations and capital needs. As a result, these companies’ flexibility to respond to changing business and economic conditions and to business opportunities may be limited. A leveraged company’s income and net assets will tend to increase or decrease at a greater rate than if borrowed money were not used. As a result, leveraged companies have a greater risk of loss. Losses on such loans could adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders.

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

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

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

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

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

The equity securities of a new publicly-held or privately-held entity in which we invest are likely to be restricted as to resale and may otherwise be highly illiquid. We expect that there will be restrictions on our ability to resell the securities of any private or newly-public company that we acquire for a period of at least one year after we acquire those securities. In addition, applicable REIT tax provisions may cause sales of certain assets to be disadvantageous. Thereafter, a public market sale may be subject to volume limitations or dependent upon securing a registration statement for a secondary offering of the securities.

The securities of newly-public entities may trade less frequently and in smaller volume than securities of companies that are more widely held and have more established trading patterns. Sales of these securities may cause their values to fluctuate more sharply. Because we will make investments through an affiliate of FBR & Co., a registered broker-dealer in the U.S., and FBRIL, a registered broker-dealer in the United Kingdom, our ability to invest in companies may be constrained by applicable securities laws and regulations and the rules of the NASD and similar self-regulatory organizations. FBR & Co.’s investment and trading activities are regulated by the SEC, the NASD and other governmental authorities, and FBRIL’s investment and trading activities are regulated by similar regulatory authorities in the United Kingdom. As a result, the rules of the SEC, the NASD and other governmental authorities may limit our ability to invest in the securities of companies whose securities are underwritten or privately placed by our broker-dealer affiliates.

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

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

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

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

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

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

We may incur losses as a result of our sector investment activities, which could negatively affect the market price of our common stock and our ability to make distributions to our stockholders.

Our investments are made primarily through funds which we manage and funds which a third party acts as a manager. These funds may invest in companies in the early stages of their development or in industry sectors that are historically volatile, such as technology or sub-prime mortgage issuers. Our business and prospects must be

considered in light of the risks, expenses and difficulties frequently encountered by companies in early stages of development, particularly companies in new and rapidly evolving markets. Moreover, these funds may invest in privately held companies as to which little public information is available. Accordingly, we depend on these fund managers to obtain adequate information to evaluate the potential returns from investing in these companies. Fund managers may or may not be successful in this task. Also, these companies frequently have less diverse product lines and smaller market presence than large competitors. They are thus generally more vulnerable to economic downturns and may experience substantial variations in operating results.

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

Risks Related to our Non-Conforming Residential Mortgage Loan Origination Business

Recent increased delinquencies and losses with respect to residential mortgage loans, particularly in the sub-prime sector, may cause our First NLC subsidiary to recognize increased losses, which would adversely affect our consolidated operating results.

You should note that the residential mortgage market has recently encountered difficulties which may adversely affect the performance of our First NLC subsidiary. In recent months, delinquencies and losses with respect to residential mortgage loans generally have increased and may continue to increase, particularly in the sub-prime sector. In addition, in recent months residential property values in many states have declined or remained stable, after extended periods during which those values appreciated. A continued decline or a lack of increase in those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to second homes and investor properties, and with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable rate mortgage loans. Moreover, with respect to hybrid mortgage loans after their initial fixed rate period, and with respect to mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an increase in prevailing market interest rates. In addition, several residential mortgage loan originators who originate sub-prime loans have recently experienced serious financial difficulties and, in some cases, bankruptcy. Those difficulties have resulted in part from declining markets for their mortgage loans as well as from claims for repurchases of mortgage loans previously sold under provisions that require repurchase in the event of early payment defaults and for breaches of other representations regarding loan quality. The inability to repurchase such loans in the event of early payment defaults and other loan representation breaches may also affect the performance of any securities backed by those loans.

These general market conditions may adversely affect the performance of First NLC.

Our non-conforming residential mortgage loans are secured by interests in real property and we may suffer a loss if the value of any of the underlying properties declines.

The mortgage loans we originate and acquire are secured by interests in real property. If the value of the property underlying a mortgage loan decreases, our risk of loss with respect to the mortgage loan increases. In the event there is a default under a mortgage loan, our sole recourse may be to foreclose on the mortgage loan to

recover the outstanding amount under the mortgage loan. If the value of the property is lower than the amount of the mortgage loan, we would suffer a loss. If the losses are significant enough, they could have a material adverse effect on our results of operations, and our ability to make distributions to our shareholders.

The geographic concentration of our mortgage loan originations and acquisitions increases our exposure to risks in those areas, especially California.

Over-concentration of our mortgage loan originations and acquisitions in any one geographic area increases our exposure to the economic and natural hazard risks associated with that area. For example, in the twelve months ended December 31, 2006, approximately 17% of the aggregate principal amount of the mortgage loans that we originate were secured by property located in California. Certain parts of California have experienced an economic downturn in the past and have suffered the effects of certain natural hazards. Declines in the residential real estate markets in which we are concentrated may reduce the values of the properties collateralizing our mortgage loans, increase the risk of delinquency, foreclosure, bankruptcy, or losses and could harm our results of operations, financial condition and business prospects.

Furthermore, if borrowers are not insured for natural disasters, which are typically not covered by standard hazard insurance policies, they may not be able to repair the property or may stop paying their mortgages if the property is damaged. A natural disaster that results in a significant number of delinquencies would cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters and would harm our results of operations, financial condition and business prospects. We originate and acquire loans in jurisdictions which may suffer the effects of natural disasters.

Likewise, the secondary market pricing for pools of loans that are not geographically diverse is typically less favorable than for a diverse pool. Our inability to originate or purchase geographically diverse pools of loans could harm our results of operations, financial condition and business prospects.

We are subject to increased risk of default, foreclosure and losses associated with our strategy of focusing on non-conforming mortgage loan originations and acquisitions.

We are an originator and acquirer in the single-family, non-conforming, residential mortgage market, which means that we and the originators from which we acquire loans focus marketing efforts on borrowers who may be unable to obtain mortgage financing from conventional mortgage origination sources because they do not satisfy the loan amount limitations, credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage sources. A significant number of the loans we originate or acquire are to borrowers with derogatory credit items including delinquent mortgage payments, civil judgments, bankruptcies and foreclosures. These non-conforming loans generally involve a higher risk of delinquency, foreclosure and losses than loans made to prime borrowers. Delinquency interrupts the flow of projected interest income from a mortgage loan, and default can ultimately lead to a loss if the net realizable value of the real property securing the mortgage loan is insufficient to cover the principal and interest due on the loan. Also, our cost of financing and servicing a delinquent or defaulted loan is generally higher than for a performing loan. We generally bear the risk of delinquency and default on loans beginning when we originate them. In whole loan sales, our risk of delinquency typically only extends to prepayment or early payment defaults, but when we securitize a mortgage loan, we continue to bear some exposure to delinquencies and losses through our over-collateralization obligations and the loans underlying our on-balance sheet securitization transactions. We also re-acquire the risks of delinquency and default for loans that we are obligated to repurchase. As a result, we will need to establish allowances based on the amount of the anticipated delinquencies and losses on our mortgage loans. In addition, our mortgage loan underwriting standards do not prohibit our borrowers from obtaining secondary financing at the time of origination of our first lien mortgage loans (or at any time thereafter). Secondary financing would reduce a borrower’s equity in the mortgaged property compared to the amount indicated in our loan- to-value ratio determination at the time we made our credit decision, thereby increasing the risk of default on the loan. We

attempt to manage these risks with risk-based loan pricing and appropriate underwriting policies and loan collection methods. However, if such policies and methods are insufficient to control our delinquency and default risks and do not result in appropriate loan pricing and appropriate allowance for loss allowances, our results of operations could be materially adversely affected.

We may underestimate the default risk of, and therefore under-price, the non-conforming mortgage loans that we originate or acquire.

There can be no assurance that the criteria and methods, such as our proprietary credit scoring models, risk-based mortgage loan pricing and other underwriting procedures and guidelines and loan collection methods, that we employ to manage the risks associated with non-conforming mortgage loan borrowers who have negative credit characteristics will be effective to manage the risk of mortgage loan default. If we were to underestimate the default risk of, or under-price, the non-conforming mortgage loans that we originate, our results of operations would be adversely affected, possibly to a material degree.

The residential mortgage loan origination business is a cyclical industry, and is expected to decline in 2007 and subsequent years, which could reduce our current levels of non-conforming mortgage loan originations and our ability to generate net income in the future.

The residential mortgage origination business historically has been a cyclical industry, enjoying periods of strong growth and profitability followed by periods of shrinking volumes and industry-wide losses. The residential mortgage industry has experienced rapid growth in the past largely due to historically low interest rates. The Mortgage Bankers Association of America has predicted that total residential mortgage originations, which include both conforming and non-conforming mortgage loans, will decrease in 2007 relative to the 2004 and 2005 levels due to stable or rising interest rates. During periods of rising interest rates, rate and term refinancing originations decrease, as higher interest rates provide reduced economic incentives for borrowers to refinance their existing mortgages. Our historical performance may not be indicative of results in a rising interest rate environment, and our results of operations may be materially adversely affected if interest rates rise. In addition, our recent and rapid growth may distort some of our ratios and financial statistics and may make period-to-period comparisons difficult. In light of this growth and our change in business strategy, among other factors, our historical performance and operating and origination data may be of little relevance in predicting our future performance.

We face intense competition that could adversely affect our market share and our revenues.

We face intense competition from finance, investment banking and mortgage banking companies, other mortgage REITs, Internet-based lending companies for which entry barriers are relatively low, and, to a growing extent, from traditional bank and thrift lenders that have entered the mortgage industry. As we seek to expand our business further, we will face a significant number of additional competitors, that may be well established in the markets we desire to penetrate. Some of our competitors are much larger than we are, have better name recognition than we do and have far greater financial and other resources than we do.

Further, we compete with federally chartered institutions and their operating subsidiaries that also operate in a multi-state market environment. Federal statutes and rules governing federally chartered banks and thrifts allow those entities to engage in mortgage lending in multiple states on a substantially uniform basis and without the need to comply with state licensing and other laws (including new state “predatory lending” laws) affecting mortgage lenders. Federal regulators have expressed their position that these preemption provisions benefit mortgage subsidiaries of federally chartered institutions, as well. In January 2004, the Comptroller of the Currency finalized preemption rules that confirm and expand the scope of this federal preemption for national banks and their operating subsidiaries. Such federal preemption rules and interpretations generally have been upheld in the courts. In addition, such federally chartered institutions and their operating subsidiaries have defenses under federal law to allegations of noncompliance with such state and local laws that are unavailable to

us. Moreover, at least one national rating agency has announced that, in recognition of the benefits of federal preemption, it will not require additional credit enhancement by federal institutions when they issue securities backed by mortgages from a state with predatory lending laws. As a non-federal entity, we will continue to be subject to such rating agency requirements arising from state or local lending-related laws or regulations. Accordingly, as a mortgage lender that is generally subject to the laws of each state in which we do business, except as may specifically be provided in federal rules applicable to all lenders (such as the Fair Credit Reporting Act, Real Estate Settlement Procedures Act or Truth in Lending Act), unlike those competitors, we are generally subject to all state and local laws applicable to mortgage lenders in each jurisdiction where we lend, including new laws directed at non-conforming mortgage lending, as described below under “Business—Government Regulation.” This disparity may have the effect of giving those federal entities legal and competitive advantages.

In addition to finance, investment banking and mortgage banking companies, other mortgage REITs, Internet-based lending companies, traditional banks and thrift lenders, government-sponsored entities such as Fannie Mae and Freddie Mac are expanding their participation in the mortgage industry. These government-sponsored entities have a size and cost-of-funds advantage that allows them to purchase loans with lower rates or fees than we are able to offer. While these entities are not legally authorized to originate mortgage loans, they do have the authority to buy loans. A material expansion of their involvement in the market to purchase non-prime loans could change the dynamics of the industry by virtue of their sheer size, pricing power and the inherent advantages of a government charter. In addition, if as a result of their purchasing practices Fannie Mae or Freddie Mac experiences significantly higher-than-expected losses, these losses could adversely affect the overall investor perception of the non-prime mortgage industry.

The intense competition in the mortgage industry has also led to rapid technological developments, evolving industry standards and frequent releases of new products and enhancements. As mortgage products are offered more widely through alternative distribution channels, such as the Internet, we may be required to make significant changes to our current wholesale and retail origination structure and information systems to compete effectively. An inability to continue enhancing our current systems and Internet capabilities, or to adapt to other technological changes in the industry, could significantly harm our business, financial condition, liquidity and results of operations.

Competition in the mortgage industry can take many forms, affecting interest rates and costs of a loan, stringency of underwriting standards, convenience in obtaining a loan, customer service, loan amounts and loan terms and marketing and distribution channels. The need to maintain mortgage loan volume in a competitive environment may create price competition, which could cause us to lower the interest rates that we charge borrowers and could lower the value of our mortgage loans held for sale or retained in our investment portfolio, or credit competition, which could cause us to adopt less stringent underwriting standards. The combination of price competition and credit competition could result in greater loan risk without compensating pricing. If we do not address either or both of these competitive pressures in response to our competitors, we may lose market share, reduce the volume of our mortgage loan originations and sales and significantly harm our business, financial condition and results of operations.

The expected cyclical decline in the mortgage industry’s overall level of originations may lead to increased competition for the remaining loans. We cannot assure you that we will be able to continue to compete effectively in the markets we serve and our results of operations, financial condition and business could also be materially adversely affected to the extent our competitors significantly expand their activities in our markets.

The poor performance of a pool of mortgage loans we securitize could increase the expense of our subsequent securitizations, which could have a material adverse effect on our results of operations, financial condition and business.

The poor performance of a pool of mortgage loans that we securitize could increase the expense of any subsequent securitizations we bring to market. Increased expenses on our securitizations could reduce the net

interest income we receive on our investment portfolio. A change in the market’s demand for our mortgage-backed securities or a decline in the securitization market generally could have a material adverse effect on our results of operations, financial condition and business prospects.

Our ability to generate net interest income from the mortgage loans we retain in our portfolio is dependent upon the success of our portfolio-based model of securitizations, which is subject to several risks.

We expect to generate a portion of our earnings and cash flow from the net interest income earned on the mortgage loans we originate, securitize in non-REMIC securitizations and retain in our investment portfolio. A substantial portion of the net interest income generated by these securitized loans will be based upon the difference, or spread, between the weighted average interest earned on the mortgage loans held in our investment portfolio and the interest payable to holders of the asset-backed securities we issue in our securitizations. The interest expense on the asset-backed securities is typically adjusted monthly relative to market interest rates. Because the interest expense associated with the asset-backed securities typically adjusts faster than the interest income from the mortgage loans, the net interest income derived from our spread can be volatile and decrease in response to changes in interest rates. Also, the net interest income we receive from our investment portfolio of mortgage loans will likely decrease and our cash flow will be reduced if there are defaults on a significant number of our loans or if a large number of loans prepay prior to their scheduled maturities. The effects will be magnified if the defaults or prepayments occur with respect to mortgage loans with interest rates that are high relative to the rest of our loans.

In connection with the securitization of the mortgage loans held in our portfolio, we may issue senior securities with various ratings that are priced at a spread over an identified benchmark rate, such as the yield on U.S. Treasury bonds, interest rate swaps or LIBOR. If the spread that investors demand over the benchmark rate widens and the rates we charge on our loans are not commensurately increased, our spread may be compressed and we may experience a material adverse effect on the net interest income from our securitizations and therefore experience a reduction in the economic value of the pool of mortgage loans in our investment portfolio.

Our portfolio-based model is based on our expectation that the interest income we receive from the mortgage loans held in our investment portfolio will exceed the interest expense of the debt we incur to finance those loans. In other words, we expect to increase our net earnings by using debt to “leverage” our return on equity. However, our investment portfolio income is at risk for the expense of repaying our debt as well as for the performance of the loans. This is true both for the short-term financing we use prior to securitization and for the securitization debt that we incur as long-term financing of our mortgage loans held for investment.

We are subject to two risks during the period our loans held for investment are financed with short-term borrowings that we are not subject to relative to our securitization debt: first, we may be required to make additional payments to our lenders (known as “margin calls”) relative to our short-term financing if the lenders determine that the market value of the mortgage loans they hold as collateral has declined, which could happen at any time as a result of increases in market interest rates; and second, we are obligated to repay the entire amount of the debt, without limitation, regardless of the value of the mortgage loans. If we are required to make margin call payments to our lenders, it could have an adverse effect on our business, financial condition and results of operations. On the other hand, our securitization debt will be long-term structured debt on which we never have margin calls and are at risk only for the amount we have invested in the loans, that is, the funded amount of the loans, pledged to secure the mortgage-backed securities we issue. We generally will not be obligated to repay the holders of our securitized debt if the mortgage loans pledged to secure the mortgage-backed securities we have issued default and there is not enough cash from the mortgage loans to pay the mortgage-backed securities as they become due.

We will rely upon our ability to securitize the mortgage loans held in our investment portfolio to generate cash proceeds for repayment of our warehouse lines and repurchase facilities and to originate additional mortgage loans. We cannot assure you, however, that we will be successful in securitizing these loans. In the

event that it is not possible or economical for us to complete the securitization of our mortgage loans, we may continue to hold these loans and bear the risks of interest rate changes and loan defaults and delinquencies, which may cause us to exceed our capacity under our warehouse lines and repurchase facilities and be unable or limited in our ability to originate future mortgage loans, which would have a material adverse effect on our business, financial condition and results of operations. If we determine that we should sell all or part of our loans rather than securitizing them, there could be significant adverse effects on our net income and stockholder distributions as a result of federal corporate income tax that would be imposed on gains from such sales which would be made through our taxable REIT subsidiary, FNLC Financial Services, Inc.

We may incur additional losses in our securitized mortgage loan portfolio

As of September 30, 2006, the Company made a determination in evaluating its investment strategy and its intent related to its held-for-investment mortgage loan portfolio that it no longer intends to hold this portfolio for investment. Accordingly, as of September 30, 2006, these loans were reclassified to held for sale. As a result of this change, in accordance with SFAS No. 65, “Accounting for Certain Mortgage Banking Activities,” the Company recorded its investment in this loan portfolio at the lower of cost or market and during 2006 recognized write-downs of $149.8 million in the value of these loans.

Although the Company considers its valuation methodology to be appropriate, the realized value from a market transaction may differ given the inherently subjective nature of the valuation, including uncertainties related to the various market assumptions and other data used in the calculation and that difference could be material. The actual value from a market transaction will be subject to, among other things, changes in both short- and long-term interest rates, prepayment rates, housing prices, credit loss experience and the shape and slope of the yield curve. The Company will continue to monitor and assess the significant assumptions underlying this value in the future.

The use of securitizations with over-collateralization requirements may have a negative impact on our cash flow.

We expect that our mortgage loan securitizations may restrict our cash flow if loan delinquencies exceed specified levels. The terms of the securitizations will generally provide that, if loan delinquencies or losses exceed specified levels set based on analysis by the rating agencies (or the financial guaranty insurer, if applicable) of the characteristics of the loans pledged to collateralize the mortgage-backed securities, the required level of over-collateralization may be increased or may be prevented from decreasing as would otherwise be permitted if losses and/or delinquencies did not exceed those levels. Other terms of the securitizations, triggered by delinquency levels or other criteria, may also restrict our ability to receive net interest income that we would otherwise be entitled to in connection with a securitization transaction. We cannot assure you that loan delinquencies and losses will be limited to levels necessary to permit us to maximize our cash flows. Nor can we provide you, in advance of completing negotiations with the rating agencies and other key transaction parties that may be involved with our future securitizations, information regarding the actual terms of delinquency tests, over-collateralization requirements, cash flow release mechanisms or other significant terms affecting the calculation of net interest income to us.

An interruption or reduction in the securitization and whole loan markets would harm our financial position.

We are dependent on the securitization market for the sale of mortgage loans that we originate because we may securitize mortgage loans directly and many of our whole loan buyers purchase our loans with the intention to securitize them. Additionally, we currently rely on the securitization market for the long-term financing of some of our mortgage loans. The securitization market is dependent upon a number of factors, including general economic conditions, conditions in the securities market generally and conditions in the asset-backed securities market specifically. In addition, poor performance of our previously securitized loans could harm our access to the securitization market. Accordingly, a decline in the securitization market or a change in the market’s demand

for our loans could harm our results of operations, financial condition and business prospects. Finally, failure to satisfy the requirements of regulations issued by the SEC and known as Regulation AB may impact our ability to access the securitization market using our shelf registrations.

Our failure to negotiate, or otherwise obtain, favorable securitization terms may materially and adversely affect the availability of net interest income to us.

Fluctuating or rising interest rates may adversely affect the amount of net interest income we receive.

The interest payable on the floating-rate asset-backed securities we issue in securitizations generally will adjust monthly and will be based on shorter term floating interest rates, while the interest income we receive from our mortgage loans generally will either be fixed, adjust less frequently than monthly or be subject to caps on the rates the borrowers pay. Accordingly, when interest rates rise, the interest rates that we pay to finance our mortgage loan originations may rise faster than the interest rates on our mortgage loans, which could cause the net interest income generated by our mortgage loan portfolio to decrease.

Fluctuations in interest rates may affect our profitability several other ways, including but not limited to the following:

•

decreases in interest rates may cause prepayments to increase and may result in losses arising from our hedging activities, adversely affecting our net interest income over time from our securitized loans; and

•

increases in interest rates may reduce overall demand for mortgage loans, accordingly reduce our origination of new loans, and reduce the value of loans and other securities on our consolidated balance sheet, which could have a material adverse effect on our business, financial condition, and results of operations.

Changes in interest rates could negatively affect the value of our residual interests, mortgage loans held for sale and mortgage loans held for investment, which could result in reduced earnings or losses and could negatively affect the cash available for distribution to our stockholders.

When we securitize loans, the value of the residual interests we retain and the income we receive from the securitizations structured as financings are based primarily on LIBOR. This is because the interest on the underlying mortgage loans is based on fixed rates payable on the underlying loans for the first two or three years from origination while the holders of the applicable securities are generally paid based on an adjustable LIBOR-based yield. Therefore, an increase in LIBOR reduces the net income we receive from, and the value of, these mortgage loans and residual interests.

In addition, our adjustable-rate mortgage loans have periodic and lifetime interest rate caps above which the interest rate on the loans may not rise. In the event of general interest rate increases, the rate of interest on these mortgage loans could be limited, while the rate payable on the senior certificates representing interests in a securitization trust into which these loans are sold may be uncapped. This would reduce the amount of cash we receive over the life of the loans in securitizations structured as financings and our residual interests, and could require us to reduce the carrying value of our residual interests.

Accordingly, changes in interest rates could negatively affect the value of our residual interests, mortgage loans held for sale and mortgage loans held for investment, which could result in reduced earnings or losses and could negatively affect the cash available for distribution to our stockholders.

A decrease in the value of the mortgage loans used as collateral under our credit facilities could cause us to default under our credit facilities.

The amount available to us under our warehouse lines of credit and repurchase facilities depends in large part on the lender’s valuation of the mortgage loans that secure the facilities. Each credit facility provides the

lender the right, under certain circumstances, revalue the mortgage loan collateral that secures our outstanding borrowings at any time. In the event the lender determines that the value of the mortgage loan collateral has decreased, it has the right to initiate a margin call. A margin call would require us to provide the lender with additional collateral or to repay a portion of the outstanding borrowings at a time when we may not have a sufficient inventory of mortgage loans or cash to satisfy the margin call and at a time when the market value of our loans may be at a low. Accordingly, any failure by us to meet a margin call could cause us to default under our credit facilities and otherwise have a material adverse effect on our business, financial condition and results of operations.

If we are unable to realize cash proceeds from non-conforming mortgage loan sales in excess of the loan acquisition cost, our financial position would be adversely affected.

The net cash proceeds received from loan sales consist of the premiums we receive on sales of loans in excess of the outstanding principal balance, minus the discounts on loans that we sell for less than the outstanding principal balance. The proceeds we receive on loan sales are dependent on demand for consumer credit. Economic slowdowns or recessions may be accompanied by decreased real estate values and an increased rate of delinquencies, defaults and foreclosures. Potential purchasers might reduce the premiums they pay for the loans during these periods to compensate for any increased risks. Any sustained decline in demand for loans or increase in delinquencies, defaults or foreclosures is likely to significantly harm the pricing of our future loans sales such that it falls below our costs to originate loans. If we are unable to originate loans at a cost lower than the cash proceeds realized from loan sales, our results of operations could be materially adversely affected. Similarly, we securitize a portion of our loans and if there is no market for the purchase of our securities, our results of operations could be materially adversely affected.

We have limited experience hedging the interest rate risk associated with retaining a portfolio of non-conforming mortgage loans over the long term, and any hedging strategies we may use may not be successful in mitigating these risks.

We may use various derivative financial instruments to provide a level of protection against interest rate risks, but no hedging strategy can protect us completely. Additionally, we have limited experience hedging interest rate volatility arising from retaining a portfolio of mortgage loans over the long term. When interest rates change, we expect the gain or loss on derivatives to be offset by a related but inverse change in the value of our mortgage loans. We cannot assure you, however, that our use of derivatives will fully offset the risks related to changes in interest rates. It is likely that there will be periods during which we will recognize losses on our derivative financial instruments under our required accounting rules that will not be fully offset by gains we recognize on loans held for sale or loans held for investment. The derivative financial instruments that we select may not have the effect of reducing our price risk on our loans, including our interest rate risk. In addition, the nature and timing of hedging transactions may influence the effectiveness of these strategies. Poorly designed strategies, or improperly executed transactions or unanticipated market fluctuations could actually increase our risk and losses. In addition, hedging strategies involve transaction and other costs. Any hedging strategy or derivatives we use may not adequately offset the risk of interest rate volatility and our hedging transactions may result in losses. Finally, complying with the REIT requirements may limit our ability to enter into certain hedging transactions.

We may be required to repurchase or substitute mortgage loans that we have sold or securitized, as the case may be, or to indemnify holders of our asset-backed securities, which could have a material adverse effect on our results of operations, financial condition and business.

When we originate or acquire a mortgage loan and include it in a securitization transaction or whole loan sale, we make certain representations and warranties regarding certain characteristics of the loans, the borrowers and the underlying properties. If we are found to have breached any of these representations and warranties, we

may be required to repurchase or substitute those loans or, in the case of securitized loans, replace them with substitute loans or cash, as the case may be. If this occurs, we may have to bear any associated losses directly. In addition, in the case of loans that we sold, we may be required to indemnify the purchasers of the loans for losses or expenses incurred as a result of a breach of a representation or warranty. Repurchased loans typically require a significant allocation of working capital to carry on our books, and our ability to borrow against these loans is limited. Furthermore, repurchased mortgage loans typically can be sold only at a significant discount to the unpaid principal balance. Any repurchases, substitutions or indemnification payments could significantly harm our results of operations.

The success of our investment portfolio management and securitization business will depend in part upon a third party’s ability to effectively service the loans held in our investment portfolio and in our securitizations.

Historically, we have not serviced loans. We must continue to contract with a third-party to service the loans for us to fully implement our strategy The fees paid to a servicer will reduce our net interest income. Furthermore, our net interest income will depend in part upon the effectiveness of the third-party servicer. We cannot assure you that we will be able to continue to contract with a third-party servicer on reasonable terms or at all. We also cannot assure you that we or a servicer will be able to service the loans according to industry standards either at the outset or in the future. Any failure to service the loans properly will harm our operating results.

A prolonged economic slowdown, a lengthy or severe recession or declining real estate values could harm our operations, particularly if it results in a decline in the real estate market.

The risks associated with our business are more acute during periods of economic slowdown or recession because these periods may be accompanied by decreased demand for consumer credit and declining real estate values. Declining real estate values likely will reduce our level of new originations, because borrowers frequently use increases in the value of their homes to support new loans and higher levels of borrowings. Declining real estate values also negatively affect loan-to-value ratios, or LTVs, of our existing loans and significantly increase the likelihood that borrowers will default on existing loans. Any sustained period of economic slowdown or recession could adversely affect our net interest income from mortgage loans in our investment portfolio, as well as our ability to originate, sell and securitize loans, which conditions would significantly harm our results of operations.

If we are unable to maintain our network of independent brokers, our mortgage loan origination business will decrease and if we are unable to grow our network of independent brokers our ability to increase our total mortgage loan originations volume may be hampered.

A significant portion of the mortgage loans that we originate comes from independent brokers in our wholesale channels. Our brokers are not contractually obligated to do business with us. Further, our competitors also have relationships with our brokers and actively compete with us in our efforts to obtain loans from our brokers and to expand our broker networks. Accordingly, we cannot assure you that we will be successful in maintaining our existing relationships or expanding our broker networks, the failure of which could negatively affect the volume and pricing of our loans, which would have a material adverse effect on our business, financial condition and results of operations.

We may be subject to losses due to fraudulent and negligent acts on the part of loan applicants, mortgage brokers, other vendors and our employees.

When we originate mortgage loans, we rely heavily upon information supplied by third parties, including the information contained in the loan application made by the applicant, property appraisal, title information and employment and income documentation. If a third party misrepresents any of this information and if we do not

discover the misrepresentation prior to funding the loan, the value of the loan may be significantly lower than anticipated. As a practical matter, we generally bear the risk of loss associated with the misrepresentation whether it is made by the loan applicant, the mortgage broker, another third party or one of our employees. A loan with respect to which a material misrepresentation has been made is typically unsalable or subject to repurchase if it was sold prior to detection of the misrepresentation. In addition, the persons and entities that make such material misrepresentations, are often difficult to locate, and it is nearly impossible to recoup any monetary losses that we may have suffered, as a result of such material misrepresentations from those who have made them.

For a portion of the mortgage loans we originate, we required no or limited documentation of the borrowers’ income and bank account information. Instead, we based our credit decisions largely on the borrowers’ credit score and credit history, the collateral value of the property securing the loan and the effect of the loan on the borrowers’ debt service. There is a higher risk of default on loans where there is little or no documentation of the borrowers’ income.

We will incur significant costs related to governmental regulation.

Our business is subject to extensive regulation, supervision and licensing by federal, state and local governmental authorities and is subject to various laws and judicial and administrative decisions imposing requirements and restrictions on a substantial portion of our operations. Our lending and servicing activities are subject to numerous federal laws and regulations, including the Truth-in-Lending Act and Regulation Z (including the Home Ownership and Equity Protection Act of 1994), the Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the Real Estate Settlement Procedures Act, or RESPA, the Fair Housing Act, the Home Mortgage Disclosure Act, or HMDA, the Fair Debt Collection Practices Act, the privacy requirements of the Gramm-Leach-Bliley Act, and the Fair and Accurate Credit Transactions Act of 2003, or the FACT Act. We also are required to comply with a variety of state and local consumer protection laws and are subject to the rules and regulations of, and examination by state regulatory authorities with respect to originating, processing, underwriting, selling, securitizing and servicing mortgage loans. Additionally, in connection with our shelf registrations we are required to comply with Regulation AB, which recently became effective. Regulation AB may have an impact on our origination costs because our whole loan purchasers that participate in the securitization market may require us to provide additional undertakings in connection with Regulation AB. These requirements can and do change as statutes and regulations are amended.

These statutes and regulations, among other things, impose licensing and disclosure obligations upon us, establish eligibility criteria for mortgage loans, prohibit discrimination, provide for inspections and appraisals of properties securing mortgage loans, require credit reports on mortgage loan applicants, regulate assessment, servicing-related fees collection, foreclosure and claims handling, investment and interest payments on escrow balances and payment features, mandate certain disclosures and notices to borrowers, require performance tracking of loans and securities backed by our loans and, in some cases, fix maximum interest rates, finance charges, fees and mortgage loan amounts. We will incur significant costs attributable to such governmental regulations, which will have a negative effect on our net income.

If we do not obtain the necessary state licenses and approvals, we will not be allowed to acquire, fund or originate mortgage loans in some states, which would adversely affect our operations and may result in our inability to qualify as a REIT.

Most states in which we do business require that we be licensed to conduct our business. As part of our acquisition of First NLC, we were required to obtain various new licenses and approvals under existing licenses. We cannot assure you that we will be able to retain all necessary licenses and approvals.

Our inability to comply with the large body of complex laws and regulations at the Federal, state and local levels associated with our business could have a material adverse effect on our results of operations, and our ability to pay dividends to our stockholders.

Our subsidiary, First NLC currently is licensed, approved or authorized, or exempt from licensing, to originate mortgage loans in 45 states. Our subsidiary, MHC currently is licensed, or exempt from licensing, to acquire mortgage loans in 49 states and the District of Columbia. We must comply with the laws and regulations, as well as judicial and administrative decisions, in all of these jurisdictions, as well as an extensive body of federal law and regulations. The volume of new or modified laws and regulations has increased in recent years, and, in addition, individual cities and counties have begun to enact laws that restrict non-prime mortgage loan origination activities in those cities and counties. The laws and regulations of each of these jurisdictions are different, complex and, in some cases, in direct conflict with each other. As our operations continue to grow, it may be more difficult to comprehensively identify, accurately interpret, properly program our technology systems and effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. Our failure to comply with these laws and regulations can lead to:

•

civil and criminal liability, including potential monetary penalties;

•

loss of state licenses or other approval status required for continued lending or servicing operations;

•

legal defenses causing delay or otherwise adversely affecting our ability to enforce loans, or giving the borrower the right to rescind or cancel the loan transaction;

•

refunds to borrowers;

•

demands for indemnification or loan repurchases under our whole-loan sales and securitizations;

•

litigation, including class action lawsuits;

•

administrative enforcement actions and fines;

•

damage to our reputation in the industry;

•

loss of the ability to obtain ratings on our securitizations by rating agencies; and

•

the inability to obtain credit to fund our operations.

Any of these results could have a material adverse effect on our results of operations, financial condition and business. We cannot assure you that more restrictive laws, rules and regulations will not be adopted in the future, or that existing laws and regulations will not be interpreted in a more restrictive manner, that could make compliance more difficult or expensive.

We are also subject to examination by state regulatory authorities in each of the states in which we operate. To resolve issues raised in these examinations, we have in the past, and may in the future, be required to take various corrective actions, including changing certain business practices and making refunds in certain circumstances to borrowers.

The laws and regulations described above are subject to legislative, administrative and judicial interpretation, and certain of these laws and regulations have been infrequently interpreted or only recently enacted. Infrequent interpretations of these laws and regulations or an insignificant number of interpretations of recently enacted regulations can result in ambiguity with respect to permitted conduct under these laws and regulations. Any ambiguity under the regulations to which we are subject may lead to regulatory investigations or enforcement actions and private causes of action, such as class action lawsuits, with respect to our compliance with the applicable laws and regulations. As a mortgage lender, we may be also subject to regulatory

enforcement actions and private causes of action from time to time with respect to our compliance with applicable laws and regulations. We cannot assure you that future examinations or governmental actions will not cause us to change certain business practices, make refunds or take other actions that would be financially or competitively detrimental to us.

We cannot assure you that we will be able to obtain or maintain all necessary licenses and approvals in a timely manner or at all. Failure to obtain and maintain these licenses and approvals would limit, delay and disrupt (1) our ability to increase REIT qualifying assets and income and (2) our operations in certain geographical regions, and perhaps nationwide, and could have a material adverse effect on our results of operations, financial condition and business.

The complex federal, state and municipal laws governing loan servicing activities could increase our exposure to the risk of noncompliance.

If we were to service the loans we originate or acquire, we would be confronted with the laws and regulations, as well as judicial and administrative decisions, of all relevant jurisdictions pertaining to loan servicing, as well as an extensive body of federal laws and regulations. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan servicing activities. The laws and regulations of each of these jurisdictions are different, complex and, in some cases, in direct conflict with each other. If we were to become involved in servicing operations, it may be more difficult to comprehensively identify, to accurately interpret and to properly program our technology systems and effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with the laws and regulations pertaining to loan servicing. Our failure to comply with these laws could lead to, among other things: (i) civil and criminal liability, including potential monetary penalties; (ii) legal defenses delaying or otherwise harming the servicer’s ability to enforce loans, or giving the borrower the right to rescind or cancel the loan transactions; (iii) class action lawsuits; and (iv) administrative enforcement actions. This could harm our results of operations, financial condition and business prospects.

New legislation could restrict our ability to make or to acquire mortgage loans, which could adversely impact our results of operations, financial condition and business.

Several states, counties and cities are considering or have passed laws or regulations aimed at curbing “predatory lending” practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing Federal Home Ownership and Equity Protection Act thresholds for defining a “high-cost” loan, and establishing enhanced protections and remedies for borrowers who receive such high-cost loans. However, many of these laws and regulations extend beyond curbing predatory lending practices to restrict commonly accepted lending activities. For example, some of these laws and regulations prohibit or limit prepayment charges or severely restrict a borrower’s ability to finance the points and fees charged in connection with the origination of a mortgage loan. Passage of these laws and regulations could reduce our mortgage loan origination volume. In fact, we have withdrawn from certain jurisdictions due to such legislation and any new legislation may cause us to withdraw from additional jurisdictions. Some of these restrictions expose a lender to risks of litigation and regulatory sanction no matter how carefully a mortgage loan is underwritten or originated. In addition, an increasing number of these laws, rules and regulations seek to impose liability for violations on purchasers of mortgage loans, regardless of whether a purchaser knew of or participated in the violation. Accordingly, for reputational reasons, the purchasers and lenders that buy our mortgage loans or provide financing for our mortgage loan originations may not want to buy or finance any mortgage loans subject to these types of laws, rules and regulations. These purchasers and lenders are not contractually required to purchase or finance such mortgage loans. In addition, for reputational reasons and because of the enhanced risk, many whole-loan purchasers will not buy and rating agencies may refuse to rate any securitization containing any mortgage loan labeled as a “high-cost” loan under

any local, state or federal law or regulation. Accordingly, these laws and regulations severely constrict the secondary market and limit the acceptable standards of mortgage loan production in our industry. This could effectively preclude us from originating or acquiring mortgage loans that fit within the newly defined parameters and could have a material adverse effect on our ability to securitize or sell mortgage loans and, therefore, our results of operations, financial condition and business.

If, for competitive reasons, we were to decide to relax our self-imposed restrictions on originating and purchasing mortgage loans subject to these laws, we would be subject to greater risks for actual or perceived non-compliance with such laws, rules, and regulations, including demands for indemnification or loan repurchases from our lenders and purchasers of our mortgage loans, class action lawsuits, increased defenses to foreclosure of individual loans in default, individual claims for significant monetary damages, and administrative enforcement actions. Any of the foregoing could significantly harm our results of operations, financial condition and business.

Furthermore, members of Congress and government officials have from time to time suggested the elimination of the mortgage interest deduction for federal income tax purposes, either entirely or in part, based on borrower income, type of loan or principal amount. Because many of our mortgage loans are made to borrowers for the purpose of consolidating consumer debt or financing other consumer needs, the competitive advantage of tax deductible interest, when compared with alternative sources of financing, could be eliminated or seriously impaired by such government action. Accordingly, the reduction or elimination of these tax benefits to borrowers could have a material adverse effect on the demand for the mortgage loan products we offer.

We may be subject to various legal actions, which if decided adversely could have a material adverse effect on our financial condition.

Because the non-conforming mortgage lending and servicing business by its nature involves the collection of numerous accounts, the validity of liens and compliance with local, state and federal lending laws, mortgage lenders and servicers, including us, are subject to numerous claims and legal actions in the ordinary course of business. These legal actions include lawsuits styled as class actions and alleging violations of various federal, state and local regulations and laws. In addition, in recent years, both state and federal regulators and enforcement agencies have subjected the practices of non-conforming mortgage lenders to particularly intense regulatory scrutiny, which has resulted in a number of well publicized governmental and other investigations of certain of our competitors. Lawsuits can be very expensive, harm a company’s reputation and otherwise disrupt operations. We cannot assure you that we will not be the subject of legal actions that could materially adversely affect our financial condition.

The conduct of the independent brokers through whom we originate our wholesale mortgage loans could subject us to fines or other penalties.

The mortgage brokers through whom we originate wholesale mortgage loans have parallel and separate legal obligations to which they are subject. While these laws may not explicitly hold the originating lenders responsible for the legal violations of mortgage brokers, federal and state agencies increasingly have sought to impose such liability. Recently, for example, the United States Federal Trade Commission, or the FTC, entered into a settlement agreement with a mortgage lender where the FTC characterized a broker that had placed all of its loan production with a single lender as the “agent” of the lender. The FTC imposed a fine on the lender in part because, as “principal,” the lender was legally responsible for the mortgage broker’s unfair and deceptive acts and practices. The United States Department of Justice in the past has sought to hold mortgage lenders responsible for the pricing practices of mortgage brokers, alleging that the mortgage lender is directly responsible for the total fees and charges paid by the borrower under the Fair Housing Act, even if the lender neither dictated what the mortgage broker could charge nor kept the money for its own account. Although we exercise little or no control over the activities of the independent mortgage brokers from whom we obtain our wholesale loans, we may be subject to fines or other penalties based upon the conduct of our independent mortgage brokers. Further,

we have in the past made refunds to our borrowers because of the conduct of mortgage brokers and it is possible that we may in the future be subject to additional payments, fines or other penalties based upon the conduct of the brokers with whom we do business.

“Do not call” registry and “Do not fax” rules may limit our ability to market our products and services.

Our marketing operations, including the activities of brokers who originate mortgage loans for us, may be restricted by the development of various federal and state laws, including “do not call” list requirements and “do not fax” requirements. Federal and state laws have been enacted that permit consumers to protect themselves from unsolicited marketing telephone calls. In 2003, the Federal Trade Commission, or FTC, amended its rules to establish a national “do not call” registry. Generally, vendors are prohibited from calling anyone on that registry unless the consumer has initiated the contact or given prior consent. Even though court decisions in 2003 questioned the FTC’s authority to effect such a registry and raised First Amendment issues, the FTC put the registry into operation. A 2004 U.S. Court of Appeals decision has held that the FTC rules do not conflict with the freedom of commercial speech under the First Amendment, which has increased the likelihood that the FTC rules will remain in effect. In October 2004, the U.S. Supreme Court declined to hear an appeal seeking to overturn the Tenth Circuit ruling. The Telephone Consumer Protection Act of 1981 and rules issued by the Federal Communications Commission, or FCC, prohibit vendors from sending unsolicited fax advertisements. Currently, a fax is not unsolicited if the sender has an established business relationship with the recipient. However, beginning July 1, 2005, a fax advertisement may be sent only if the sender has a signed, written consent from the recipient that includes the fax number to which any advertisements may be sent. In view of the public concern with privacy, we cannot assure you that additional rules that restrict or make more costly the marketing activities that we or our vendors employ will not be adopted. Such regulations may restrict our ability to market our products and services to new customers effectively. Furthermore, compliance with these regulations may prove costly and difficult, and we, or our vendors, may incur penalties for improperly conducting our marketing activities.

We are subject to significant legal and reputational risks and expenses under federal and state laws concerning privacy, use, and security of customer information.

The scope of business activity affected by “privacy” concerns is likely to expand and will affect our non-prime mortgage loan origination business. The federal Gramm-Leach-Bliley financial reform legislation imposes significant privacy obligations on us in connection with the collection, use and security of financial and other non-public information provided to us by applicants and borrowers. We adopted a privacy policy and adopted controls and procedures to comply with the law after it took effect on July 1, 2001. Privacy rules also require us to protect the security and integrity of the customer information we use and hold. Although we have systems and procedures designed to help us with these privacy requirements, we cannot assure you that more restrictive laws and regulations will not be adopted in the future, or that governmental bodies will not interpret existing laws or regulations in a more restrictive manner, making compliance more difficult or expensive. These requirements also increase the risk that we may be subject to liability for non-compliance.

A number of states are considering privacy amendments that may be more demanding than federal law, and California recently has enacted two statutes—the California Financial Information Privacy Act (also know as SB-1) and the California Online Privacy Protection Act, both of which took effect on July 1, 2004. Under SB-1, a financial company must allow its customers to opt out of the sharing of their information with affiliates in separately regulated lines of business and must receive a customer opt-in before confidential customer data may be shared with unaffiliated companies (subject to certain exceptions). A federal court rejected the effort of three financial trade associations to prevent SB-1 from taking effect, and as of July 1, 2004, the California Department of Financial Institutions announced that it would require immediate compliance with SB-1. Under the new California Online Privacy Act, all operators of commercial websites and online services that allow interaction with California consumers (even if no transactions may be effected online) must post privacy policies meeting statutory requirements. The FTC, which administers the federal privacy rules for mortgage lenders, has

determined that privacy laws in several states are not preempted by Gramm-Leach-Bliley, most recently new privacy laws enacted by Vermont and Illinois. In view of the public concern with privacy, we cannot assure you that additional rules that restrict or make more costly our activities and the activities of our vendors will not be adopted and will not restrict the marketing of our products and services to new customers.

Because laws and rules concerning the use and protection of customer information are continuing to develop at the federal and state levels, we expect to incur increased costs in our effort to be and remain in full compliance with these requirements. Nevertheless, despite our efforts, we will be subject to legal and reputational risks in connection with our collection and use of customer information, and we cannot assure you that we will not be subject to lawsuits or compliance actions under such state or federal privacy requirements. Furthermore, to the extent that a variety of inconsistent state privacy rules or requirements are enacted, our compliance costs could substantially increase.

Our inability to rely on the Alternative Mortgage Transactions Parity Act to preempt certain state law restrictions on prepayment charges could have a material adverse effect on our results of operations, financial condition and business.

The value of a mortgage loan depends, in part, upon the expected period of time that the mortgage loan will be outstanding. If a borrower pays off a mortgage loan in advance of this expected period, the holder of the mortgage loan does not realize the full value expected to be received from the mortgage loan. A prepayment charge payable by a borrower who repays a mortgage loan earlier than expected helps offset the reduction in value resulting from the early payoff. Consequently, the value of a mortgage loan is enhanced to the extent it includes a prepayment charge and a mortgage lender can offer a lower interest rate and lower loan fees on a mortgage loan which has a prepayment charge. Certain state laws restrict or prohibit prepayment charges on mortgage loans and, until July 1, 2003, we relied on the federal Alternative Mortgage Transactions Parity Act, or the Parity Act, and related rules issued in the past by the Office of Thrift Supervision, or the OTS, to preempt state limitations on prepayment charges related to adjustable rate mortgage loans. The Parity Act was enacted to extend the federal preemption that federally chartered depository institutions enjoy related to adjustable rate mortgage loans to all qualifying financial institutions, including mortgage banking companies. However, on September 25, 2002, the OTS released a new rule that reduced the scope of the Parity Act preemption and, as a result, we are no longer able to rely on the Parity Act to preempt state restrictions on prepayment charges. The effective date of the new rule was July 1, 2003. In July 2004, the U.S. Court of Appeals for the District of Columbia upheld the OTS action withdrawing its Parity Act regulations and, as a result, non-federal housing creditors are subject to state law concerning prepayment and late fees. The elimination of this federal preemption requires us to comply with state restrictions on prepayment charges. These restrictions prohibit us from making any prepayment charge in certain states and restrict the amount and duration of prepayment charges that we may impose in other states. This may place us at a competitive disadvantage relative to certain state and federally chartered depository institutions that will continue to enjoy federal preemption of such state restrictions. Such institutions may still impose prepayment charges without regard to state restrictions and, as a result, may be able to offer mortgage loans with interest rate and loan fee structures that are more attractive than the interest rate and loan fee structures that we are able to offer. This competitive disadvantage could have a material adverse effect on our results of operations, financial condition and business.

If many of our borrowers become subject to the Servicemembers Civil Relief Act of 2003, our cash flows and interest income may be adversely affected.

Under the Servicemembers Civil Relief Act of 2003, which re-enacted the Soldiers’ and Sailors’ Civil Relief Act of 1940, a borrower who enters military service after the origination of his or her mortgage loan generally may not be required to pay interest above an annual rate of 6%, and the lender is restricted from exercising certain enforcement remedies, during the period of the borrower’s active duty status. This act also applies to a borrower who was on reserve status and is called to active duty after origination of the mortgage

loan. In view of the large number of U.S. Armed Forces personnel on active duty and likely to be on active duty in the future, our compliance with this act could reduce our cash flow and the interest payments collected from those borrowers, and in the event of default, delay or prevent us from exercising the remedies for default that otherwise would be available to us.

We are exposed to environmental liabilities with respect to properties to which we take title.

In the course of our business, we may foreclose and take title to residential properties, and, if we do take title, we could be subject to environmental liabilities with respect to these properties. The laws and regulations related to environmental contamination often impose liability without regard to responsibility for the contamination. We may be liable to a governmental entity or third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business, financial condition and results of operations could be materially and adversely affected.

Tax Risks of our Business and Structure

Our ownership limitation may restrict change of control or business combination opportunities in which our shareholders might receive a premium for their shares.

In order for us to qualify as a REIT, no more than 50% in value of our outstanding capital stock may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year. “Individuals” include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts. In order to preserve our REIT status, our amended and restated articles of incorporation generally prohibit any shareholder from directly or indirectly owning more than 9.9% of any class or series of our outstanding common stock or preferred stock.

The ownership limitation could have the effect of discouraging a takeover or other transaction in which holders of our common stock might receive a premium for their shares over the then prevailing market price or which holders might believe to be otherwise in their best interests.

U.S. federal income tax requirements may restrict our operations, which could restrict our ability to take advantage of attractive investment opportunities, which could negatively affect the cash available for distribution to our shareholders.

We intend to continue to operate in a manner that is intended to cause us to qualify as a REIT for U.S. federal income tax purposes. However, the U.S. federal income tax laws governing REITs are extremely complex, and interpretations of the U.S. federal income tax laws governing qualification as a REIT are limited. Qualifying as a REIT requires us to meet various tests regarding the nature of our assets and our income, the ownership of our outstanding stock, and the amount of our distributions on an ongoing basis. In some instances, compliance with these tests may not be completely within our control. For example, some of our investments are in equity securities of other REITs, which generally are qualifying assets and produce qualifying income for purposes of the REIT qualification tests. The failure of the REITs in which we invest to maintain their REIT status, however, could jeopardize our REIT status. Accordingly, we cannot be certain that we will be successful in operating so as to qualify as a REIT.

At any time, new laws, interpretations, or court decisions may change the federal tax laws regarding, or the U.S. federal income tax consequences of, qualification as a REIT. In addition, compliance with the REIT

qualification tests could restrict our ability to take advantage of attractive investment opportunities in non-qualifying assets, which would negatively affect the cash available for distribution to our shareholders. For example, we may be required to limit our investment in non-REIT equity securities and mezzanine loans to the extent that such loans are not secured by real property.

Our ownership of and relationship with our taxable REIT subsidiaries will be limited and a failure to comply with the limits would jeopardize our REIT status and may result in the application of a 100% excise tax.

A REIT may own up to 100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT subsidiary may earn income that would not be qualifying income if earned directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a taxable REIT subsidiary. A corporation of which a taxable REIT subsidiary directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a taxable REIT subsidiary. Overall, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more taxable REIT subsidiaries. A taxable REIT subsidiary will pay income tax at regular corporate rates on any income that it earns. In addition, the taxable REIT subsidiary rules limit the deductibility of interest paid or accrued by a taxable REIT subsidiary to its parent REIT to assure that the taxable REIT subsidiary is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a taxable REIT subsidiary and its parent REIT that are not conducted on an arm’s-length basis.

All of our operating businesses are conducted through taxable REIT subsidiaries. Our taxable REIT subsidiaries pay corporate income tax on their taxable income, and their after-tax net income is available for distribution to us but is not required to be distributed to us.

The aggregate value of the taxable REIT subsidiary stock and securities currently owned by us is significantly less than 20% of the value of our total assets (including the taxable REIT subsidiary stock and securities). Furthermore, we will monitor the value of our investments in our taxable REIT subsidiaries for the purpose of ensuring compliance with the rule that no more than 20% of the value of our assets may consist of taxable REIT subsidiary stock and securities (which is applied at the end of each calendar quarter). In addition, we will scrutinize all of our transactions with our taxable REIT subsidiaries for the purpose of ensuring that they are entered into on arm’s-length terms in order to avoid incurring the 100% excise tax described above. There can be no complete assurance, however, that we will be able to comply with the 20% limitation on ownership of taxable REIT subsidiary stock and securities on an ongoing basis so as to maintain REIT status or to avoid application of the 100% excise tax imposed on certain non-arm’s-length transactions.

Failure to make required distributions would subject us to tax, which would reduce the cash available for distribution to our shareholders.

In order to qualify as a REIT, an entity must distribute to its shareholders, each calendar year, at least 90% of its taxable income, other than any net capital gain and excluding any retained earnings of taxable REIT subsidiaries. To the extent that a REIT satisfies the 90% distribution requirement, but distributes less than 100% of its taxable income, it will be subject to federal corporate income tax on its undistributed income. In addition, the REIT will incur a 4% nondeductible excise tax on the amount, if any, by which its distributions in any calendar year are less than the sum of:

•

85% of its ordinary income for that year;

•

95% of its capital gain net income for that year; and

•

100% of its undistributed taxable income from prior years.

We intend to continue to pay out our REIT taxable income to our shareholders in a manner intended to satisfy the 90% distribution requirement and to avoid both corporate income tax and the 4% excise tax. However, there is no requirement that taxable REIT subsidiaries distribute their after-tax net income to their parent REIT or their shareholders and our taxable REIT subsidiaries may elect not to make any distributions to us.

Our taxable income may substantially exceed our net income as determined based on generally accepted accounting principles because, for example, capital losses will be deducted in determining our GAAP income, but may not be deductible in computing our taxable income. In addition, we may invest in assets that generate taxable income in excess of economic income or in advance of the corresponding cash flow from the assets, referred to as phantom income. Although some types of phantom income are excluded in determining the 90% distribution requirement, we will incur corporate income tax and the 4% excise tax with respect to any phantom income items if we do not distribute those items on an annual basis. As a result of the foregoing, we may generate less cash flow than taxable income in a particular year. In that event, we may be required to use cash reserves, incur debt, or liquidate non-cash assets at rates or times that we regard as unfavorable in order to satisfy the distribution requirement and to avoid corporate income tax and the 4% excise tax in that year.

Failure to qualify as a REIT would subject us to U.S. federal income tax, which would reduce the cash available for distribution to our shareholders.

If we fail to qualify as a REIT in any calendar year, we would be required to pay U.S. federal income tax on our taxable income. We might need to borrow money or sell assets in order to pay that tax. Our payment of income tax would decrease the amount of our income available for distribution to our shareholders. Furthermore, if we cease to be a REIT, we no longer would be required to distribute substantially all of our taxable income to our shareholders. Unless our failure to qualify as a REIT were excused under federal tax laws, we could not re-elect REIT status until the fifth calendar year following the year in which we failed to qualify.

The requirement that we distribute at least 90% of our taxable income to our shareholders, other than net capital gains and excluding the retained earnings of our taxable REIT subsidiaries, each year will result in our shareholders receiving periodic taxable distributions.

In order to qualify as a REIT, we must distribute to our shareholders, each calendar year, at least 90% of our taxable income; other than net capital gains and excluding the taxable income of our taxable REIT subsidiaries. As a result, our shareholders receive periodic distributions from us. These distributions generally are taxable as ordinary income to the extent that they are made out of our current or accumulated earnings and profits. Our ordinary REIT dividends generally are not eligible for the reduced tax rates applicable to dividends paid by regular C corporations.

A sale of assets acquired from FBR Group within ten years after the merger would result in corporate income tax, which would reduce the cash available for distribution to our shareholders.

If we sell any asset that we acquired from FBR Group, including the stock and securities of certain of our taxable REIT subsidiaries, within ten years after the merger and recognize a taxable gain on the sale, we will be taxed at the highest corporate rate on an amount equal to the lesser of:

•

the amount of gain that we recognize at the time of the sale; or

•

the amount of gain that we would have recognized if we had sold the asset at the time of the merger for its then fair market value.

This rule potentially could inhibit us from selling assets acquired from FBR Group within ten years after the merger.

We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of our common stock.

The federal income tax laws governing REITs or the administrative interpretations of those laws may be amended at any time. Any of those new laws or interpretations may take effect retroactively and could adversely affect us or you as a shareholder.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

Our principal executive offices are located at Potomac Tower, 1001 Nineteenth Street North, Arlington, Virginia 22209. We carry out aspects of all of our business segments at that location. We lease more than nine floors of our headquarters building and at an adjacent property in Arlington, Virginia, totaling approximately 158,854 square feet. We also lease offices in the following locations and conduct certain portions of our business segments in those locations as indicated: Boston, Massachusetts (capital markets and asset management); Dallas, Texas (capital markets); Herndon, Virginia (operations); Houston, Texas (capital markets); Irvine, California (capital markets); New York, New York (capital markets); Phoenix, Arizona (asset management); Reston, Virginia; San Francisco, California (capital markets); and London, England (capital markets). We lease approximately 92,639 total square feet in these other offices. Our First NLC subsidiary leases executive offices in Deerfield Beach, Florida and also leases office space in approximately 78 other locations throughout the United States, totaling approximately 554,316 total square feet. We believe that our present facilities, together with current options to extend lease terms and occupy additional space, are adequate for our current and presently projected needs.

ITEM 3. LEGAL PROCEEDINGS

Except as described below, as of December 31, 2006, we were not a defendant or plaintiff in any lawsuits or arbitrations that are expected to have a material adverse effect on our financial condition or statements of operations. We are a defendant in a small number of civil lawsuits and arbitrations (together, litigation) relating to our various businesses.

There can be no assurance that these matters individually or in the aggregate will not have a material adverse effect on our financial condition or results of operations in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial conditions or results of operations.

Many aspects of our business involve substantial risks of liability and litigation. Underwriters, broker-dealers, investment advisors and mortgage originators are exposed to liability under federal and state securities laws, other federal and state statutes and court decisions, including decisions with respect to underwriters’ liability and limitations on indemnification, as well as with respect to the handling of customer accounts. For example, underwriters may be held liable for material misstatements or omissions of fact in a prospectus used in connection with the securities being offered and broker-dealers may be held liable for statements made by their securities analysts or other personnel. In certain circumstances, broker-dealers and asset managers may also be held liable by customers and clients for losses sustained on investments. In recent years, there has been an increasing incidence of litigation and actions by government agencies and SROs involving the securities industry, including class actions that seek substantial damages. We are also subject to the risk of litigation, including litigation that may be without merit. As we intend to actively defend such litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against the Company could materially affect the Company’s operating results and financial condition. Pursuant to the corporate agreement that we entered into with FBR Capital Markets upon completion of the FBR Capital Markets 2006 private offering, we have agreed to indemnify FBR Capital Markets against claims related to the businesses contributed to FBR Capital Markets prior to the completion of the FBR Capital Markets 2006 private offering and that arise out of actions or events that occurred prior to that offering.

Regulatory Investigations

On December 20, 2006, the SEC and the NASD accepted settlement offers made by FBR & Co. with respect to alleged violations relating to FBR & Co.’s trading in a company account and the offering of a private investment in public equity on behalf of CompuDyne, Inc, in October 2001.

In the SEC settlement, FBR & Co., without admitting or denying any wrongdoing, proposed to pay disgorgement, civil penalties and interest totaling approximately $3.7 million and to consent to the entry of a permanent injunction with respect to violations of the antifraud provisions of the federal securities laws. FBR & Co. also agreed to consent to an administrative proceeding under Section 15(b) of the Exchange Act in which FBR & Co. would be subjected to a censure and agreed to certain additional undertakings, including review by an independent consultant of its Chinese Wall procedures and the implementation of any recommended improvements. In the parallel NASD settlement, FBR & Co. agreed to the same undertakings provided for in the SEC settlement approved by the staff of the Division of Enforcement of the SEC, including agreeing to an independent consultant to review its Chinese Wall procedures and implementing any recommended improvements, and also agreed pay a fine of $4.0 million to NASD.

One of our investment adviser subsidiaries, Money Management Associates, Inc., or MMA, is involved in an investigation by the SEC with regard to the adequacy of disclosure of risks concerning the strategy of a sub-advisor to a now-closed bond fund. The SEC staff has advised MMA that it is considering recommending that the SEC bring a civil action and/or institute public administrative proceeding against MMA and one of its officers (who is not one of our officers) for violating and/or aiding and abetting violations of the federal securities laws. MMA and its officer have made a Wells submission and, if necessary, intend to defend vigorously any charges brought by the SEC. Based on management’s review with counsel, resolution of this matter is not expected to have a material adverse effect on our financial condition or results of operations. It is possible that the SEC may initiate proceedings as a result of its investigations, and any such proceedings could result in adverse judgments, injunctions, fines, penalties or other relief against MMA or one or more of its officers or employees.

Putative Class Action Securities Lawsuits

The Company and certain current and former senior officers and directors have been named in a series of putative class action securities lawsuits filed in the second quarter of 2005, all of which are pending in the United States District Court for the Southern District of New York. These cases have been consolidated under the name In re FBR Inc. Securities Litig. A consolidated amended complaint has been filed asserting claims under the Securities Exchange Act of 1934 and alleging misstatements and omissions concerning (i) the SEC and NASD investigations described below relating to FBR & Co.’s involvement in the private investment in public equity on behalf of CompuDyne, Inc. in October 2001 and (ii) the alleged conduct of FBR and certain FBR officers and employees in allegedly facilitating certain sales of CompuDyne shares. The Company is contesting these lawsuits vigorously, but the Company cannot predict the likely outcome of these lawsuits or their likely impact on the Company at this time.

Shareholders’ Derivative Action

Our company has been named a nominal defendant, and certain current and former senior officers and directors have been named as defendants, in three shareholders’ derivative actions. Two of these actions, brought by Lemon Bay Partners LLC and Walter Boyle, are pending in the United States District Court for the Southern District of New York. The third, brought by Gary Walter and Harry Goodstadt, has been filed in the Circuit Court for Arlington County, Virginia. All three cases claim that certain of our current and former officers and directors breached their duties to our company based on allegations substantially similar to those in the Weiss et al. putative class action lawsuits described above. We have not responded to any of these complaints and no discovery has commenced. We cannot predict the likely outcome of this action or its likely impact on us at this time. Our board of directors has established a special committee whose jurisdiction includes the Boyle and Walter/Goodstadt matters as well as consideration of shareholder demand letters which contain similar allegations, and the special committee has been authorized to make final decisions whether such litigation is in the company’s best interests.

We have agreed to indemnify FBR Capital Markets against all claims related to this lawsuit.

Other Litigation

Our subsidiary First NLC Financial Services, LLC (“First NLC), has been named in a putative class action in the U.S. District Court for the Northern District of Illinois (Cerda v. First NLC Financial Services, LLC), which alleges violations of the Fair Credit Reporting Act, 15 U.S.C. § 1681 et seq. First NLC is contesting this lawsuit vigorously, but we cannot predict the likely outcome of this lawsuit or the likely impact on First NLC or on us at this time.

Our subsidiary, First NLC Financial Services, LLC (“First NLC”), has been named in a putative class action in the U.S. District Court for the Northern District of California (Stanfield, et al. v. First NLC Financial Services, LLC, Case No. C 06-3892 SBA). The complaint was brought on behalf of former and current First NLC employees who worked as loan officers, loan processors, and account managers, for alleged violations of the Fair Labor Standards Act. The complaint also alleges violations of California wage and hour laws, including claims for Unfair Competition, waiting-time penalties, and damages for missed meal and rest periods under California law. The court granted conditional class certification on November 1, 2006 for violations of the Fair Labor Standards Act and ordered circulation of a notice about the case on December 5, 2006. First NLC denies plaintiffs’ allegations in their entirety and intends to vigorously defend itself. This litigation is in its preliminary stages and the outcome of these types of cases is highly fact specific. We therefore cannot predict the likely outcome of this lawsuit or the likely impact on First NLC or on us at this time. We are aware that the number of cases involving alleged violations of the FSLA and state wage and hour laws have recently increased in the financial services industry and that a certain number of judgments and settlements involving these claims have already occurred.

Alleging claims similar to those in Stanfield, a group of plaintiffs who work (or worked) for First NLC as “funders” filed suit in the U.S. District Court for the Central District of California on January 30, 2007 (Sparrow-Milrot, et al. v. First NLC Financial Services, LLC, Case No. SA CV 07-0119 AHS RCX). Plaintiffs have not obtained class or collective action certification and First NLC has not answered the complaint. First NLC denies plaintiffs’ allegations in their entirety and intends to vigorously defend itself, but we cannot predict the likely outcome of this lawsuit or the likely impact on First NLC or on us at this time.

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

None.

PART II

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

Our Class A common stock is listed on the New York Stock Exchange under the symbol “FBR.” The following table shows the high and low sales prices of our Class A common stock during each fiscal quarter during the years ended December 31, 2006 and 2005, and the cash distributions per share declared during those periods.


	Price Range of Class A Common Stock				Cash Distributions Declared Per Share of Class A Common Stock
	High		Low
Year Ended December 31, 2006
Fourth Quarter	$	8.58	$	6.95	$	0.05
Third Quarter		11.39		7.70		0.05
Second Quarter		12.07		8.70		0.20
First Quarter		11.99		8.95		0.20
Year Ended December 31, 2005
Fourth Quarter	$	11.35	$	8.37	$	0.20
Third Quarter		15.35		9.64		0.34
Second Quarter		16.23		10.46		0.34
First Quarter		20.35		15.17		0.34

On January 31, 2007, there were approximately 380 record holders of our Class A common stock, including shares held in “street name” by nominees who are record holders.

There is no established public trading market for our Class B common stock and on January 31, 2007, there were approximately 29 record holders of our Class B common stock. Class B shares receive dividends in the same amounts and on the same dates as Class A shares.

Information regarding securities authorized for issuance under our equity compensation plans as of December 31, 2006 will be incorporated by reference from our annual proxy statement (under the heading “Security Ownership of Certain Beneficial Owners and Management”) to be filed with respect to our Annual Meeting of Shareholders to be held on or about June 7, 2007.

We intend to make regular quarterly distributions to our Class A and Class B stockholders. There can be no assurance that we will be able to make or sustain dividend payments in the future.

In order to qualify as a REIT for federal income tax purposes, we must distribute to our stockholders with respect to each year at least 90% of our taxable income. Although we generally intend to distribute to our shareholders each year an amount equal to our taxable income for that year, distributions paid by us will be at the discretion of our board of directors and will depend on our actual cash flow, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code and other factors our board of directors deems relevant.

We did not repurchase any shares of our Class A common stock or Class B common stock in 2006 and 2005.

The following graph compares the change in the cumulative total shareholder return for the Company’s Class A common stock from December 31, 2001 to December 31, 2006 with the comparable cumulative return of two indexes: the Standard & Poors (“S&P”) 500 Stock Index and the FSA Mid-Cap Index published by Financial Service Analytics, Inc.

The Company’s Class A common stock trades on the New York Stock Exchange. The graph assumes $100 invested on December 31, 2001 in the Company’s Class A common stock and $100 invested at the same time in each of the above mentioned indexes. The comparison assumes that all dividends are reinvested.

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

Inc., the S&P 500 Index and the FSA Mid-Cap Index

LOGO


	FBR Prices⁽¹⁾		FBR Indexed		FSA Mid-Cap		S&P 500 Indexed
Dec-01	$	5.19	$	100	$	100	$	100
Dec-02		9.36		180		97		78
Dec-03		23.08		476		159		100
Dec-04		19.39		430		186		111
Dec-05		9.90		245		196		117
Dec-06		8.00		211		247		135

(1)	Closing price of the Company’s Class A common stock on the NYSE on December 31 of the indicated year.

ITEM 6.

SELECTED CONSOLIDATED FINANCIAL DATA

SELECTED CONSOLIDATED FINANCIAL INFORMATION

(Dollars in thousands, except per share amounts)


	Year Ended December 31,
	2006			2005			2004		2003		2002
Consolidated Statements of Operations
Revenues:
Investment banking:
Capital Raising	$	190,187		$	356,753		$	398,183	$	246,567	$	115,407
Advisory		24,148			17,759			30,115		14,815		19,744

		214,335			374,512			428,298		261,382		135,151

Institutional brokerage:
Principal transactions		5,814			17,950			20,444		23,965		27,512
Agency commissions		101,009			82,778			89,650		50,178		35,672
Mortgage trading interest		51,147			30,859			—		—		—
Mortgage trading net investment loss		(3,301	)		(3,820	)		—		—		—

		154,669			127,767			110,094		74,143		63,184

Asset management:
Base management fees		20,093			30,348			28,307		24,782		28,956
Incentive allocations and fees		1,327			1,929			10,940		13,959		13,884

		21,420			32,277			39,247		38,741		42,840

Principal investment:
Interest		594,879			549,832			350,691		168,393		—
Net investment (loss) income		(184,552	)		(239,754	)		101,973		70,619		19,753
Dividends		14,551			36,622			14,644		4,078		—

		424,878			346,700			467,308		243,090		19,753

Mortgage Banking:
Interest		88,662			78,007			—		—		—
Net investment income		83,786			13,741			—		—		—

		172,448			91,748			—		—		—

Other		20,154			22,302			7,155		11,169		7,275

Total revenues		1,007,904			995,306			1,052,102		628,525		268,203

Interest expense		611,800			546,313			164,156		68,995		2,073
Provision for loan losses		15,740			14,291			—		—		—

Revenues, net of interest expense and provision for loan losses		380,364			434,702			887,946		559,530		266,130

Non-Interest Expenses:
Compensation and benefits		309,065			331,492			323,524		226,389		147,072
Professional services		59,722			66,550			50,467		21,628		17,140
Business development		42,150			46,648			44,955		21,416		13,449
Clearing and brokerage fees		11,820			8,882			9,123		7,014		5,353
Occupancy and equipment		50,051			34,044			14,458		9,585		8,838
Communications		24,398			20,634			13,959		10,574		8,185
Other operating expenses		89,377			70,679			22,740		16,919		10,652

Total non-interest expenses		586,583			578,929			479,226		313,525		210,689

Operating (loss) income		(206,219	)		(144,227	)		408,720		246,005		55,441
Other Income:
Gain on sale of subsidiary shares		121,511			—			—		—		—

Net (loss) income before taxes, minority interest & extraordinary gain		(84,708	)		(144,227	)		408,720		246,005		55,441
Income tax (benefit) provision		(14,682	)		26,683			59,161		44,591		3,035
Minority interest in loss of consolidated subsidiary		(2,751	)		—			—		—		—

Net (loss) income before extraordinary gain		(67,275	)		(170,910	)		349,559		201,414		52,406
Extraordinary gain		—			—			—		—		1,413
Income tax provision on extraordinary gain		—			—			—		—		536

Net (loss) income	$	(67,275	)	$	(170,910	)	$	349,559	$	201,414	$	53,283


	Year Ended December 31,
	2006			2005			2004			2003			2002
Consolidated Balance Sheet Data
Assets:
Cash and cash equivalents	$	189,956		$	238,615		$	224,371		$	92,688		$	90,007
Restricted cash		132			6,101			7,156			—			—
Mortgage-backed securities, at fair value		6,870,661			8,002,561			11,726,689			10,551,570			—
Loans held for investment, net		—			6,841,266			—			—			—
Loans held for sale, net		5,367,934			963,807			—			—			—
Long-term investments		185,492			347,644			441,499			379,002			150,447
Reverse repurchase agreements		—			283,824			183,375			—			—
Trading securities, at fair value		18,180			1,032,638			7,744			4,932			8,298
Other		720,163			719,334			337,454			300,893			157,433

Total assets	$	13,352,518		$	18,435,790		$	12,928,288		$	11,329,085		$	406,185

Liabilities:
Trading account securities sold but not yet purchased, at fair value	$	202		$	150,547		$	17,176		$	9,525		$	19,932
Commercial paper		3,971,389			6,996,950			7,294,949			4,392,965			—
Repurchase agreements		3,059,330			2,698,619			3,467,569			5,095,676			16,352
Dividends payable		8,743			34,588			65,870			56,744			—
Accounts payable and other liabilities		195,867			284,032			375,830			165,647			119,470
Securitization financing, net		4,486,046			6,642,198			—			—			—
Long-term debt		324,453			324,686			128,370			54,189			5,266

Total liabilities		12,046,030			17,131,620			11,349,764			9,774,746			161,020

Minority interest		135,443			—			—			—			—
Shareholders’ equity		1,171,045			1,304,170			1,578,524			1,554,339			245,165

Total liabilities and shareholders’ equity	$	13,352,518		$	18,435,790		$	12,928,288		$	11,329,085		$	406,185

Statistical Data
Basic (loss) earnings per share before extraordinary gain	$	(0.39	)	$	(1.01	)	$	2.09		$	1.68		$	1.14
Diluted (loss) earnings per share before extraordinary gain	$	(0.39	)	$	(1.01	)	$	2.07		$	1.63		$	1.08
Basic (loss) earnings per share	$	(0.39	)	$	(1.01	)	$	2.09		$	1.68		$	1.16
Diluted (loss) earnings per share	$	(0.39	)	$	(1.01	)	$	2.07		$	1.63		$	1.10
Book value per share(1)	$	6.78	(2)	$	7.66	(2)	$	9.46	(2)	$	9.41	(2)	$	5.28	(2)
Total employees(1)		3,019			2,499			698			494			481
Net revenue per employee(3)	$	137		$	188		$	1,399		$	1,138		$	581
Pre-tax return on average equity		(7	)%		(10	)%		26	%		27	%		26	%
Compensation and benefits expense as a percentage of net revenues		81	%		76	%		36	%		40	%		55	%
Basic weighted average shares outstanding (in thousands)		171,667			169,333			167,099			119,801			46,098
Diluted weighted average shares outstanding (in thousands)		171,667			169,333			168,490			123,307			48,442
Cash dividends per common share	$	0.50		$	1.22		$	1.53		$	1.36		$	—

(1)	As of end of the period reported.

(2)	Excludes employee stock and purchase loan receivable shares of 1.6 thousand shares, 0.6 million shares, 0.7 million shares, 1.3 million shares, and 4.0 million shares, pledged as collateral as of December 31, 2006, 2005, 2004, 2003, and 2002, respectively.

(3)	Net revenue per employee is calculated by dividing net revenue by average employees for the year. Average employees is determined by average of quarter end headcounts.

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Friedman, Billings, Ramsey Group, Inc. is a leading investment banking firm that provides investment banking, institutional brokerage and asset management services and invests as principal in mortgages and mortgage securities (MBS) and merchant banking investments. Additionally, the Company owns First NLC Financial Services, LLC (First NLC), a non-conforming residential mortgage loan originator. When we use the terms “FBR,” “we” “us” “our” and “the Company,” we mean Friedman, Billings, Ramsey Group, Inc. and its consolidated subsidiaries. We conduct most of our principal investing activities at the parent company level, which has elected Real Estate Investment Trust (REIT) status for U.S. federal income tax purposes and through a qualified REIT subsidiary (QRS) of the parent company (Principal Investing). We conduct our investment banking and institutional brokerage activities (Capital Markets), investment management and advisory activities (Asset Management) and loan origination and mortgage banking activities (Mortgage Banking) in taxable REIT subsidiaries. Our Company operates primarily in the United States and Europe.

Executive Summary

For the year ended December 31, 2006, FBR’s total revenues net of interest expense and loan loss provisions were $380.4 million compared to $434.7 million in 2005. The 2006 net loss of $67.3 million, or $0.39 per share, compares to a net loss of $170.9 million, or $1.01 per share in 2005.

The 2006 net loss is primarily due to our decision as of September 30, 2006, to reclassify the mortgage loan portfolio, which consists primarily of non-conforming mortgage loans, held at the REIT from held for investment to held for sale. As a result of this change, we recorded our investment in this portfolio at the lower of cost or market, and consequently recognized $149.8 million in write-downs in 2006. The change in intent is primarily based on the strategy to redeploy the capital invested in the portfolio more rapidly to investments with higher earnings potential than if the portfolio were held to maturity.

In addition, in 2006, we recognized other-than-temporary impairment write-downs of $79.7 million relating to certain investments in our merchant banking investment portfolio. These impairment losses are primarily related to equity investments in the non-conforming mortgage sector reflecting a continued decline in this sector during 2006. The decrease in operating income also reflects a significant reduction in capital raising revenues in 2006 as compared to 2005, consistent with the industry’s relatively low volume of new equity issues as well as reductions in dividends from principal investing activities and asset management fees.

These operating results for the year ended December 31, 2006 compare to operating results for the year ended December 31, 2005 which included a write-down in our mortgage-backed securities portfolio of $180.1 million, net of hedging gains, and a separate write-down of certain equity investments in the Company’s merchant banking portfolio of $74.5 million. The 2005 MBS portfolio write-down reflected the Company’s decision to reposition the portfolio to eliminate a negative spread on much of the portfolio. During 2006, in connection with this repositioning, the Company sold $7.6 billion of securities from the portfolio held at December 31, 2005. Subsequent to these sales, during 2006, the Company reinvested capital to the MBS portfolio and entered into hedging transactions related to a portion of the borrowings that will be used to finance these investments. As of December 31, 2006, we maintain a MBS portfolio at the REIT with a fair value of $6.5 billion.

The Company’s net loss for year ended December 31, 2006 includes a $121.5 million gain recorded as a result of the July 2006 share issuance by FBR Capital Markets, a holding company for the Company’s capital markets and asset management operations formed in the second quarter 2006. This gain represents the increase in value of the Company’s investment in FBR Capital Markets as a result of the share issuance and, based on the structure of the transaction, this gain was not taxable. Subsequent to the share issuance and as of December 31, 2006, the Company retained a 71.9% beneficial ownership interest in FBR Capital Markets.

In addition to the above, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). Pursuant to the provisions of SFAS 123R, we recorded $5.0 million of compensation expense related to such share-based payments during 2006. The net loss in 2006 also includes a $14.7 million tax benefit as compared to a $26.7 million income tax provision recorded in 2005. The 2006 tax benefit includes charges of $2.3 million to establish valuation reserves for certain deferred tax assets and a $2.3 million charge under SFAS 123R reflecting the effects of vesting during the year of certain share-based compensation awards.

For the year 2006, the Company declared a total of $0.50 per share in dividends, down from $1.22 per share in 2005. The Company’s book value per share decreased to $6.78 as of December 31, 2006 compared to $7.66 as of December 31, 2005. The reduction in book value per share reflects the impact from the net loss and dividends declared in 2006.

The following provides analysis of our operating segments and their activities during 2006.

Capital Markets

Our capital markets activities consist of investment banking and institutional brokerage (including research).

The operating income (loss) from our capital markets activities decreased from operating income of $79.7 million in 2005 to an operating loss of $34.4 million in 2006. This decrease is primarily attributable to a 43% or $160.2 million decrease in investment banking revenues during 2006, as a result of the Company completing fewer private equity placements and initial public offerings in 2006 as compared to 2005. This decrease reflects a lower volume of capital raising activity in our financial institutions and real estate sectors due primarily to the adverse effects of a continued inverted yield curve during 2006. Our institutional brokerage net revenues increased by 6% or $6.2 million which is primarily attributable to a 22% increase in agency commissions offset by a decrease in revenues from principal transactions. In addition, compensation and benefits costs within our capital markets segment decreased 14% or $33.9 million and other non-interest expenses in this segment decreased 15% or $25.8 million both primarily as result of the decreased capital markets revenues.

Investment Banking

Our investment banking activities consist of a broad range of services, including underwritings, public and private capital raising transactions that include a wide variety of securities, and financial advisory services in merger, acquisition, restructuring and strategic partnering transactions. Revenues from FBR’s investment banking operations totaled $214.3 million for the year, representing a decrease of 43% from the prior year. In 2006, FBR’s investment banking team executed 87 banking assignments with a total transaction value of over $16.1 billion, including more than $5.2 billion in lead-managed equity capital raising transactions. Highlights for lead-managed capital raises include:

•

$634.9 million in 4 IPOs

•

$ 3.1 billion in 15 (sole managed) private placements

•

$ 1.2 billion in 12 follow-on and secondary offerings

In addition, during 2006 FBR advised on 28 successful mergers, acquisitions and advisory transactions representing $400.5 million in aggregate transaction value.

FBR earned the following investment banking rankings for 2006¹:

•

#1 book-running manager of all common stock offerings for U.S. companies with a market capitalization of $1 billion or less,

•

#7 book-running manager for U.S. IPOs and 144A equity placements combined,

•

#1 book-running manager of all common stock offerings for domestic mining, oil and gas, utility and energy companies with a market capitalization of $1 billion or less, and

•

#1 book-running manager of all common stock offerings for U.S. and Bermuda finance and insurance companies with a market capitalization of $1 billion or less.

¹	Source: Dealogic

The following table shows details of our investment banking revenues for the years indicated (dollars in thousands):


	2006		2005		2004
Capital raising:
Institutional private equity placements	$	139,276	$	225,489	$	165,163
Initial public offerings		13,763		69,677		163,112
Secondary (follow-on) public offerings		35,010		50,511		55,876
High yield debt & preferred		122		2,822		10,674
Asset-backed securities		2,016		8,254		3,358

Total capital raising		190,187		356,753		398,183
Advisory services		24,148		17,759		30,115

Total investment banking	$	214,335	$	374,512	$	428,298

Institutional Brokerage

In addition to our investment banking activities, we also offer institutional brokerage services to customers. In a rapidly changing trading environment characterized by continuing pressure on commission rates, revenue from institutional brokerage (principal transactions and agency commissions) was up 6.1% on a year-to-year basis, increasing from $100.7 million in 2005 to $106.8 million in 2006.

In addition, in May 2005 we initiated certain fixed income trading activities, primarily related to mortgage-backed, asset-backed and other structured securities. These trading activities continued through October 2006. During the third quarter 2006, we made a decision to sell our trading positions and eliminate our MBS trading desk. At present, we do not expect to redeploy capital to this fixed income trading activity. Revenues, net of related interest expense related to institutional brokerage activities are (dollars in thousands):


	2006		2005		2004
Principal transactions	$	5,814	$	17,950	$	20,444
Agency commissions		101,009		82,778		89,650
Mortgage trading interest and net investment loss		47,846		27,039		—

		154,669		127,767		110,094
Interest expense		44,472		23,743		—

Institutional brokerage revenues, net of interest expense	$	110,197	$	104,024	$	110,094

Our investment banking and institutional brokerage businesses are focused in the consumer, diversified industrials, energy and natural resources, financial institutions, healthcare, insurance, real estate and technology sectors. Historically, we have focused on small and mid-cap stocks, although our research coverage and

associated brokerage activities increasingly involve larger-cap stocks. By their nature, our business activities are highly competitive and are not only subject to general market conditions, volatile trading markets, and fluctuations in the volume of market activity, but also to the conditions affecting the companies and markets in our areas of focus. As a result, our capital markets revenues and profits can be subject to significant volatility from period to period.

Asset Management

Our asset management activities consist of managing a broad range of pooled investment vehicles, including mutual funds, hedge funds, venture capital and private equity funds and separate accounts. Our total net assets under management were $2.4 billion at both December 31, 2006 and 2005. However, the mix of net assets changed during 2006 with hedge and offshore funds decreasing during 2006 based on fund closures and equity mutual funds increasing based on fund performance.

The operating loss from our asset management activities increased from an operating loss of $1.4 million in 2005 to an operating loss of $11.1 million in 2006. The increase in operating loss is primarily attributable to a decrease in net revenues of 25% or $9.0 million during 2006 as a result of a decrease in average assets under management during 2006 as compared to 2005 and the fees earned from those assets. The decrease in the average assets under management related principally to the closure of six hedge and offshore funds during 2005 and 2006.

We generate fees from our asset management activity for services provided in the management of investment vehicles or accounts and administration of mutual funds. Base management fees are earned on our net assets under management and are determined based on a percentage of actual or committed capital, excluding, in some cases, our own direct investments and certain other affiliated capital. The percentages used to determine our base fee vary from vehicle to vehicle.

We recorded $20.1 million in base management fees (including mutual fund administrative fees) for the year ended December 31, 2006. Our annualized effective fee during the fourth quarter of 2006 on the year end net assets under management was 86 basis points.

The incentive allocations and gains (losses) in our managed investment partnerships are determined, in part, by the value of securities held by those partnerships. To the extent that these partnerships hold securities of public companies that are restricted as to resale due to contractual lock-ups, regulatory requirements (including Rule 144 holding periods), or for other reasons, these securities are generally valued by reference to the public market price, subject to discounts to reflect the restrictions on liquidity. These discounts are sometimes referred to as haircuts. As the restriction period runs, the amount of the discount is generally reduced. We review these valuations and discounts quarterly.

The following provides detail relating to our assets under management (dollars in millions):

Assets Under Management


	December 31, 2006
	Gross(1)		Net(2)
Managed accounts	$	259.9	$	259.9
Hedge and offshore funds		97.5		96.4
Mutual funds:
Equity		1,749.6		1,743.4
Fixed Income and money market		212.3		211.3
Private equity funds		42.2		40.5

Total	$	2,361.5	$	2,351.5


	December 31, 2005
	Gross(1)		Net(2)
Managed accounts	$	463.4	$	329.5
Hedge and offshore funds		154.3		150.5
Mutual funds:
Equity		1,585.5		1,576.2
Fixed income and money market		297.8		296.6
Private equity funds		56.2		46.8

Total	$	2,557.2	$	2,399.6

(1)	Gross assets under management represent the amount of actual gross assets of our proprietary investment partnerships and mutual funds including leverage.

(2)	Net assets under management represent gross assets under management, net of any repurchase agreement debt, margin loans, securities sold but not yet purchased, lines of credit, and any other liabilities.

Our asset management revenues and net income are subject to fluctuations due to a variety of factors that cannot be predicted with great certainty. These factors include the overall condition of the economy and the securities markets as a whole and the sectors on which we focus. This condition can in turn influence inflows and outflows of assets under management, and the performance of our asset management funds. For example, a significant portion of the performance-based or incentive revenues that we recognize from our hedge fund, venture capital and private equity activities is based on the value of securities held in the funds we manage. The value of these securities includes unrealized gains or losses that may change from one period to another.

Mortgage Banking

We conduct our mortgage banking activities primarily through our subsidiary First NLC, a residential mortgage banking company originating and acquiring primarily non-conforming mortgage loans in 45 states across the United States. We acquired First NLC during the first quarter of 2005 with the expectation that the acquisition would assist in expanding and adding flexibility to our mortgage loan business by providing the ability to originate, price, portfolio and sell non-conforming mortgage loans based on market conditions.

First NLC originates, underwrites and funds mortgage loans secured primarily by single-family residences, and then sells those loans to institutional loan purchasers or to our REIT subsidiary for our mortgage loan portfolio. Non-conforming mortgage loans include loans to borrowers who do not meet the conforming underwriting guidelines of Fannie Mae, Freddie Mac or Ginnie Mae because of higher loan-to-value ratios, the nature or absence of income documentation, limited credit histories, high levels of consumer debt, past credit

difficulties or other factors. Non-conforming loans also include loans to more creditworthy borrowers where the size of the loan exceeds conforming underwriting guidelines. First NLC originates loans based upon an assessment of the borrower’s willingness and ability to repay the loan and the adequacy of the collateral.

The operating loss from our mortgage banking segment decreased $15.1 million during 2006 from an operating loss of $33.3 million in 2005 to an operating loss of $18.2 million in 2006. The 2006 operating loss is primarily attributable to continued compression on loan sales premiums and an industry-wide increase in the numbers of loans required to be repurchased by originators due to early pay defaults during 2006. Since First NLC was purchased in mid-February 2005, 2006 results reflect a full year of activity as compared to 2005.

In contrast to the negative industry conditions, the Company has improved elements of its loan origination platform. In addition to increasing loan volume during 2006, the Company decreased direct loan origination costs by 53 basis points. Considering the increase in loan originations, net revenues from this segment increased by 114% or $60.0 million. Conversely, in order to support the increase in loan originations and reflecting a full year of expenses in 2006, non-interest expenses, primarily compensation and benefits and occupancy and equipment, increased by 52% or $44.9 million as compared to 2005.

During 2006, First NLC originated $7.2 billion of non-conforming mortgage loans through its wholesale and retail channels. First NLC’s wholesale channel originated 70% of total loan originations through approximately 5,300 brokers and its retail channel originated 26% of total loan originations through 70 branch offices in 28 states. During 2005, subsequent to our acquisition, First NLC originated $5.6 billion through its wholesale, retail and correspondent channels. First NLC’s wholesale channel originated 68% of total loan originations through approximately 3,900 brokers and its retail channel originated 20% of total loan originations through 45 branch offices located in 21 states. In April 2005, First NLC began acquiring loans through a newly created correspondent channel. During 2006, First NLC acquired $267 million of loans through this correspondent channel. This compares to $647 million of such loans acquired in 2005. As of January 2007, First NLC stopped acquiring loans through its correspondent division.

During 2006, First NLC sold $7.5 billion, including correspondent loans, through whole loan sales and recognized a gross gain from loan sale transactions, including the effects of hedging, of $158.5 million. After reducing the gross gain on sale by the repurchase and premium recapture provisions for losses and direct loan origination costs, net of fees earned, our mortgage banking activities generated a net gain on sale of $83.8 million, including lower of cost or market valuation allowances relating to certain loans held for sale that were acquired from third parties.

During 2005, First NLC sold $4.4 billion, including correspondent loans, through whole loan sales or securitization and recognized a gross gain from loan sale transactions of $89.3 million. After reducing the gross gain on sale by the repurchase and premium recapture provisions for losses and direct loan origination costs, net of fees earned, our mortgage banking activities generated a net gain on sale of $13.7 million, including lower of cost or market valuation allowances relating to certain loans held for sale that were acquired from third parties.

Principal Investing

Our principal investing activity consists primarily of investments in non-conforming mortgage loans, mortgage-backed securities, merchant banking investments and investments in hedge and venture funds.

We constantly evaluate the rates of return that can be achieved in each investment category and for each individual investment in which we participate. Historically, based on market conditions, our mortgage-backed securities investments have provided us with higher relative risk-adjusted rates of return than most other investment opportunities we have evaluated. Consequently, we have maintained a high allocation of our assets and capital in this sector.

We intend to continue to evaluate investment opportunities against the returns available in each of our investment alternatives and endeavor to allocate our assets and capital with an emphasis toward the highest risk-adjusted return available. This strategy may cause us to have different allocations of capital in different environments.

Non-conforming Mortgage Loans

As discussed previously, the Company made a determination to reclassify its held-for-investment mortgage loan portfolio held at the REIT to held-for-sale. As a result of this reclassification, the Company recognized a $149.8 million write-down in the value of these loans during 2006. The change in intent is primarily based on the strategy to redeploy the capital invested in that portfolio more rapidly to investments with higher earnings potential than if the portfolio were to held to maturity.

The revenues from the non-conforming mortgage loan portfolio are generated primarily from interest income. Interest expense we pay on the related funding source offsets the interest income. The Company recorded net interest income of $82.6 million from the non-conforming mortgage loans held at the REIT during 2006.

Loans held for sale at the REIT, net, were comprised of the following as of December 31, 2006 (dollars in thousands):


Principal balance	$	4,452,708
Valuation allowance for lower of cost or market value		(36,370	)

Loans held for sale, net	$	4,416,338

As of December 31, 2006, $4.5 billion of asset-backed debt securities is outstanding. The securities have a final maturity in 2035 and are callable at par once the total balance of the loans collateralizing the debt is reduced to a certain percentage of their respective original balances as defined in the securitization documents. The balance of the debt is reduced as the underlying loan collateral is paid down. The Company did not issue any new asset-backed debt securities during 2006.

Mortgage-Backed Securities

We also invest in agency-backed and, to a lesser extent, private-label MBS. Our MBS investment strategy is based on investing in hybrid-ARM mortgage-backed securities financed by short-term commercial paper and repurchase agreement borrowings. The Company recorded net interest income of $35.7 million from MBS held in our principal investment portfolio during 2006 compared to $26.1 million during 2005.

As a result of the Company’s decision in December 2005 to reposition its MBS portfolio to eliminate a negative interest spread that resulted in a recognition of $180.1 million in other-than-temporary impairment write-downs in 2005, during 2006, the Company sold $7.6 billion of securities from the portfolio the Company held at December 31, 2005. Subsequent to these sales, during 2006, the Company began to reinvest capital in the MBS portfolio and as of December 31, 2006, the fair value of our investments in mortgage-backed securities totaled $6.9 billion. These investments were primarily comprised of securities guaranteed as to principal and interest by Fannie Mae, Freddie Mac, or Ginnie Mae. The following table summarizes our portfolio of mortgage-backed securities (including principal receivable) by issuer (dollars in thousands).


	Face Amount		Fair Value
Agency-backed:
Fannie Mae	$	3,307,319	$	3,343,756
Freddie Mac		2,527,613		2,546,001
Ginnie Mae		36,253		35,949

Total		5,871,185		5,925,706
Private-label		937,193		944,955

Total	$	6,808,378	$	6,870,661

Merchant Banking

The total value of FBR’s merchant banking portfolio and other long-term investments was $185.5 million as of December 31, 2006. Of this total, $143.4 million was held in the merchant banking portfolio, $26.1 million was held in alternative asset funds, and $16.0 million was held in other long-term investments. Net unrealized gains in the merchant banking portfolio included in Accumulated Other Comprehensive Income (AOCI) totaled $7.8 million as of December 31, 2006.

As previously noted, during 2006, we recorded $79.7 million in other than temporary impairment write-downs on certain merchant banking investments. These write-downs were recorded as part of the Company’s quarterly assessments of unrealized losses in its portfolio of marketable equity securities for potential other than temporary impairments and its related assessment of cost method investments. We also recognized $34.7 million in realized gains and earned $14.6 million in dividend income. These amounts compare to $74.5 million of other than temporary impairment charges, $20.9 million of realized gains and $36.6 million dividend income in 2005.

The following table provides additional detail regarding the Company’s merchant banking investments as of December 31, 2006 (dollars in thousands):

Merchant Banking and Other Long-Term Investments


	December 31, 2006
Merchant Banking Investments	Shares	Cost/Adjusted Basis		Fair Value/ Carrying Value
Accredited Home Lenders	253,692	$	9,120	$	6,938
Amtrust Financial Services	2,558,994		16,749		21,879
Asset Capital Corporation, Inc.⁽¹⁾	948,766		7,500		7,500
Castlepoint Holdings⁽¹⁾	500,000		4,650		4,650
Cmet Finance Holdings, Inc.⁽¹⁾⁽²⁾	65,000		975		975
Cypress Holdings	537,604		5,000		5,000
ECC Capital⁽²⁾	3,940,110		4,807		4,689
Fieldstone Investment Corporation⁽²⁾	3,588,329		19,126		19,126
Government Properties Trust⁽²⁾	210,000		1,894		2,226
Horsehead Holdings⁽¹⁾	17,582		215		215
Legacy Reserves⁽¹⁾	619,133		9,894		9,894
NNN Realty Advisors⁽¹⁾	537,634		5,000		5,000
People’s Choice Financial Corporation⁽¹⁾⁽²⁾	3,500,000		7,000		7,000
Quanta Capital Holdings Ltd.⁽²⁾	2,870,620		5,282		6,172
RAIT Financial Trust	531,173		18,256		18,315
Specialty Underwriters Alliance, Inc.⁽²⁾	782,102		4,817		6,569
Vintage Wine Trust, Inc.⁽¹⁾	1,075,269		10,000		10,000
Whittier Energy Corporation	511,407		2,854		4,741
Preferred equity investment⁽¹⁾⁽²⁾			2,500		2,500

Total merchant banking investments		$	135,639	$	143,389
Investment funds					26,122
Other investments					3,359
Investment securities – marked to market					12,622

Total long-term investments				$	185,492

(1)	As of December 31, 2006 these shares cannot be traded in a public market (e.g., NYSE or Nasdaq) but may be sold in private transactions.

(2)	Cost/Adjusted basis reflects the effects of other than temporary impairment charges.

Results of Operations

Revenues

Our revenues consist primarily of capital raising and advisory fees in investment banking; agency commissions, principal transactions and mortgage trading interest and net investment income in institutional brokerage; base management fees and incentive allocations and fees in asset management; net interest income, net investment income, including realized gains or losses and other-than-temporary impairments, dividends from merchant banking investments and investment fund earnings from principal investing activities; and net interest income and net investment income, including gain or loss on sale of loans from mortgage banking activities.

Revenue from capital raising transactions is substantially dependent on the market for public and private offerings of equity and debt securities within the sectors in which we focus. Agency commissions are dependent on the level of overall market trading volume and penetration of our institutional client base by our research, sales and trading staff. Principal brokerage transactions are dependent on these same factors and on NASDAQ

trading volume and spreads in the securities of such companies; net trading gains and losses are dependent on the market performance of securities held, as well as our decisions as to the level of market exposure we accept in these securities. Asset management revenues are dependent on the level of the capital on which our base management fees are calculated and the amount and performance of capital on which we have the potential to generate incentive income. Our asset management vehicles are subject to market risk caused by illiquidity and volatility in the markets in which they would seek to sell financial instruments. Revenue earned from these activities, including unrealized gains that are included in the incentive income portion of our asset management revenues and in net investment income, may fluctuate as a result. Accordingly, our revenues in these areas have fluctuated in the past, and are likely to continue to fluctuate, based on these factors.

In our principal investing and mortgage banking activities, we invest in mortgage loans and mortgage-backed securities that are financed by repurchase agreement, commercial paper and securitization borrowings all of which are interest sensitive financial instruments. We are exposed to interest rate risk that fluctuates based on changes in the level or volatility of interest rates and mortgage prepayments and in the shape and slope of the yield curve. The Company attempts to hedge a portion of its exposure to rising interest rates through the use of various derivative instruments. For example, as of December 31, 2006, the Company’s Eurodollar futures contracts will be used to hedge short-term borrowings of up to $2.7 billion and $2.5 billion in 2007 and 2008, respectively. We are also exposed to credit risk as a result of our investments in mortgage loans. The Company manages credit risk by, among other things, purchasing or originating loans at favorable loan to value ratios and for a portion of the portfolio by purchasing mortgage insurance. As of December 31, 2006, we had purchased mortgage insurance on $635 million in principal balance of loans held for sale at the REIT.

Investment Banking

Capital raising revenue consists of underwriting discounts, selling concessions, management fees and reimbursed expenses associated with underwriting activities and 144A institutional equity placements. We act in varying capacities in our underwriting activities, which, based on the underlying economics of each transaction, determine our ultimate revenues from these activities. When we are engaged as lead-manager of an underwriting, we generally bear more risk and earn higher revenues than if engaged as a co-manager, an underwriter (syndicate member) or a broker-dealer included in the selling group.

Advisory revenue consists primarily of advisory fees and reimbursed expenses associated with such activities. Advisory fees have fluctuated in the past, and are likely to continue to fluctuate, based on the number and size of our completed transactions.

Institutional Brokerage

Principal transactions consist of a portion of dealer spreads attributed to the securities trading activities of FBR & Co. as principal in listed and other securities, and are primarily derived from FBR & Co.’s activities as a market-maker. Trading gains and losses on equity securities are combined and reported on a net basis as part of principal transactions. Gains and losses result primarily from market price fluctuations that occur while holding positions in FBR & Co.’s trading security inventory.

Agency commissions consist of revenue resulting from executing stock exchange-listed securities and other transactions as agent.

Mortgage trading activities include buying and selling mortgage-backed securities and other structured securities in various financial transactions (which may include forward trades, dollar rolls and reverse repurchase transactions). The Company manages market risk associated with these securities positions primarily through forward purchases and sales of such securities. These transactions result in interest income and net investment gain/loss.

Asset Management

We receive asset management revenue in our capacity as the investment manager to advisory clients, including our mutual funds, as general partner of several hedge, private equity and venture capital investment partnerships and as administrator to mutual funds. Management fees and incentive income on investment partnerships have been earned from entities that have invested primarily in the securities of companies engaged in the financial services, real estate and technology sectors. Incentive income is likely to fluctuate with the performance of securities in these sectors.

Principal Investing

Principal investing interest income relates to interest earned on our portfolio of mortgage-backed securities and mortgage loans. Net investment income primarily includes net realized gains on sale of equity securities and mortgage-backed securities, income from investments funds and derivative activities as well as lower of cost or market value adjustments on securitized mortgage loans held for sale and other than temporary write-downs of equity securities. Principal investing dividends relate to our portfolio of merchant banking investments.

As of December 31, 2006, we had $7.8 million of net unrealized gains related to merchant banking equity investments recorded in AOCI. If we liquidate these securities or determine that a decline in value of these investments below our cost basis is other-than-temporary, a portion or all of the gains or losses will be recognized as a gain or loss in the statement of operations during the period in which the liquidation or determination is made. Our investment portfolio is exposed to potential future downturns in the markets and private debt and equity securities are exposed to deterioration of credit quality, defaults, and downward valuations.

We record allocations for our proportionate share of the earnings or losses of the hedge, private equity and venture funds and other partnerships in which we have made investments. Income or loss allocations are recorded in net investment income in our statements of operations.

Net investment income also includes unrealized gains and losses on investments held at FBR & Co. In connection with certain capital raising transactions, we have received and hold warrants for the stock of the issuing companies, which are generally exercisable at the respective offering price of the transaction. Similarly, we may receive and hold shares of the issuing companies. For restricted warrants and shares, including private Company warrants and shares, we carry the securities at fair value based on internal valuation models and estimates made by management. Due to the restrictions on the warrants and the underlying securities, and the subjectivity of these valuations, these warrants may have nominal values. We value warrants to purchase publicly traded stocks, where the restriction periods have lapsed, using an option valuation model.

Mortgage Banking

Mortgage banking revenue includes net interest income on loans held for sale at First NLC as well as net investment income, consisting primarily of net gains and losses on sales of mortgage loans by First NLC. Our mortgage banking revenue is highly dependent on conditions in the residential mortgage market. Recent industry-wide increases in delinquencies and losses with respect to residential mortgage loans, particularly in the non-prime sector, may negatively impact our mortgage banking revenue and could adversely affect our operating results.

Other Revenue

Other revenue primarily includes miscellaneous interest, dividends and fees.

Expenses

Interest expense includes the costs of our repurchase agreement borrowings, commercial paper borrowings, and securitization financing as well as long-term debt securities we have issued. Interest expense also includes costs of subordinated credit lines, bank deposits and other financing.

Compensation and benefits expense includes base salaries as well as incentive compensation. Incentive compensation varies primarily based on revenue production and net income. Salaries, payroll taxes and employee benefits are relatively fixed in nature. In addition, compensation and benefits includes non-cash expenses associated with all stock-based awards granted to employees.

Professional services expense includes legal and consulting fees, recruiting fees and asset management sub-advisory fees. Many of these expenses, such as legal fees associated with investment banking transactions and sub-advisory fees, are to a large extent variable with revenue.

Business development expenses includes travel and entertainment expenses related to investment banking transactions, costs of conferences and advertising, and the Company’s sponsorship of the PGA TOUR’s FBR Open. Expenses that are directly related to investment banking transactions are variable with revenue.

Clearing and brokerage fees include trade processing expense that we pay to our clearing brokers, and execution fees that we pay to floor brokers and electronic communication networks. These expenses are almost entirely variable with revenue.

Occupancy and equipment includes rental costs for our facilities, depreciation and amortization of equipment, software and leasehold improvements and expenses. These expenses are largely fixed in nature.

Communications expenses include voice, data and Internet service fees, and data processing costs. While variable in nature, these do not tend to vary with revenue.

Other operating expenses include mortgage insurance premium, loan servicing costs, amortization of certain intangible assets, professional liability and property insurance, printing and copying, business licenses and taxes, offices supplies, charitable contributions and other miscellaneous office expenses.

The following table sets forth financial data as a percentage of net revenues for the years presented:

Financial Data as a Percentage of Net Revenue


	Year Ended December 31,
	2006		2005		2004
Revenues:
Investment banking:
Capital raising	50.0	%	82.1	%	44.8	%
Advisory	6.3	%	4.1	%	3.4	%

	56.3	%	86.2	%	48.2	%

Institutional brokerage:
Principal transactions	1.5	%	4.1	%	2.3	%
Agency commissions	26.6	%	19.0	%	10.1	%
Mortgage trading interest	13.4	%	7.1	%	—
Mortgage trading net investment loss	(0.9	)%	(0.9	)%	—

	40.6	%	29.3	%	12.4	%

Asset management:
Base management fees	5.3	%	7.0	%	3.2	%
Incentive allocations and fees	0.3	%	0.4	%	1.2	%

	5.6	%	7.4	%	4.4	%

Principal investment:
Interest	156.4	%	126.5	%	39.5	%
Net investment (loss) income	(48.5	)%	(55.2	)%	11.5	%
Dividends	3.8	%	8.4	%	1.7	%

	111.7	%	79.7	%	52.7	%

Mortgage banking:
Interest	23.3	%	17.9	%	—
Net investment income	22.0	%	3.2	%	—

	45.3	%	21.1	%	—

Other	5.3	%	5.1	%	0.8	%

Total revenues	264.8	%	228.8	%	118.5	%
Interest expense	160.8	%	125.7	%	18.5	%
Provision for loan losses	4.0	%	3.1	%	—

Revenues, net of interest expense and provision for loan losses	100.0	%	100.0	%	100.0	%

Non-interest expenses:
Compensation and benefits	81.3	%	76.3	%	36.4	%
Professional services	15.7	%	15.3	%	5.7	%
Business development	11.1	%	10.7	%	5.1	%
Clearing and brokerage fees	3.1	%	2.0	%	1.0	%
Occupancy and equipment	13.2	%	7.8	%	1.6	%
Communications	6.4	%	4.8	%	1.6	%
Other operating expenses	23.5	%	16.3	%	2.6	%

Total non-interest expenses	154.3	%	133.2	%	54.0	%

Operating (loss) income	(54.3	)%	(33.2	)%	46.0	%

Comparison of the Years Ended December 31, 2006 and 2005

Net loss decreased from a loss of $170.9 million in 2005 to a $67.3 million loss in 2006. The 2006 loss is primarily due to our decision as of September 30, 2006, to reclassify the mortgage loan portfolio held at the REIT from held for investment to held for sale. As a result of this change, we recorded our investment in this portfolio at the lower of cost or market, and consequently recognized a $149.8 million write-down in 2006. In addition, in 2006 we recognized other-than-temporary impairment write-downs of $79.7 million relating to certain investments in our merchant banking investment portfolio. The decrease in net loss from 2005 is also impacted by the gain recorded on the share issuance by FBR Capital Markets (described below), a decrease in principal investment write-downs and an increase in net interest income from principal investments. Conversely, the 2006 net loss reflects a significant reduction in capital raising revenues as compared to 2005 as well as reductions in dividends from principal investing activities and asset management fees.

These write-downs, reduced investment banking activities, asset management and returns were partially offset by a $121.5 million gain recorded as a result of the July 2006 share issuance by FBR Capital Markets, a holding company for the Company’s capital markets operations formed in the second quarter 2006. This gain represents the increase in value of the Company’s investment in FBR Capital Markets as a result of the share issuance and, based on the structure of the transaction, this gain was not taxable. Subsequent to the share issuance and as of December 31, 2006, the Company retained a 71.9% beneficial ownership interest in FBR Capital Markets.

In addition to the above, effective January 1, 2006, the Company adopted SFAS 123R. Pursuant to the provisions of SFAS 123R, we recorded $5.0 million of compensation expense related to share-based payments during 2006. The net loss in 2006 also includes a $14.7 million tax benefit as compared to a $26.7 million income tax provision recorded in 2005.

The Company’s net revenues decreased 12.5% from $434.7 million in 2005 to $380.4 million in 2006 due to the following changes in revenues and interest expense:

Capital raising revenue decreased 46.7% from $356.8 million in 2005 to $190.2 million in 2006. The decrease is attributable to a decrease in amounts raised in private placement transactions as well as fewer lead or co-lead managed transactions completed in 2006 as compared to 2005. The lower volume of capital raising activity related primarily to our financial institutions and real estate sections which were adversely affected by the continued inverted yield curve during 2006. During 2006, the Company completed 17 private equity placements generating $139.3 million in revenues compared to 16 private equity placements in 2005 generating $225.5 million. The average capital raised on sole-managed private equity placements decreased from $237.4 million per transaction in 2005 on 15 transactions to $209.7 million per transaction in 2006 on 15 transactions. In addition, during 2006, the Company managed 35 public equity offerings raising $7.7 billion, compared to 60 public equity offerings raising $15.5 billion in 2005.

Advisory revenue increased 35.4% from $17.8 million in 2005 to $24.1 million in 2006 primarily due to an increase in the average revenues generated from each transaction.

Institutional brokerage revenue from agency commissions and principal transactions increased 6.1% from $100.7 million in 2005 to $106.8 million in 2006 as a result of increases in trading volume offset by a decrease in trading gains. In addition, the Company’s mortgage sales and trading operations contributed revenues net of interest expense of $3.3 million, reflecting $51.1 million in interest income, a net investment loss of $3.3 million and $44.5 million of interest expense compared to revenues net of interest expense of $3.4 million in 2005.

Asset management base management fees decreased 33.7% from $30.3 million in 2005 to $20.1 million in 2006. The decrease is primarily attributable to the decrease in average net assets under management in 2006 as compared to 2005, due in large part to the closure and liquidation of certain hedge and offshore funds during the third and fourth quarters of 2005, as well as a decrease in mutual fund administrative fees. Asset management incentive allocations and fees decreased 31.6% from $1.9 million in 2005 to $1.3 million in 2006 as a result of fund performance during the period.

Revenues from our principal investment, mortgage banking and warehouse financing activities, net of related interest expense, totaled $68.0 million for 2006 compared to $(57.8) million for 2005. The increase in net revenues is primarily the result of a decrease in impairment charges, an increase in the interest spread and an increase in net investment income from mortgage banking activities, as summarized below (dollars in thousands).


	For the year ended December 31,
	2006			2005
Net interest income	$	154,198		$	131,567
Net investment loss—principal investing		(184,552	)		(239,754	)
Dividend income		14,551			36,622
Net investment income—mortgage banking		83,786			13,741

	$	67,983		$	(57,824	)

In 2006, the Company made a determination in evaluating its investment strategy and its intent related to its held-for investment mortgage loan portfolio to reclassify these loans to held-for-sale. As a result of this change, the Company recorded its investment in this loan portfolio at the lower of cost or market and recognized a $149.8 million write-down in the value of these loans. The change in intent is primarily based on the strategy to redeploy the capital invested in that portfolio more rapidly to investments with higher earnings potential than if the portfolio were held to maturity. In addition, during 2006 we recognized other-than-temporary impairment losses of $79.7 million relating to merchant banking investments. The effects of these write-downs on the operating results for 2006 compare to operating results for 2005 which included a write-down in our mortgage-backed securities portfolio of $180.1 million, net of hedging gains, and a separate write-down of $74.5 million relating to the Company’s merchant banking portfolio. The 2005 MBS portfolio write-down reflected the Company’s decision to reposition the portfolio to eliminate a negative spread on much of the portfolio.

The components of net interest income from mortgage investments are summarized in the following table (dollars in thousands):


	For the year ended December 31, 2006							For the year ended December 31, 2005
	Average Balance		Income / (Expense)			Yield / Cost		Average Balance		Income / (Expense)			Yield / Cost
Mortgage-backed securities	$	3,727,748	$	208,444		5.59	%	$	10,237,443	$	338,044		3.30	%
Mortgage loans		6,734,153		469,192		6.97	%		4,179,939		289,437		6.92	%
Reverse repurchase agreements		151,950		8,442		5.48	%		253,680		10,208		4.02	%

	$	10,613,851		686,078		6.46	%	$	14,671,062		637,689		4.35	%

Other(1)				6,542							101

				692,620							637,790
Repurchase agreements	$	839,446		(43,867	)	(5.15	)%	$	2,401,180		(72,271	)	(3.01	)%
Commercial paper		2,610,719		(136,738	)	(5.17	)%		7,923,351		(263,958	)	(3.33	)%
Mortgage financing credit facilities		1,043,776		(61,221	)	(5.79	)%		2,286,890		(100,672	)	(4.40	)%
Securitization		5,593,131		(319,980	)	(5.64	)%		1,667,578		(77,796	)	(4.67	)%
Derivative contracts(2)		—		23,384					—		8,474

	$	10,087,072		(538,422	)	(5.34	)%	$	14,278,999		(506,223	)	(3.55	)%

Net interest income/spread			$	154,198		1.12	%			$	131,567		0.80	%

(1)	Includes interest income on cash and other miscellaneous interest-earning assets.

(2)	Includes the effect of derivative instruments accounted for as cash flow hedges.

As a result of the First NLC acquisition in February 2005, the increase in the mortgage loan portfolio and the repositioning of the MBS portfolio to eliminate a negative spread on much of the portfolio, the Company’s 2006 principal investment portfolio composition shifted significantly from that of the same period in 2005. In 2006, in connection with the repositioning of the mortgage-backed securities portfolio, the Company sold $7.6 billion of securities from the MBS portfolio held at December 31, 2005. As a result of these sales, the related repurchase agreement and commercial paper borrowings used to fund these investments likewise decreased significantly.

As shown in the table above, net interest income increased by $22.6 million from 2005 to 2006. This increase was due to an increase in the average balance of mortgage loans which have higher yields than those earned on our MBS portfolio offset by increased borrowing costs due to continued increases in short term interest rates. Amortization expense totaled $35.9 million in 2006 compared to $85.5 million in 2005. This decrease in amortization expense is a result of both the repositioning of the MBS portfolio during 2006 and the reclassification of the mortgage loans held at the REIT from held for investment to held for sale.

Net interest income from the MBS portfolio increased by $9.6 million from $26.1 million in 2005 to $35.7 million in 2006 due to a increase in the net interest spread earned on the portfolio from 0.13% in 2005 to 0.43% in 2006.

Mortgage loan portfolio, mortgage banking and warehouse financing related interest income was $477.6 million with related interest expense of $365.7 million, resulting in net interest income of $111.9 million for the year ended December 31, 2006. This compares to mortgage loan portfolio, mortgage banking and warehouse financing related interest income of $299.6 million with related interest expense of $194.2 million, resulting in net interest income of $105.4 million for the year ended December 31, 2005.

In addition to net interest income, the Company recorded $14.6 million in dividend income from its merchant banking equity investment portfolio in 2006, compared to $36.6 million during 2005. The decrease in dividend income was primarily due to the decrease in the number of and amount of capital invested in dividend paying companies in the merchant banking portfolio as well as reduced dividend rates. Also, the Company realized a net investment loss of $184.6 million during 2006 compared to net investment loss of $239.8 million in 2005. The following table summarizes the components of net investment income (loss) (dollars in thousands):


	For the year ended December 31,
	2006			2005
Securitized mortgage loans held-for-sale—lower of cost or market adjustments	$	(149,823	)	$	—
Available for sale and cost method securities—other-than-temporary impairments		(79,665	)		(74,452	)
MBS portfolio—other-than-temporary impairments, net of hedging gains		—			(180,087	)
Realized gains on sale of equity investments and mortgage-backed securities		39,164			12,286
Income from investments funds		3,244			62
Gains on investment securities—marked-to-market, net		4,994			1,362
Other, net		(2,466	)		1,075

	$	(184,552	)		(239,754	)

The 2006 net investment loss is due primarily to the effects of reclassifying the portfolio of securitized loans held-for-investment to held-for-sale as of September 30, 2006, as well as other than temporary impairment losses relating to merchant banking investments. In determining the lower-of-cost or market value of the securitized mortgage loans, the Company considered various factors effecting the overall value of the portfolio, including but not limited, to factors such as prepayment speeds, default rates, loss assumptions, geographic locations, collateral values, and mortgage insurance coverage. The Company utilized the present value of expected cash flows considering the specific characteristics of each individual loan, aggregating the loans by specific securitization issuance, in determining the value of the portfolio. The Company also considered that these loans

are collateral for securitization borrowings; therefore, taking into consideration the impact of any sale of the loan portfolio on the securitization borrowings, the related cash flows and the overall value of the residual interests in the securitization transactions that have been retained by the Company. Significant assumptions used by the Company in determining this value were supported by comparison to available market data for similar portfolios and transactions as well as a third party valuation of the residual interests in the securitization transactions.

As part of the Company’s quarterly assessments of unrealized losses in its portfolio of marketable equity securities for potential other-than-temporary impairments and its assessment of cost method investments, the Company recorded other-than-temporary impairment charges of $79.7 million relating to marketable equity securities and cost method investments in 2006. This compares to $74.5 million of impairment charges during 2005.

Other net investment income primarily includes net gains and losses from derivatives not designated as cash flow hedges under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and for Hedging Activities,” as amended (SFAS 133). These derivatives primarily include hedges relating to the financing for certain MBS positions and the mortgage loan portfolio.

Income from investment funds reflects the Company’s earnings from investments in proprietary investment partnerships and other managed investments. See Note 5 to the financial statements for further information on investment funds, other gains and losses, as well as realized gains on sales of equity investments and mortgage-backed securities.

During the year ended December 31, 2006 and 2005, the Company sold $7.5 billion and $4.4 billion of loans, respectively, and earned a gross premium of 1.44% and 1.99%, respectively. During the third quarter of 2006, the provision for losses increased significantly as compared to the prior year and prior 2006 quarters reflecting the effects of an industry-wide increase in requests for buy-backs of loans related to early pay defaults. The components of net investment income from mortgage banking activities are as follows (dollars in thousands):


	For the year ended December 31,
	2006			2005
Gross gain from loan sale transactions, including hedge activities	$	158,501		$	89,310
Provision for losses, including repurchase and premium recapture and lower of cost or market valuation allowances		(50,069	)		(31,863	)
Direct loan origination costs, net of fees earned		(24,646	)		(43,706	)

	$	83,786		$	13,741

Other revenues decreased 9.4% from $22.3 million in 2005 to $20.2 million in 2006 primarily due to a decrease in interest income related to warehouse financing.

The Company’s mortgage loan portfolio is comprised of loans predominately originated in 2005 and purchased by the Company in the second half of 2005 and therefore has a limited history. For the year ended December 31, 2006 and 2005, the Company’s average loans held for investment balance was $5.7 billion and

$3.1 billion, respectively. For the year ended December 31, 2006 and 2005, the Company recorded provisions for loan losses relating to its portfolio of loans held for investment $15.7 million and $14.3 million, respectively. As discussed previously, the Company reclassified these loans to a held for sale category as of September 30, 2006.

Interest expense unrelated to our principal investing, mortgage banking, warehouse financing and brokerage activities primarily relates to long-term debt issued through FBR TRS Holdings. These costs increased from $14.9 million in 2005 to $26.2 million in 2006 due to increased interest rates associated with these floating rate borrowings and the increase in the average balance outstanding for the year.

Total non-interest expenses increased 1.3% from $578.9 million in 2005 to $586.6 million in 2006. This increase was caused by the following fluctuations in non-interest expenses:

Compensation and benefits expense decreased 6.8% from $331.5 million in 2005 to $309.1 million in 2006. This decrease is primarily due to a $52.7 million decrease in variable compensation associated with the decrease in investment banking revenue offset by $5.0 million of stock compensation recorded pursuant to SFAS 123R and an increase of $27.1 million in First NLC compensation. The increase related to First NLC is attributable to the inclusion of its activities for the entire 2006 period as compared to its inclusion in 2005 results from the date of acquisition, as well as net increase in its headcount of 635 related to expansion of its origination platform.

Professional services decreased 10.4% from $66.6 million in 2005 to $59.7 million in 2006 primarily due to reductions in legal, corporate accounting and consulting costs in 2006 in part due to 2005 results including non-recurring costs associated with the integration of First NLC’s operations into the Company’s control structure. In addition, the change reflects decreased costs associated with capital raising activities consistent with the decrease in investment banking revenue.

Business development expenses decreased 9.4% from $46.6 million in 2005 to $42.2 million in 2006. This decrease is primarily due to a decrease in corporate business development costs, including advertising costs and costs associated with the Company’s sponsorship of the PGA TOUR’s FBR Open, as well as costs associated with investor conferences. In addition, the change reflects decreased costs associated with capital raising activities consistent with the decrease in investment banking revenue.

Clearing and brokerage fees increased 32.6% from $8.9 million in 2005 to $11.8 million in 2006. The increase is due to increased equity trading volumes as well as mortgage trading activity.

Occupancy and equipment expense increased 47.4% from $34.0 million in 2005 to $50.1 million in 2006, including an increase of $3.7 million in depreciation expense from $9.8 million in 2005 to $13.5 million in 2006. This overall increase is primarily due to the investments made in expanding and upgrading office space at our Arlington facilities, upgrades of technology, as well as an increase in costs associated with First NLC, reflecting the inclusion of its activities for the entire 2006 period as compared to its inclusion in 2005 results from the date of acquisition and an increase in First NLC’s office space to accommodate their increase in headcount related to expansion of its loan origination platform.

Communications expense increased 18.4% from $20.6 million in 2005 to $24.4 million in 2006 primarily due to increased costs related to market data and customer trading services as well as increased costs associated with First NLC, reflecting the inclusion of its activities for the entire 2006 period as compared to its inclusion in 2005 results from the date of acquisition.

Other operating expenses increased 26.4% from $70.7 million in 2005 to $89.4 million in 2006. This change is primarily due to an increase of approximately $20.4 million in servicing fees and insurance related to the mortgage loan portfolios.

The total income tax provision changed from a $26.7 million tax expense in 2005 to a $14.7 million tax benefit in 2006 due to the current year losses at the Company’s taxable REIT subsidiaries. Our tax provision

relates to income generated by our taxable REIT subsidiaries, and our effective tax rate relating to this income was 20% in 2006 as compared to 48% in 2005. The change in the effective tax rates is due primarily to the gain on sale of subsidiary stock which is not taxable for federal purposes (see Note 10).

Comparison of the Years Ended December 31, 2005 and 2004

Net income decreased from $349.6 million in 2004 to a loss of $(170.9) million in 2005. This decrease is primarily due to decreased net revenues, including net interest and net investment income in 2005 as compared to 2004 in our principal investment segment. These results include an other than temporary impairment write-down within FBR’s portfolio of mortgage-backed securities of $180.1 million, net of hedging gains, a separate other than temporary impairment write-down of $74.5 million relating to certain equity investments in the Company’s merchant banking portfolio. Our 2005 net loss also reflects a $26.7 million income tax provision as compared to a $59.2 million income tax provision recorded in 2004.

On February 16, 2005, the Company completed the acquisition of First NLC, a non-conforming residential mortgage originator located in Florida for $100.8 million in a combination of cash and stock. As of December 31, 2005, First NLC operates in 44 states and originates loans through both wholesale and retail channels. First NLC is part of the Company’s mortgage banking segment. The year ended December 31, 2005 results reflect higher compensation, including certain non-recurring compensation payments related to the acquisition, occupancy and equipment, communications and other expenses due to the increase in employees and related facilities as a result of the acquisition of First NLC.

The Company accounted for the acquisition of First NLC in accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations” (SFAS 141) using the purchase method of accounting. Under the purchase method, net assets and results of operations of acquired companies are included in the consolidated financial statements from the date of acquisition. In addition, SFAS 141 provides that the cost of an acquired entity must be allocated to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of cost over the fair value of the net assets acquired must be recognized as goodwill.

The $100.8 million purchase price included cash of $74.3 million, issuance of 1,297,746 shares of FBR Class A common stock at a price of $18.82 per share for a total of $24.4 million, and direct acquisition costs of $2.1 million.

Our net revenues decreased 51.0% from $887.9 million in 2004 to $434.7 million in 2005 due primarily to lower revenues associated with our principal investment activities, including the $180.1 million MBS-related and $74.5 million merchant banking-related writedowns noted above, and from lower capital market activities.

Capital raising revenue decreased 10.4% from $398.1 million in 2004 to $356.8 million in 2005. The decrease is attributable to fewer number of transactions in 2005. During 2005, we managed 89 public offerings, of which we lead-managed 45, raising $36.2 billion and generating $148.6 million in revenues. During 2004, we managed 93 public offerings, of which we lead-managed 51, raising $22.7 billion and generating $233.0 million in revenues.

Advisory revenue decreased 40.9% from $30.1 million in 2004 to $17.8 million in 2005 due primarily to the completion of fewer M&A transactions. We completed 13 M&A transactions in 2004 compared to 11 in 2005.

Institutional brokerage revenue from principal transactions decreased 11.8% from $20.4 million in 2004 to $18.0 million in 2005 and agency commissions decreased 7.7% from $89.7 million in 2004 to $82.8 million in 2005 primarily due to decreased customer trading.

In addition, during 2005 we initiated mortgage trading operations. These activities contributed $30.9 million of interest income to institutional brokerage activity. The mortgage trading interest income was offset by a net investment loss of $3.8 million and $23.7 million of interest expense related to these trading activities.

Asset management base management fees increased 7.1% from $28.3 million in 2004 to $30.3 million in 2005 due to the increase in mutual fund administrative fees. Asset management incentive allocations and fees decreased 82.6% from $10.9 million in 2004 to $1.9 million in 2005 is primarily a result of fund performance and the reversal of incentive allocation from certain investment partnerships during 2005.

Revenues from our principal investment, mortgage banking and warehouse financing activities, net of related interest expense, totaled $(57.8) million for the year ended December 31, 2005 compared to $312.0 million for the year ended December 31, 2004, as summarized below (dollars in thousands).


	For the year ended December 31,
	2005			2004
Net interest income	$	131,567		$	195,413
Net investment (loss) income—principal investing		(239,754	)		101,973
Dividend income		36,622			14,644
Net investment income—mortgage banking		13,741			—

	$	(57,824	)	$	312,030

The components of net interest income from mortgage investments are summarized in the following table (dollars in thousands):


	Year Ended December 31, 2005							Year Ended December 31, 2004
	Average Balance		Income / (Expense)			Yield / Cost		Average Balance		Income / (Expense)			Yield / Cost
Mortgage-backed securities	$	10,237,443	$	338,044		3.30	%	$	10,906,521	$	344,043		3.16	%
Mortgage loans		4,179,939		289,437		6.92	%		—		—		—
Reverse repurchase agreements		253,680		10,208		4.02	%		—		—		—

	$	14,671,062		637,689		4.35	%	$	10,906,521		344,043		3.16	%

Other(1)				101							6,648

				637,790							350,691
Repurchase agreements	$	2,401,180		(72,271	)	(3.01	)%	$	5,141,127		(72,786	)	(1.39	)%
Commercial paper		7,923,351		(263,958	)	(3.33	)%		5,054,803		(78,595	)	(1.53	)%
Mortgage financing credit facilities		2,286,890		(100,672	)	(4.40	)%		—		—		—
Securitization		1,667,578		(77,796	)	(4.67	)%		—		—		—
Derivative contracts(2)		—		8,474					—		(3,897	)

	$	14,278,999		(506,223	)	(3.55	)%	$	10,195,930		(155,278	)	(1.50	)%

Net interest income/spread			$	131,567		0.80	%			$	195,413		1.66	%

(1)	Includes interest income on cash and other miscellaneous interest-earning assets. Other interest income in the twelve months of 2004 includes $2.1 million of income related to bridge financing arrangements.

(2)	Includes the effect of derivative instruments accounted for as cash flow hedges.

As shown in the table above, net interest income decreased by $63.8 million from the year ended December 31, 2004 to the year ended December 31, 2005 due to an increase in interest expense. This increase was due to eight increases in the federal funds rate over the last year. The increase in interest expense was partially offset by increases in the average balance of interest earning assets particularly mortgage loans which have higher yields than those earned on our MBS portfolio. Amortization expense totaled $85.5 million during 2005 compared to $78.8 million during 2004.

Net interest income from the MBS portfolio decreased by $162.7 million from $188.8 million in 2004 to $26.1 million in 2005 due to a decrease in the average balance of the MBS portfolio and decrease in the net interest spread earned on the portfolio from $10.9 billion and 1.66% in 2004 to $10.2 billion and 0.13% in 2005.

The decrease in the average balance of the MBS portfolio is due to the principal paydowns in the portfolio during the year and the limited investment in MBS during the year due to the allocation of capital to non-conforming mortgage loans. The decrease in the net interest spread in the MBS portfolio is due primarily to the increase in the federal fund rates. During the year, Federal Reserve Board increased the federal fund rates eight times, almost doubling short-term interest rates. The Company’s spread-based businesses were under constant pressure from the impact of a flattening yield curve combined with persistently high mortgage prepayment speeds. Consequently, in December 2005, the Company determined to undertake a repositioning of the MBS portfolio to eliminate a negative interest spread on much of the portfolio and to be in a position to take advantage of reinvestment opportunities presented by the changing environment over the coming quarters.

Mortgage loan portfolio and mortgage banking related interest income was $299.6 million with related interest expense of $194.2 million, resulting in net interest income of $105.4 million for the year ended December 31, 2005. This net interest income includes $71.8 million relating to loans held for investment and $33.6 million relating to mortgage banking activities, primarily loans held for sale.

In addition to net interest income, the Company recorded $36.6 million in dividend income from its merchant banking equity investment portfolio in 2005, compared to $14.6 million during 2004. The increase in dividend income was primarily due to the increase in the number of and amount of capital invested in dividend paying companies in the merchant banking portfolio. The Company realized a net investment loss of $(239.8) million during 2005 compared to net investment income of $102.0 million in 2004. The following table summarizes the components of net investment (loss) income (dollars in thousands):


	Year Ended December 31,
	2005			2004
MBS Portfolio—other than temporary impairments, net of hedging gains	$	(180,087	)	$	—
Available for sale and cost method securities—other than temporary impairments		(74,452	)		—
Realized gains on sales of equity investments and mortgage-backed securities		12,286			87,673
Income from investment finds		62			9,184
Gains on investment securities—marked-to-market, net		1,362			9,476
Other, net		1,075			(4,360	)

	$	(239,754	)	$	101,973

As noted above, the Company determined to undertake a repositioning of its MBS portfolio to eliminate a negative interest spread on much of the portfolio. This decision marked a change in the Company’s intent to hold securities in its MBS portfolio that have unrealized loss positions until a recovery in fair value occurs. Consequently, a determination was made that unrealized MBS portfolio losses as of December 31, 2005, should be considered other than temporary, necessitating recognition of a $197.8 million impairment charge relating to these unrealized losses for the year ended December 31, 2005. This loss was partially offset by $17.7 million in related derivative gains.

In addition to the above, as part of the Company’s quarterly assessment of unrealized losses in its portfolio of marketable equity securities for potential other than temporary impairments and its assessment of cost method investments, the Company recorded an other than temporary impairment charge of $57.3 million relating to marketable equity securities and a $17.2 million impairment charge relating to cost method investments.

investment funds, other gains and losses, as well as realized gains on sales of equity investments and mortgage-backed securities.

The components of the gain on sale of loans are as follows for the year ended December 31, 2005 (dollars in thousands):


Gross gain from loan sale transactions	$	89,310
Provision for losses, including repurchase and premium recapture and lower of cost or market valuation allowances		(31,863	)
Direct loan origination costs, net of fees earned		(43,706	)

Total net gain on sale of loans	$	13,741

Other revenues increased from $7.2 million in 2004 to $22.3 million in 2005 primarily due to an increase in 12b-1 fees of $0.6 million, a $3.5 million increase in interest and dividend income unrelated to principal investing and interest income related to a full year of warehouse financing activities.

The Company recorded the following provision for loan losses relating to loans held for investment for the year ended December 31, 2005 (dollars in thousands):


Current year provision for:
Loans held for investment	$	14,178
Real estate owned		113

Total provision for loan losses	$	14,291

Allowance for loan losses at year end	$	14,119

Allowance for loan losses as a percentage of the principal balance at year end		0.21	%

The Company’s mortgage loan portfolio held for investment as of December 31, 2005 is comprised of loans predominately originated in 2005 and purchased by the Company in the second half of 2005 and therefore has a limited history. For the year ended December 31, 2005, the Company’s average loans held for investment balance was $3.1 billion. For the year ended December 31, 2005, the Company recorded a $14.3 million provision for loan losses relating to its portfolio of loans held for investment. As discussed previously, the Company reclassified these loans to a held for sale category as of September 30, 2006.

We evaluated the adequacy of the allowance for loan losses based upon known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of underlying collateral, and current and expected future economic conditions as well as assumptions regarding loss severity and frequency. The Company manages credit risk by, among other things, purchasing and originating loans at favorable loan to value ratios and for a portion of the portfolio by purchasing mortgage insurance.

The 2005 loan loss provision reflects the consideration of these factors and the estimate of losses incurred during the period in 2005 that we held loans for investment that likely will be realized during the next twelve months. As the portfolio of loans held for investment matures, the Company expects the incidence of incurred losses to increase. Since our accounting policy is based on estimating incurred losses, we anticipate increases in loan loss provisions in 2006 and 2007 over the current rate as the default and loss rates attributable to the seasoning of the loan portfolio likely will increase during future periods. The allowance for loan losses established through loan loss provisions is reduced as actual losses are realized. The Company will continue to monitor the performance trends of its portfolio and also compare the portfolio’s performance to the observed industry performance of similarly seasoned loan portfolios. This industry data provides additional information to support the determination of loan loss provisions and the related allowance for loan losses during the early life of the portfolio as actual portfolio performance develops.

Interest expense unrelated to our principal investing, mortgage banking and brokerage activities primarily relates to long-term debt issued through FBR TRS Holdings and increased from $4.0 million in 2004 to $14.9 million in 2005 due to increased long-term borrowings of $195 million during 2005.

Total non-interest expenses increased 20.8% from $479.2 million in 2004 to $578.9 million in 2005 due primarily to the acquisition of First NLC which contributed $86.0 million to the 2005 total. The additional First NLC employees and facilities resulted in increased compensation, occupancy and equipment, communications and other operating expenses. In addition, the Company recognized an expense of $7.5 million in 2005 based on the proposed settlements with the SEC and the NASD’s Department of Market Regulation, which were accepted by the SEC’s and NASD’s staff in the fourth quarter of 2006, (see Note 12) that is included in other operating expenses and incurred increased legal costs related to these matters that are included in professional services in 2005 that are not comparable to 2004.

Compensation and benefits expense increased 2.5% from $323.5 million in 2004 to $331.5 million in 2005 including $47.8 million relating to First NLC. This increase is primarily due to increased headcount as a result of the acquisition of First NLC offset by decreased variable compensation in 2005 as compared to 2004 as a result of decreased investment banking revenues and reduction in executive bonuses. As a percentage of net revenues, compensation and benefits expense increased from 36.4% in 2004 to 76.3% in 2005 due to the effects of the decrease in 2005 net revenues resulting from the investment writedowns and the effects of the acquisition of First NLC.

Professional services expense increased 31.9% from $50.5 million in 2004 to $66.6 million in 2005, including $5.4 million relating to First NLC. This increase is primarily due to, legal costs associated with the proposed settlements with the SEC and NASD’s Department of Market Regulation, which were accepted by the SEC’s and NASD’s staff in the fourth quarter of 2006, (see Note 12), the integration of First NLC’s operations and mortgage banking activities, sub-advisory fees, as well as costs associated with technology enhancements.

Business development expenses increased 3.6% from $45.0 million in 2004 to $46.6 million in 2005, including $5.9 million relating to First NLC. This increase is due to an increase in travel costs and business promotions related to the mortgage origination services of the Company as a result of the acquisition of First NLC offset by a reduction in travel costs relating to capital raising activities due to fewer transactions and lower revenues in 2005 as compared to 2004.

Clearing and brokerage fees decreased 2.2% from $9.1 million in 2004 to $8.9 million in 2005. As a percentage of institutional brokerage revenue, clearing and brokerage fees decreased from 8.3% in 2004 to 7.0% in 2005.

Occupancy and equipment expense increased 134.5% from $14.5 million in 2004 to $34.0 million in 2005, including $9.9 million relating to First NLC. The increase is attributable primarily to the additional First NLC facilities and headcount as well as investments made in upgrading technology and expanding our Arlington, New York and Boston facilities. Total employees as of December 31, 2005 were 2,449 employees as compared to 698 employees as of December 31, 2004 reflecting the effects of the First NLC acquisition.

Communications expense increased 47.1% from $14.0 million in 2004 to $20.6 million in 2005, including $2.3 million relating to First NLC. The increase is primarily due to increased costs related to market data and customer trading services and the acquisition of First NLC and the costs associated with its mortgage origination platform.

Other operating expenses increased 211.5% from $22.7 million in 2004 to $70.7 million in 2005, including $14.7 million relating to First NLC. This change also includes loan portfolio servicing costs of $14.0 million, costs associated with the proposed settlements with the SEC and the NASD’s Department of Market Regulation of $7.5 million (see Note 12), mortgage insurance costs of $5.7 million, and an increase in various office operations and administrative expense items.

The total income tax provision decreased from $59.2 million in 2004 to $26.7 million in 2005 due to decreased taxable income in 2005 as compared to 2004. Our tax provision relates to income generated by our taxable REIT subsidiaries, and our effective tax rate relating to this income was 48% in 2005 as compared to 40% in 2004. The increase in the effective tax rates is due to an increase in the Company’s state taxes due to changes in state apportionment and due to the non-deductible nature of the $7.5 million charge recorded in the first quarter 2005 relating to the Company’s proposed settlements with the SEC and the NASD’s Department of Market Regulation, which were accepted by the SEC’s and NASD’s staff in the fourth quarter of 2006, (see Note 12).

Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements including ongoing commitments to repay borrowings, fund investments, loan acquisition and lending activities, and for other general business purposes. In addition, regulatory requirements applicable to our broker-dealer subsidiaries require minimum capital levels for these entities. The primary sources of funds for liquidity consist of borrowings under repurchase agreements, commercial paper borrowings, securitization financings, principal and interest payments on mortgage-backed securities and mortgage loans, dividends on equity securities, proceeds from sales of securities and mortgage loans, internally generated funds, equity capital contributions, and credit provided by banks, clearing brokers, and affiliates of our principal clearing broker. Potential future sources of liquidity for us include existing cash balances, internally generated funds, borrowing capacity through margin accounts and under warehouse and corporate lines of credit, commercial paper issuances, and future issuances of common stock, preferred stock, or debt.

Cash Flows

As of December 31, 2006, the Company’s cash and cash equivalents totaled $190.0 million representing a net decrease in the balance of $48.7 million for the year ended December 31, 2006. The decrease is primarily attributable to the $143.0 million of cash used in operating activities during the year. The cash used in operating activities is primarily driven by an increase in First NLC’s mortgage loan inventory of $340 million during 2006. This use of cash in mortgage banking was offset by operating net cash inflows from capital markets related to the sale of fixed income trading positions and cash inflows related to operating assets of our principal investment segment.

Cash used in operating activities during 2006 was offset by net cash inflows of $3.9 billion from investing activities and net cash outflows of $3.8 billion from financing activities. Cash provided by investing activities and used in financing activities reflect reductions in the MBS and mortgage loan portfolios as a result of implementing changes in investment strategies with respect to these portfolios during 2006.

Specifically, our investing activities during 2006, include proceeds from sales of, and receipt of principal payments from, mortgage-backed securities totaling $9.1 billion. In addition, principal payments received on loans held for investment that were reclassified to held for sale, and proceeds from sales of such loans totaled $2.5 billion. These cash inflows were offset by $7.9 billion of mortgage-backed securities purchases. The Company’s 2006 investing activities did not include any new investments in mortgage loans to be held for investment. Similarly, the Company’s financing activities reflect net repayments of commercial paper and repurchase agreement borrowings of $1.7 billion and $2.2 billion of securitization financing repayments. These repayment activities were offset by $260 million of proceeds received from the FBR Capital Markets share issuance.

As of December 31, 2005, the Company’s cash and cash equivalents totaled $238.6 million representing a net increase in the balance of $14.2 million for the year then ended. The increase is attributable to $4.1 billion provided by financing activities offset by a use of cash in operating activities of $696.7 million and investing of $3.4 billion. Cash inflows during 2005 were comprised primarily of the net income generated by the capital

markets segment and principal paydowns received on the MBS portfolio without significant reinvestment. Cash outflows during 2005 related primarily to our purchase of First NLC, initiation of mortgage banking activities and our establishment of a mortgage loan portfolio at the parent REIT level.

Sources of Funding

We believe that our existing cash balances, cash flows from operations, borrowing capacity, other sources of liquidity and execution of our financing strategies should be sufficient to meet our cash requirements. We have obtained, and believe we will be able to continue to obtain, short-term financing in amounts and at interest rates consistent with our financing objectives. We may, however, seek debt or equity financings, in public or private transactions, to provide capital for corporate purposes and/or strategic business opportunities, including possible acquisitions, joint ventures, alliances, or other business arrangements which could require substantial capital outlays. Our policy is to evaluate strategic business opportunities, including acquisitions and divestitures, as they arise. There can be no assurance that we will be able to generate sufficient funds from future operations, or raise sufficient debt or equity on acceptable terms, to take advantage of investment opportunities that become available. Should our needs ever exceed these sources of liquidity, we believe that most of our investments could be sold, in most circumstances, to provide cash.

As of December 31, 2006, the Company’s indebtedness totaled $12.0 billion, which resulted in a leverage ratio (debt to equity) of 10.3 to 1. In addition to trading account securities sold short and other payables and accrued expenses, our indebtedness consisted of repurchase agreements with several financial institutions, commercial paper issued through Georgetown Funding, securitization financing and long term debentures issued through our taxable REIT subsidiary, FBR TRS Holdings, Inc. (TRS Holdings). Such long-term debt issuances have totaled $317.5 million. These long term debt securities accrue and require payments of interest quarterly at annual rates of three-month LIBOR plus 2.25%-3.25%, mature in thirty years, and are redeemable, in whole or in part, without penalty after five years. As of December 31, 2006, we had $324.5 million of long-term corporate debt.

During 2005, the Company completed nine securitization transactions and issued a series of multi-class mortgage-backed bonds. Depending on the structure of the securitizations, the Company accounts for the securitizations as either “sales” or “financing” transactions in accordance with SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” For securitizations that qualify as sales, the Company transfers the loans into the securitization trust and records retained financial and servicing assets or liabilities, if any, and recognizes a gain or loss on sale from the transaction. For securitizations that are accounted for as financings, the transferred loans remain on the balance sheet and are recorded as collateral and the mortgage-backed bonds issued are recorded as debt. The Company completed no securitization transactions during 2006.

As of December 31, 2006, the Company had outstanding securitization financing liabilities of $4.5 billion. The securities have a final maturity in 2035 and are callable at par once the total balance of the loans collateralizing the debt is reduced to a certain percentage of their respective original balances as defined in the securitization documents. The balance of debt is reduced as the underlying loan collateral is paid down. Interest rates on these bonds reset monthly and are indexed to one-month LIBOR. The weighted average interest rate payable on the securities was 5.79% as of December 31, 2006.

In October 2006, we entered into a $180 million, 364-day senior secured credit agreement with various financial institutions. This facility includes a one-year term-out option. The facility is available for general corporate purposes, working capital and other potential short-term liquidity needs. There were no borrowings outstanding under this facility during 2006.

Georgetown Funding is, a special purpose Delaware limited liability company, organized for the purpose of issuing extendable commercial paper notes in the asset-backed commercial paper market and entering into reverse repurchase agreements with us and our affiliates. We serve as administrator for Georgetown Funding’s

commercial paper program, and all of Georgetown Funding’s transactions are conducted with FBR. Through our administration agreement, and repurchase agreements we are the primary beneficiary of Georgetown Funding and consolidate this entity for financial reporting purposes. The extendable commercial paper notes issued by Georgetown Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. Our Master Repurchase Agreement with Georgetown Funding enables us to finance up to $12 billion of mortgage-backed securities. There were $4.0 billion of borrowings outstanding as of December 31, 2006.

Arlington Funding is, a special purpose Delaware limited liability company, organized for the purpose of issuing extendable commercial paper notes in the asset-backed commercial paper market and providing warehouse financing in the form of reverse repurchase agreements to mortgage originators with which we have a relationship. We serve as administrator for Arlington Funding’s commercial paper program and provide collateral as well as guarantees for commercial paper issuances. Through these arrangements we are the primary beneficiary of Arlington Funding and consolidate this entity for financial reporting purposes. The extendable commercial paper notes issued by Arlington Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. Our financing capacity through Arlington Funding is $5 billion. There were no borrowings outstanding as of December 31, 2006.

The Company also has short-term financing facilities that are structured as repurchase agreements with various financial institutions to fund its portfolio of mortgage loans and certain of its mortgage-backed securities. The interest rates under these agreements are based on LIBOR plus a spread that ranges between 0.60% to 1.25% based on the nature of the mortgage collateral.

Our mortgage financing repurchase agreements include provisions contained in the standard master repurchase agreement as published by the Bond Market Association and may be amended and supplemented in accordance with industry standards for repurchase facilities. Our mortgage financing repurchase agreements include financial covenants, with which the failure to comply would represent an event of default under the applicable repurchase agreement. Similarly, each repurchase agreement includes events of default for failures to qualify as a REIT, events of insolvency and events of default on other indebtedness. As provided in the standard master repurchase agreement as typically amended, upon the occurrence of an event of default or termination event the applicable counterparty has the option to terminate all repurchase transactions under such counterparty’s repurchase agreement and to demand immediate payment of any amount due from us to the counterparty.

Under our repurchase agreements, we may be required to pledge additional assets to our repurchase agreement counterparties in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (i.e., margin call), which may take the form of additional securities or cash. Margin calls on repurchase agreements collateralized by our MBS investments primarily result from events such as declines in the value of the underlying mortgage collateral caused by factors such as rising interest rates or prepayments. Margin calls on repurchase agreements collateralized by our mortgage loans primarily result from events such as declines in the value of the underlying mortgage collateral caused by interest rates, prepayments, and/or the deterioration in the credit quality of the underlying loans.

To date, we have not had any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional pledged collateral. However, should we encounter increases in interest rates, prepayments, or delinquency levels, margin calls on our repurchase agreements could result in a manner that could cause an adverse change in our liquidity position.

The following table provides information regarding the Company’s outstanding commercial paper, repurchase agreement borrowings, and mortgage financing facilities (dollars in thousands).


	December 31, 2006									December 31, 2005
	Commercial Paper			Repurchase Agreements			Short-Term Mortgage Financing Facilities(1)			Commercial Paper			Repurchase Agreements			Short-Term Mortgage Financing Facilities
Outstanding balance	$	3,971,389		$	2,116,813		$	942,517		$	6,996,950		$	1,653,599		$	1,045,020
Weighted-average rate		5.41	%		5.34	%		6.05	%		4.37	%		4.39	%		5.16	%
Weighted-average term to maturity(1)		18.3 days			21.9 days			NA			19.9 days			18.4 days			NA

(1)	Under these mortgage financing agreements, which expire or may be terminated by the Company or the counterparty within one year, the Company may finance mortgage loans for up to 180 days. The interest rates on these borrowings reset daily.

Assets

Our principal assets consist of MBS, non-conforming mortgage loans, cash and cash equivalents, receivables, long-term investments, and securities held for trading purposes. As of December 31, 2006, liquid assets consisted primarily of cash and cash equivalents of $190.0 million. Cash equivalents consist primarily of money market funds invested in debt obligations of the U.S. government. In addition, we held $6.9 billion in MBS, $5.4 billion in non-conforming mortgage loans, $185.5 million in long-term investments, $18.2 million in trading securities, a receivable due from servicer of $64.7 million, and a receivable due from our clearing broker of $29.0 million at December 31, 2006. The Company’s total assets decreased from $18.4 billion at December 31, 2005 to $13.4 billion as of December 31, 2006. The decline in total assets reflects the effects of principal payments received on mortgage loans without any new investments in mortgage loans to be held for investment, sales of mortgage trading assets and net sales of available-for-sale mortgage-backed securities.

Long-term investments primarily consist of investments in marketable equity and non-public equity securities, managed partnerships (including hedge, private equity, and venture capital funds), in which we serve as managing partner and our investment in RNR II (QP), LP (a partnership we do not manage). Although our investments in hedge, private equity and venture capital funds are mostly illiquid, the underlying investments of such entities are, in the aggregate, mostly publicly-traded, liquid equity and debt securities, some of which may be restricted due to contractual “lock-up” requirements.

As of December 31, 2006, our mortgage-backed securities portfolio was comprised primarily of agency-backed ARM and hybrid-ARM securities. Excluding principal receivable, which totaled $39.4 million, the total par and fair value of the portfolio was $6.9 billion. As of December 31, 2006, the weighted average coupon of the portfolio was 6.05%. Our portfolio of non-conforming mortgage loans is also comprised substantially of hybrid-ARMs. As of December 31, 2006, the principal balance of the mortgage loan portfolio was $5.4 billion and the weighted average coupon was 7.46%.

The actual yield on the MBS is affected by the price paid to acquire the investment. Our cost basis in MBS is normally greater than the par value (i.e., a premium), resulting in the yield being less than the stated coupon. The MBS portfolio had a premium of $57.5 million (0.84% of the unpaid par value).

Net unrealized gains related to our merchant banking investments that are included in accumulated other comprehensive loss in our balance sheet totaled $7.8 million as of December 31, 2006. If and when we liquidate these or determine that a decline in value of these investments below our cost basis is other than temporary, a portion or all of the gains or losses will be recognized as a gain or loss in the statement of operations during the period in which the liquidation or determination is made. Our investment portfolio is exposed to potential future downturns in the markets and private equity securities are exposed to deterioration of credit quality, defaults, and downward valuations. On a quarterly basis, we review the valuations of our private equity investments. If and when we determine that the net realizable value of these investments is less than our carrying value, we will reflect the reduction as an investment loss.

Regulatory Capital

FBR & Co. and FBRIS, as U.S. broker-dealers, are registered with the SEC and are members of the National Association of Securities Dealers, Inc. (NASD). Additionally, FBRIL, our U.K. broker-dealer, is registered with the Financial Services Authority (FSA) of the United Kingdom. As such, they are subject to the minimum net capital requirements promulgated by the SEC and FSA, respectively. As of December 31, 2006, FBR & Co. had total regulatory net capital of $94.6 million, which exceeded its required net capital of $4.5 million by $90.1 million. In addition, FBRIS and FBRIL had regulatory capital as defined in excess of required amounts. Regulatory net capital requirements increase when the broker-dealers are involved in underwriting activities based upon a percentage of the amount being underwritten.

Dividends

During 2006, we declared dividends as specified in the following table.


Declaration Date	Record Date	Payment Date	Dividends Per Share
December 13, 2006	December 29, 2006	January 31, 2007	$	0.05
September 13, 2006	September 29, 2006	October 31, 2006	$	0.05
June 8, 2006	June 30, 2006	July 28, 2006	$	0.20
March 15, 2006	March 31, 2006	April 28, 2006	$	0.20

Contractual Obligations

We have contractual obligations to make future payments in connection with long-term debt and non-cancelable lease agreements and other contractual commitments as well as uncalled capital commitments to various investment partnerships that may be called over the next ten years. The following table sets forth these contractual obligations by fiscal year (in thousands):


	2007		2008		2009		2010		2011		Thereafter		Total
Long-term debt(1)	$	970	$	970	$	970	$	970	$	970	$	319,603	$	324,453
Minimum rental and other contractual commitments		24,397		24,566		17,778		16,883		15,258		47,607		146,489
Securitization financing on loans held for sale(2)		—		—		—		—		—		4,501,619		4,501,619
Capital commitments(3)		—		—		—		—		—		—		—

	$	25,367	$	25,536	$	18,748	$	17,853	$	16,228	$	4,868,829	$	4,972,561

(1)

This table excludes interest payments to be made on the Company’s long-term debt securities issued through FBR TRS Holdings. Based on the 3-month LIBOR of 5.36% as of December 31, 2006, plus a weighted average margin of 2.63%, estimated annualized interest on the current outstanding principal of $317.5 million of long-term debt securities would be approximately $25.4 million for the year ending December 31, 2007. These long-term debt securities mature in thirty years beginning in March 2033 through October 2035. Note that interest on this long-term debt floats based on 3-month LIBOR, therefore, actual coupon interest will differ from this estimate.

(2)	Although the stated maturities for these securities are thirty years, the Company expects the securities to be fully repaid prior to stated maturities due to borrower prepayments and/or possible clean-up calls.

(3)

The table above excludes $6.0 million of uncalled capital commitments as of December 31, 2006 to various investment partnerships that may be called over the next ten years. This commitment was $6.7 million at December 31, 2005. This amount was excluded because we cannot currently determine when, if ever, the commitments will be called.

The Company also has short term commercial paper and repurchase agreement liabilities of $4.0 billion and $3.1 billion, respectively as of December 31, 2006. See Note 8 to the financial statements for further information.

As of December 31, 2006, the Company had made interest rate lock agreements with borrowers for the origination of new mortgage loans and entered into commitments to sell mortgage loans of $200.2 million and $400.9 million, respectively.

Quantitative and Qualitative Disclosures about Market Risk

Market risk generally represents the risk of loss through a change in realizable value that can result from a change in the prices of equity securities, a change in the value of financial instruments as a result of changes in interest rates, a change in the volatility of interest rates or a change in the credit rating of an issuer. We are exposed to the following market risks as a result of our investments in mortgage-backed securities and equity investments. Except for trading securities held by FBR & Co., none of these investments is held for trading purposes.

Interest Rate Risk

Leveraged MBS and Mortgage Loans

The Company is primarily subject to interest-rate risk as a result of its principal investment and mortgage banking activities. It is also subject to interest-rate risk in its mortgage trading activities, but the level of interest-rate risk in the trading business is low because substantially all of the interest-rate risk on mortgage trading positions is hedged. Through its principal investment and mortgage banking activities, the Company invests in mortgage-backed securities and mortgage loans and finances those investments with repurchase agreement, commercial paper and securitization borrowings, all of which are interest rate sensitive financial instruments. The Company is exposed to interest rate risk that fluctuates based on changes in the level or volatility of interest rates and mortgage prepayments and in the shape and slope of the yield curve. The Company attempts to hedge a portion of its exposure to rising interest rates primarily through the use of paying fixed and receiving floating interest rate swaps, interest rate caps, and Eurodollar futures and put option contracts. The counterparties to the Company’s derivative agreements at December 31, 2006 are U.S. financial institutions.

The Company’s primary risk is related to changes in both short and long term interest rates, which affect the Company in several ways. As interest rates increase, the market value of the mortgage-backed securities and mortgage loans may be expected to decline, prepayment rates may be expected to go down, and duration may be expected to extend. An increase in interest rates is beneficial to the market value of the Company’s derivative instruments, including economic hedges and instruments designated as cash flow hedges. For example, for interest rate swap positions, the cash flows from receiving the floating rate portion increase and the fixed rate paid remains the same under this scenario. If interest rates decline, the reverse is true for mortgage-backed securities and mortgage loans, paying fixed and receiving floating interest rate swaps, interest rate caps, and Eurodollar futures and put option contracts.

The Company records its derivatives at fair value. The differential between amounts paid and received for derivative instruments designated as cash flow hedges is recorded as an adjustment to interest expense. In addition, the Company records the ineffectiveness of its cash flows hedges, if any, in net investment income. In general (i.e., presuming the hedged risk is still probable of occurring), in the event of early termination of these derivatives, the Company receives or makes a payment based on the fair value of the instrument, and the related deferred gain or loss recorded in other comprehensive income is amortized into income or expense over the original hedge period.

The table that follows shows the expected change in fair value for the Company’s current mortgage-backed securities, mortgage loans, and derivatives related to the Company’s principal investment and mortgage banking activities under several hypothetical interest-rate scenarios. Interest rates are defined by the U.S. Treasury yield curve. The changes in rates are assumed to occur instantaneously. It is further assumed that the changes in rates occur uniformly across the yield curve and that the level of LIBOR changes by the same amount as the yield curve. Actual changes in market conditions are likely to be different from these assumptions.

100

Changes in value are measured as percentage changes from their respective values presented in the column labeled “Value at December 31, 2006.” Management’s estimate of change in value for mortgage loans and mortgage-backed securities are based on the same assumptions it uses to manage the impact of interest rates on the portfolio. Actual results could differ significantly from these estimates. The estimated change in value of the mortgage loans reflect an effective duration of 0.65. For mortgage-backed securities, the estimated change in value is based on duration of 1.00 in a rising interest rate environment and 1.60 in declining interest rate environment.

The effective durations are based on observed market value changes, as well as management’s own estimate of the effect of interest rate changes on the fair value of the investments including assumptions regarding prepayments based, in part, on age of and interest rate on the mortgages and the mortgages underlying the mortgage-backed securities, prior exposure to refinancing opportunities, and an overall analysis of historical prepayment patterns under a variety of past interest rate conditions (dollars in thousands, except per share amounts).


	Value at December 31, 2006		Value at December 31, 2006 with 100 basis point increase in interest rates			Percent Change		Value at December 31, 2006 with 100 basis point decrease in interest rates		Percent Change
Assets
Mortgage-backed securities	$	6,870,661	$	6,784,777		(1.25	)%	$	6,963,415	1.35	%
Mortgage loans		5,367,934		5,319,623		(0.90	)%		5,389,406	0.40	%
Derivative assets		36,875		67,642		83.43	%		18,485	(49.87	)%
Other		1,077,048		1,077,048					1,077,048

Total assets		13,352,518	$	13,249,090		(0.77	)%	$	13,448,354	0.72	%

Liabilities
Repurchase agreements and commercial paper	$	7,030,719	$	7,030,719				$	7,030,719
Securitization financing		4,486,046		4,486,046					4,486,046
Derivative liabilities		44,582		(6,205	)	(113.92	)%		99,887	124.05	%
Other		484,683		484,683					484,683

Total liabilities		12,046,030		11,995,243		(0.42	)%		12,101,335	0.46	%
Minority interest		135,443		135,443					135,443
Shareholders’ equity		1,171,045		1,118,404		(4.50	)%		1,211,576	3.46	%

Total liabilities and shareholders’ equity	$	13,352,518	$	13,249,090		(0.77	)%	$	13,448,354	0.72	%

Book value per share	$	6.78	$	6.47		(4.50	)%	$	7.01	3.46	%

As shown above, the Company’s portfolio of mortgage loans and mortgage-backed securities generally will benefit less from a decline in interest rates than it will be adversely affected by a same scale increase in interest rates. The changes in the fair value of mortgage loans in a declining interest rate environment as presented in the table above will not necessarily affect the Company’s earnings or shareholders’ equity since mortgage loans held for sale are reported at lower-of-cost-or-market.

Other

The value of our direct investments in other companies is also likely to be affected by significant changes in interest rates. For example, many of the companies are exposed to risks similar to those identified above as being applicable to our own investments in mortgage-backed securities. Additionally, changes in interest rates often affect market prices of equity securities. Because each of the companies in which we invest has its own interest

101

rate risk management process, it is not feasible for us to quantify the potential impact that interest rate changes would have on the stock price or the future dividend payments by any of the companies in which we have invested.

Equity Price Risk

The Company is exposed to equity price risk as a result of its investments in marketable equity securities, investment partnerships, and trading securities. Equity price risk changes as the volatility of equity prices changes or the values of corresponding equity indices change.

While it is impossible to exactly project what factors may affect the prices of equity sectors and how much the effect might be, the table below illustrates the impact a ten percent increase and a ten percent decrease in the price of the equities held by the Company would have on the value of the total assets and the book value of the Company as of December, 2006 (dollars in thousands, except per share amounts).


	Value at December 31, 2006			Value of Equity at December 31, 2006 with 10% Increase in Price			Percent Change		Value of Equity at December 31, 2006 with 10% Decrease in Price			Percent Change
Assets
Marketable equity securities	$	90,655		$	99,721		10.00	%	$	81,590		(10.00	)%
Equity method investments		26,122			28,734		10.00	%		23,510		(10.00	)%
Investment securities-marked to market		12,622			13,884		10.00	%		11,360		(10.00	)%
Other long-term investments		3,360			3,360					3,360
Trading securities-equities		18,180			19,998		10.00	%		16,362		(10.00	)%
Other		13,201,579			13,201,579					13,201,579

Total assets	$	13,352,518		$	13,367,276		0.11	%	$	13,337,761		(0.11	)%

Liabilities	$	12,046,030		$	12,046,030				$	12,046,030

Minority Interest	$	135,443		$	135,443				$	135,443
Shareholders’ Equity
Common stock		1,747			1,747					1,747
Paid-in-capital		1,562,497			1,562,497					1,562,497
Employee stock loan receivable		(12	)		(12	)				(12	)
Accumulated other comprehensive income		(15,136	)		(6,070	)	59.90	%		(24,201	)	(59.90	)%
Accumulated retained deficit		(378,051	)		(372,359	)	1.51	%		(383,743	)	(1.51	)%

Total shareholders’ equity		1,171,045			1,185,803		1.26	%		1,156,288		(1.26	)%

Total liabilities and shareholders’ equity	$	13,352,518		$	13,367,276		0.11	%	$	13,337,761		(0.11	)%

Book value per share	$	6.78		$	6.87		1.26	%	$	6.69		(1.26	)%

Except to the extent that the Company sells its marketable equity securities or other long term investments, or a decrease in their market value is deemed to be other than temporary, an increase or decrease in the market value of those assets will not directly affect the Company’s earnings, however an increase or decrease in the value of equity method investments, investment securities-marked to market, as well as trading securities will directly effect the Company’s earnings.

102

High Yield and Non-Investment Grade Debt and Preferred Securities

We may from time-to-time underwrite, trade, invest in, and make markets in high-yield corporate debt securities and preferred stock of below investment grade-rated companies. For purposes of this discussion, non-investment grade securities are defined as preferred securities or debt rated BB+ or lower, or equivalent ratings, by recognized credit rating agencies, as well as non-rated securities or debt. Investments in non-investment grade securities generally involve greater risks than investment grade securities due to the issuer’s creditworthiness and the comparative illiquidity of the market for such securities.

Off-Balance Sheet Arrangements

Loan Sales and Securitizations

We are a party to various transactions that have an off-balance sheet component. In connection with whole loan sales to unaffiliated third parties, $7.5 billion and $4.4 billion in 2006 and 2005, respectively, and in connection with mortgage loans securitized in off balance sheet transactions, $-0- and $1.4 billion in 2006 and 2005, respectively, our subsidiaries involved in originating or acquiring mortgage loans have made representations and warranties about certain characteristics of the loans, the borrowers, and the underlying properties. Generally, while neither the bondholders in the securitization transactions nor the purchasers of whole loans have recourse to us in the event that the transferred loans do not perform as expected, such parties do have recourse to us in the event of a breach of any such representations and warranties, and in the case of whole loan sales, if a borrower fails to make one or more of the first loan payments due on the loan. Specifically, we are required to repurchase certain mortgage loans that fail to meet the standard representations and warranties included in the documents evidencing the transfer of the mortgage loans and such defaulted loans. Additionally, in the context of whole loan sales, our subsidiaries are subject to premium recapture expenses. Premium recapture expenses represent repayment of a portion of certain loan sale premiums to purchasers of previously sold loans that are repaid within a specified period subsequent to sale. From time to time, we have been required to repurchase loans that we sold.

The Company maintains a liability reserve for its repurchase agreement and premium recapture obligations. The reserve is increased through charges to the gain (loss) recorded at the time of sale. The reserve is reduced by charge-offs when loans are repurchased or premiums are repaid. As of December 31, 2006, this reserve balance was $23.5 million. During 2006, we recorded provisions of $40.8 million and charge-offs of $29.7 million to this reserve.

General Partner and Managing Member Interests

The hedge funds and other partnerships that we manage through subsidiaries as general partner or managing member had $2.8 million of liabilities as of December 31, 2006, primarily margin debt, not reflected on our balance sheet. We believe that our maximum potential exposure to a catastrophic loss (defined for these purposes as a 40% decline in the asset value of each partnership) would not exceed the value of our investment in these entities.

Critical Accounting Policies

The Company’s financial statements are prepared in conformity with U.S. Generally Accepted Accounting Principles (GAAP) and follow general practices within the industries in which it operates. The preparation of the Company’s financial statements requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although we base our estimates and assumptions on historical experience, when available, and on various other factors that we believe to be reasonable under the circumstances, management exercises significant judgment in the final determination of our estimates. Actual results may differ from these estimates.

103

Our significant accounting policies are presented in Note 2 to the consolidated financial statements. Our most critical policies that are both very important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective or complex judgments or estimates are discussed below.

Principal Investing Segment Marketable Securities

The Company accounts for its long-term investments in mortgage-backed securities and marketable equity securities under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS 115 requires that investments in debt securities be designated at the time of acquisition as “held-to-maturity,” “available-for-sale” or “trading,” and investments in equity securities be designated as either “available-for-sale” or “trading.” Nearly all of the Company’s long-term mortgage-backed securities and marketable equity securities are designated as available-for-sale and are carried at their estimated fair values with unrealized gains and losses excluded from earnings and reported in other comprehensive income or loss, a component of stockholders’ equity.

Although the Company generally intends to hold its mortgage-backed securities until maturity, it may, from time to time, sell any of its MBS as part of the overall management of its business. The available-for-sale designation provides the Company with the flexibility to sell its MBS in order to act on potential market opportunities or changes in economic conditions to ensure future liquidity and to meet other general corporate purposes as they arise.

The Company evaluates available-for-sale securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. The value of our mortgage-backed securities and our long-term investments in marketable equity securities can fluctuate significantly. In evaluating these investments for other than temporary impairment consideration is given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value, which for MBS may be maturity. If it is determined that an investment impairment is other than temporary then the amount that the fair value is below its current basis is recorded as an impairment charge and recorded through earnings as opposed to through other comprehensive income, as other temporary changes in fair value would be.

For unrealized losses that are determined to be temporary, we continue to evaluate these at each reporting date. If we determine at a future date that an impairment is other than temporary, the applicable unrealized loss will be reclassified from accumulated other comprehensive income and recorded as a realized loss at the time the determination is made.

In December 2005, the Company made a decision to reposition its MBS portfolio to eliminate a negative interest spread on much of the portfolio. This decision marked a change in the Company’s intent to hold securities in its MBS portfolio that have unrealized loss positions until a recover in fair value occurs. Consequently, a determination was made that unrealized MBS portfolio losses as of December 31, 2005, should be considered other than temporary, necessitating recognition of a $197.8 million impairment charge relating to these losses for the year ended December 31, 2005. During, 2006, the Company sold $7.6 billion of securities from the portfolio held at December 31, 2005, and subsequently during the year began to reinvest capital in the MBS portfolio. As of December 31, 2006, the fair value of investments in the mortgage-backed securities portfolio totaled $6.9 billion and the net unrealized gain with respect to these investments was $4.8 million.

Regarding the Company’s investments in marketable equity securities, as part the assessments performed at each reporting period during 2006, the Company recorded other than temporary impairment write downs of $63.3 million. These write downs related primarily to investments in the non-prime mortgage sector. As of December 31, 2006, the Company’s investments in marketable equity securities totaled $90.7 million and the net unrealized gain recorded in other comprehensive income and loss with respect to these investments was $7.8 million.

104

Accounting for Mortgage Loans Held-for-Sale

Mortgage loans originated by First NLC and other purchased loans that the Company intends to sell to third parties are classified as held for sale and are carried at the lower of cost or market value.

Mortgage loans purchased by MHC from third parties and loans originated by First NLC that the Company intends to hold for investment in its REIT portfolio are classified as held for investment and carried at amortized cost basis. If a determination is made, based on changes to the Company’s investment strategy, to sell a loan classified as held for investment, the loan will be reclassified to held for sale and carried at the lower of cost or market value.

As of September 30, 2006, the Company made a decision to reclassify the securitized mortgage loan portfolio held at the REIT from held for investment to held for sale. As a result of this change, the Company recorded its investment in these loans at the lower of cost or market, and consequently recognized $149.8 million in write-downs during 2006. The change in intent is primarily based on the strategy to redeploy the capital invested in the portfolio more rapidly to investments with higher earnings potential than if the portfolio were held to maturity. As of December 31, 2006, the net carrying value of the securitized loans held for sale was $4.4 billion.

In determining the lower-of-cost or market value of the securitized mortgage loans held for sale, the Company considers various factors affecting the overall value of the portfolio, including but not limited, to factors such as prepayment speeds, default rates, loss assumptions, geographic locations, collateral values, and mortgage insurance coverage. The Company utilizes the present value of expected cash flows considering the specific characteristics of each individual loan, aggregating the loans by specific securitization issuance, in determining the value of the portfolio. The Company also considers that these loans are collateral for securitization borrowings; therefore, taking into consideration the impact of any sale of the loan portfolio on the securitization borrowings, the related cash flows and the overall value of the residual interests in the securitization transactions that have been retained by the Company. Significant assumptions used by the Company in determining this value are supported by comparison to available market data for similar portfolios and transactions as well as a third party valuation of the residual interests in the securitization transactions.

For non-securitized mortgage loans held for sale by First NLC, the Company determines fair value based on third party pricing quotes when available, current investor commitments and/or requirements for loans of similar terms and credit quality or is estimated based on the same pricing models used by the Company to bid on whole loans in the open market. Such models incorporate aggregated characteristics of groups of loans including, collateral type, index, interest rate, margin, length of fixed interest rate period, life cap, periodic cap, underwriting standards, age and credit.

Accounting for Securitization Activities

From time to time, the Company issues asset-backed securities through securitization trusts to fund a portion of the Company’s mortgage loan portfolio. Although these securitizations are structured legally as sales, the Company accounts for the securitizations as either “sales” or “financing” transaction, depending on the structure of the securitization, in accordance with SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The transfers of loans are accounted for as sales, when control over the assets has been surrendered. Control over the transferred assets is deemed to be surrendered when (1) the loan

105

has been isolated from the Company, (2) the transferee has the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loan, and (3) the Company does not maintain effective control over the transferred loan through either (a) an agreement that both entitles and obligates the Company to repurchase or redeem them before their maturity or (b) the ability to unilaterally cause the holder to return the specific loan. For the sales securitizations, the Company derecognizes the loans transferred into the securitization and records retained financial and servicing assets or liabilities, if any, and recognizes gain or loss on sale from the transaction. For the financing securitizations, the trusts do not meet the various qualifying special purpose entity criteria under SFAS 140 and the Company has a continuing interest. Accordingly, the Company records the loans held as collateral as assets and the asset-backed securities as debt liabilities.

When the Company sells mortgage loans in securitizations, it may retain one or more retained interests in the securitization receivables. Gain or loss on sale of the receivables depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer. To obtain fair value, quoted market prices are used, if available. However, quotes are generally not available for retained interests, so the Company generally estimates fair value based on the present value of future expected cash flows estimated using management’s best estimates of the key assumptions—credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved.

The Company did not complete any securitizations in 2006 and, except for securitizations accounted for as financings, did not hold any retained interests in securitizations as of December 31, 2006.

Valuation of Private and Restricted Public Company Investments

The investment partnerships that we manage record their investments in securities at fair value. Certain investments consist of equity investments in securities of development-stage and early-stage privately and publicly held companies. The disposition of these investments may be restricted due to the lack of a ready market (in the case of privately held companies) or due to contractual or regulatory restrictions on disposition (in the case of publicly held companies). In addition, these securities may represent significant portions of the issuer’s equity and carry special contractual privileges not available to other security holders. As a result of these factors, precise valuation for the restricted public securities and private Company securities is a matter of judgment, and the determination of fair value must be considered only an approximation and may vary significantly from the amounts that could be realized if the investment were sold.

The Company evaluates its investments in private equity securities and its restricted investments in publicly traded securities at each reporting date or more frequently when economic or market concerns warrant such evaluation. In evaluating these investments for other than temporary impairment consideration is given to the financial condition and near-term prospects of the issuer and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. As part the assessments performed at each reporting period during 2006, for investments carried at cost, the Company recorded other than temporary impairment write downs of $13.9 million. These write downs related primarily to investments in the non-prime mortgage sector. As of December 31, 2006, the Company’s investments in equity securities accounted for under the cost method investments totaled $52.7 million.

Goodwill and Other Intangible Assets

We account for our intangible assets consisting of goodwill recorded as a result of the merger with FBR Asset ($108 million) and acquisition of First NLC ($54.7 million) (see Note 4), a broker relationship intangible ($10.8 million) recorded in connection with the First NLC acquisition, and an intangible related to acquired mutual fund management contracts ($11 million) (see Note 7) in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS 142, the goodwill recorded is not amortized but is tested at least annually for impairment. The values of acquired management contracts and broker relationships are amortized in

106

proportion to their expected economic benefit of 15 years and 10 years, respectively, and tested for impairment by comparing expected future gross cash flows to the asset’s carrying amount. If the expected gross cash flows are less than the carrying amount, the asset is impaired and is written-down to its fair value.

Interest Income

Interest income includes contractual interest payments adjusted for the amortization of premiums and discounts and other deferred costs in accordance with SFAS 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” Interest on loans from borrowers not expected to service the debt and interest on loans that are contractually past due 90 or more days is charged-off, or an allowance is established based upon management’s periodic evaluation. The allowance is established by a charge to interest income equal to all interest previously accrued and unpaid, and income is subsequently recognized only to the extent that cash payments are received until the borrower’s ability to make periodic interest and principal payments is adequate, in which case the loan is returned to accrual status.

Hedging Activities

In the normal course of the Company’s operations and to hedge the interest rate risk associated with its short-and long-term borrowings, the Company is a party to various financial instruments that are accounted for as derivatives in accordance with SFAS No. 133, “Accounting for Derivative Instruments and for Hedging Activities,” as amended. These instruments include interest rate caps, Eurodollar futures contracts, and interest rate swaps. In general, certain of these derivatives have qualified for hedge accounting treatment, and are accounted for as cash flow hedges. These derivatives are intended to provide income and cash flow to offset potential for reduced net interest income and cash flow under certain interest rate environments.

A key element to qualify for hedge accounting is the maintenance of adequate documentation of the hedging relationship and the Company’s risk management objective and strategy for undertaking the hedge. To qualify, on the date a derivative instrument agreement is entered into, the derivative and its hedging relationship are identified, designated and documented.

In accounting for such derivatives as cash flow hedges, the fair values of the Company’s derivative instruments are included on the consolidated balance sheets. To the extent these hedges are effective, changes in the fair value of derivative instruments are reported in accumulated other comprehensive income and reclassified to earnings in the periods in which the earnings are affected by the hedged cash flows. Changes in the fair value of derivative instruments related to hedge ineffectiveness and activity not qualifying for hedge treatment are recorded in current period earnings. As of December 31, 2006, the Company recorded deferred losses of $26.9 million related to cash flow hedges in other comprehensive income and loss. If these derivatives failed to qualify as cash flow hedges the total amount deferred would be recorded to earnings.

The Company documents the relationships between hedging instruments and hedged items, as well as the Company’s risk-management objective and strategy for undertaking various hedge transactions. This process includes linking derivatives to specific liabilities on the balance sheet or related exposures. The Company also assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in the variability of cash flows of the hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively, as discussed below.

When hedge accounting is discontinued, the derivative will continue to be recorded on the balance sheet at its fair value, until terminated. The effective position previously recorded remains in accumulated other comprehensive income and continues to be reclassified to earnings in the periods in which the earnings are affected by the hedged cash flows; however, changes in the fair value of an ineffective hedge subsequent to the date it was determined to be ineffective is recognized in the current period earnings.

107

If the hedged risk is extinguished or is not probable of occurring, the Company typically terminates any applicable hedges and recognizes any remaining related accumulated other comprehensive income balance to income or expense. However, if the Company continues to hold the derivatives, they continue to be recorded on the balance sheet at fair value with any changes being recorded to current period earnings.

Accounting for Taxes including REIT Compliance Related Matters

The parent Company, FBR Group, has elected to be treated as a REIT under the Internal Revenue Code. As a REIT, FBR Group is not subject to Federal income tax at the parent Company level to the extent that it distributes its taxable income to shareholders and complies with certain other requirements. Other requirements include distribution of at least 90% of the REIT’s taxable income, and meeting certain percentage requirements for assets and income that effectively serve to focus FBR Group’s investments into real estate, including mortgage-backed securities, and other portfolio investments. Holdings of non-real estate and portfolio investments is limited, including no more than 20% of the value of FBR Group’s total assets may consist of securities of one or more taxable REIT subsidiaries, discussed below. FBR Group intends to distribute 100% of its REIT taxable income, so we have provided no income taxes on the REIT’s book income.

The non-REIT subsidiaries of FBR Group elected to be treated as taxable REIT subsidiaries, and are subject to normal corporate income taxes. The financial statements include a provision for current and deferred taxes on the book income of our taxable REIT subsidiaries. The taxable REIT subsidiaries, including FBR TRS Holdings, Inc. and FBR Capital Markets, elected to file consolidated Federal income tax returns. We have endeavored to treat all transactions and shared expenses between the REIT and our taxable REIT subsidiaries at arms-length. There are no distribution requirements applicable to the taxable REIT subsidiaries, and after-tax earnings may be retained.

Deferred tax assets and liabilities for our taxable REIT subsidiaries represent the differences between the financial statement and income tax bases of assets and liabilities using enacted tax rates. The measurement of net deferred tax assets is adjusted by a valuation allowance if, based on our evaluation, it is more likely than not that they will not be realized. As of December 31, 2006, the Company had net deferred tax assets of $21 million, including a valuation allowance of $4.1 million.

Recently Issued Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140”. This Statement will be effective beginning in the first quarter of 2007. Earlier adoption is permitted. The statement permits interests in hybrid financial assets that contain an embedded derivative that would require bifurcation to be accounted for as a single financial instrument at fair value with changes in fair value recognized in earnings. This election is permitted on an instrument-by-instrument basis for all hybrid financial instruments held, obtained, or issued as of the adoption date. Based on its current activities, the Company does not expect that adoption of SFAS 155 will have a material effect on the consolidated financial statements.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140,” which permits entities to elect to measure servicing assets and servicing liabilities at fair value and report changes in fair value in earnings. Adoption of SFAS 156 is required for financial periods beginning after September 15, 2006. Based on its current activities, the Company does not expect the standard to have a material impact on the consolidated financial statements.

In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements”. This statement clarifies the definition of fair value, establishes a framework and hierarchy of fair value measurements, and expands disclosures about fair value measurements. This statement emphasizes that companies should use a market-based approach using similar assumptions that market participants would use in their assessment of the fair value of an

108

asset or liability. These assumptions should include, but are not limited to, risks associated with the asset or liability and restrictions on the sale or use of the asset. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently assessing the impact of adoption of SFAS 157.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115” (SFAS 159). Under SFAS 159, entities will be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis (the fair value option). This Statement is effective for the fiscal years that beginning after November 15, 2007 with early adoption permitted. The Company is currently assessing the impact of adoption of SFAS 159.

In July 2006, the FASB released FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109”. FIN 48 clarifies the accounting and reporting for income taxes where interpretation of the tax law may be uncertain. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax uncertainties with respect to positions taken or expected to be taken in income tax returns. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of adoption of FIN 48.

In June 2005, the FASB ratified the consensus reached by the EITF on Issue 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights”. EITF 04-5 presumes that a general partner controls a limited partnership, and should therefore consolidate a limited partnership, unless the limited partners have the substantive ability to remove the general partner without cause based on a simple majority vote or can otherwise dissolve the limited partnership, or unless the limited partners have substantive participating rights over decision making. The Company adopted EITF 04-5 effective January 1, 2006. Adoption of this guidance did not have an impact on the consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108. Due to diversity in practice among registrants, SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether financial statement restatement is necessary. SAB 108 is effective for fiscal years ending after November 15, 2006, and early application is encouraged. The implementation of SAB 108 did not have an impact on the consolidated financial statements.

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See Item 7 of this Form 10-K—“Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this item appears in a subsequent section of this report. See “Index to Consolidated Financial Statements of Friedman, Billings, Ramsey Group, Inc.” on page F-1.

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

109

ITEM 9A.

DISCLOSURE CONTROLS AND PROCEDURES

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, our company carried out an evaluation, under the supervision and with the participation of our company’s management, including our company’s principal executive officer, Eric F. Billings, and principal financial officer, Kurt R. Harrington, of the effectiveness of the design and operation of our company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this annual report. Based upon that evaluation, Eric F. Billings and Kurt R. Harrington concluded that our company’s disclosure controls and procedures as of December 31, 2006 are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding disclosure.

Management’s Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). The Company’s internal control over financial reporting is designed under the supervision of the firm’s principal executives and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with generally accepted accounting principles.

The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of the Company’s assets that could have a material effect on our financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.

As of December 31, 2006, management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the framework established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2006.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report appearing on page F-2, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006.

There has been no change in our company’s internal control over financial reporting during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our company’s internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

None.

110

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

This information will be provided under the headings “Proposal 1—Election of Directors,” “Corporate Governance—Executive Officers of the Company,” “—Director Candidate Recommendations and Nominations by Shareholders,” “—Committee Responsibilities and Meetings” and “Security Ownership—Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive proxy statement for our 2007 annual meeting of shareholders, which will be filed with the SEC no later than 120 days after the end of the fiscal year, and the information under those headings is hereby incorporated by reference.

We have not adopted a code of ethics that applies only to our principal executive officer, principal financial officer and principal accounting officer, because our Statement of Business Principles is broadly written to cover these officers and their activities. Shareholders may view our Statement of Business Principles, as well as other corporate governance materials on our Internet web site at http://www.fbr.com under Corporate Governance. Information on or connected to our Internet web site shall not be considered a part of or incorporated by reference into this Form 10-K. A copy of Statement of Business Principles, as well as other corporate governance materials, may also be obtained free of charge by submitting a written request to the Corporate Secretary, Friedman, Billings, Ramsey Group, Inc., 1001 Nineteenth Street North, Arlington, Virginia 22209.

Because our Class A common stock is listed on the New York Stock Exchange (“NYSE”), our chief executive officer is required to make, and has made, an annual certification to the NYSE stating that he was not aware of any violation by us of the corporate governance listing standards of the NYSE. Our chief executive officer made his annual certification to that effect to the NYSE as of July 8, 2006. In addition, we have filed, as exhibits to the Annual Report on Form 10-K, the certifications of our principal executive officer and our principal financial officer required under Section 302 of the Sarbanes Oxley Act of 2002 to be filed with the Securities and Exchange Commission regarding the quality of our public disclosure.

ITEM 11. EXECUTIVE COMPENSATION

This information will be provided under the headings “Compensation Committee Interlocks and Insider Participation,” “Directors and Management Compensation” and “Compensation Discussion and Analysis” in our definitive proxy statement for our 2007 annual meeting of shareholders, which will be filed with the SEC no later than 120 days after the end of the fiscal year, and the information under those headings is hereby incorporated by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS

This information will be provided under the headings “Security Ownership—Equity Compensation Plans” “—Security Ownership of Management” and “—Security Ownership of Certain Beneficial Owners” in our definitive proxy statement for our 2007 annual meeting of shareholders, which will be filed with the SEC no later than 120 days after the end of the fiscal year, and the information under those headings is hereby incorporated by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

This information will be provided under the headings “Transactions with Related Persons and Review, Approval or Ratification of Transactions with Related Persons” and “Corporate Governance—Independence of our Board of Directors” in our definitive proxy statement for our 2007 annual meeting of shareholders, which will be filed with the SEC no later than 120 days after the end of the fiscal year, and the information under those headings is hereby incorporated by reference.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

This information will be provided under the heading “Principal Auditor Fees and Services” in our definitive proxy statement for our 2007 annual meeting of shareholders, which will be filed with the SEC no later than 120 days after the end of the fiscal year, and the information under that heading is hereby incorporated by reference.

111

PART IV

ITEM 15. EXHIBITS AND CONSOLIDATED FINANCIAL STATEMENT SCHEDULES

(a) (1) Financial Statements. The Friedman Billings Ramsey Group, Inc. consolidated financial statements for the year ended December 31, 2006, filed as part of this Form 10-K, are incorporated by reference into this Item 15:

•

Report of Independent Registered Public Accounting Firm (page F-2)

•

Consolidated Balance Sheets—Years ended 2006 and 2005 (page F-4)

•

Consolidated Statements of Operations—Years ended 2006, 2005 and 2004 (page F-5)

•

Consolidated Statements of Changes in Shareholder’s Equity—Years ended 2006, 2005 and 2004 (page F-6)

•

Consolidated Statements of Cash Flows—Years ended 2006, 2005 and 2004 (page F-7)

•

Notes to Consolidated Financial Statements (page F-8)

(2) Financial Statement Schedules. All schedules are omitted because they are not required or because the information is shown in the financial statements or notes thereto.

(3) Exhibits


Exhibit Number		Exhibit Title
2.01		Agreement and Plan of Merger dated as of November 14, 2002, by and among the Registrant, FBR Asset Investment Corporation and Forest Merger Corporation (incorporated by reference to Annex A to the joint proxy statement/prospectus which is a part of Amendment No. 4 to the Registration Statement on Form S-4 (File No. 333-101703))

3.01		Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K filed on March 31, 2003, as amended May 15, 2003).

3.02		Amended and Restated Bylaws (incorporated by reference to Exhibit 2.1 to the Current Report on Form 8-K filed on March 31, 2003, as amended May 15, 2003).

4.01		Form of Specimen Certificate for Class A Common Stock (incorporated by reference to Exhibit 4.1 to the Amendment No. 1 to the Registration Statement on Form S-3 (File No. 333-107731)).

4.02		Form of Senior Indenture (incorporated by reference to Exhibit 4.2 to the Registration Statement on Form S-3 (File No. 333-107731)).

4.03		Form of Senior Debt Security (incorporated by reference to Exhibit 4.3 to the Registration Statement on Form S-3 (File No. 333-107731)).

4.04		Form of Subordinated Indenture (incorporated by reference to Exhibit 4.4 to the Registration Statement on Form S-3 (File No. 333-107731)).

4.05		Form of Subordinated Debt Security (incorporated by reference to Exhibit 4.5 to the Registration Statement on Form S-3 (File No. 333-107731)).

10.01		Friedman, Billings, Ramsey Group, Inc. 2004 Long-Term Incentive Plan (incorporated by reference to Appendix A to the Definitive Proxy Statement filed on April 29, 2004).*

112


Exhibit Number		Exhibit Title
10.02		1997 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.05 to Amendment No. 2 to the Registration Statement on Form S-1 (File No. 333-39107)).*

10.03		FBR Stock and Annual Incentive Plan (incorporated by reference to Exhibit 10.03 to the Annual Report on Form 10-K for the fiscal year ended December 31, 1999).*

10.04		Non-Employee Director Stock Compensation Plan (incorporated by reference to Exhibit 10.07 to Amendment No. 2 to the Registration Statement on Form S-1 (File No. 333-39107)).*

10.05		Key Employee Incentive Plan (incorporated by reference to Exhibit 10.08 to Amendment No. 2 to the Registration Statement on Form S-1 (File No. 333-39107)).*

10.06		Agreement between Friedman Billings Ramsey Group, Inc., FBR Capital Management, Inc., Orkney Holdings, Inc., Friedman, Billings, Ramsey Investment Management, Inc. and Chevy Chase Bank, F.S.B. (incorporated by reference to Exhibit 10.09 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2002).

10.07		Securities Purchase Agreement, dated as of January 10, 2005, by and among Friedman, Billings, Ramsey Group, Inc., FNLC Financial Services, Inc., NLC Financial Services, LLC, Neal S. Henschel, Jeffrey M. Henschel, Benjamin Henschel, Andrew Henschel and Sun Mortgage Partners, L.P. (incorporated by reference to Exhibit 10.08 to the Annual Report on Form 10-K for the fiscal year ended December 31, 2004).

10.08		Credit Agreement, dated as of July 21, 2005, among the Registrant, the lenders party thereto, and JPMorgan Chase Bank, N.A., as Administrative Agent (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on July 26, 2005).

10.09		Credit Agreement, dated as of October 20, 2006, among the Registrant and JP Morgan Chase Bank, N.A., as Administrative Agent, J.P. Morgan Securities, Inc., as Sole Lead Arranger and Sole Bookrunner, Calyon New York Branch, as Syndication Agent (incorporated by reference to Exhibit 10.01 to the Quarterly Report on Form 10-Q filed on November 9, 2006).

10.10		Letter Agreement, dated as of June 22, 2006, by and among the Registrant, FBR TRS Holdings, Inc., FBR Capital Markets Corporation, Forest Holdings LLC and Forest Holdings (ERISA) LLC (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on June 22, 2006).

10.11		Contribution Agreement, dated July 20, 2006, by and between FBR TRS Holdings, Inc. and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on July 26, 2006).

10.12		Corporate Agreement, dated July 20, 2006, by and between FBR Capital Markets Corporation and the Registrant (incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K filed on July 26, 2006).

10.13		Management Services Agreement, dated as of July 20, 2006, by and between the Registrant and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K filed on July 26, 2006).*

10.14		Services Agreement, dated as of July 20, 2006, by and between Friedman, Billings, Ramsey Group, Inc. and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.4 to the Current Report on Form 8-K filed on July 26, 2006).

10.15		Tax Sharing Agreement, dated as of July 20, 2006, by and between the FBR TRS Holdings, Inc. and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.5 to the Current Report on Form 8-K filed on July 26, 2006).

113


Exhibit Number		Exhibit Title
10.16		Trademark License Agreement, dated as of July 20, 2006, by and between Friedman, Billings, Ramsey Group, Inc. and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.6 to the Current Report on Form 8-K filed on July 26, 2006).

10.17		Investment Agreement, dated as of July 19, 2006, by and among Forest Holdings LLC, Forest Holdings (ERISA) LLC and FBR Capital Markets Corporation and Friedman, Billings, Ramsey Group, Inc. (incorporated by reference to Exhibit 10.7 to the Current Report on Form 8-K filed on July 26, 2006).

10.18		Governance Agreement, dated as of July 20, 2006, by and among Forest Holdings LLC, Forest Holdings (ERISA) LLC, FBR TRS Holdings, Inc. and Friedman, Billings, Ramsey Group, Inc. (incorporated by reference to Exhibit 10.8 to the Current Report on Form 8-K filed on July 26, 2006).

10.19		Voting Agreement, dated as of July 20, 2006, by and among by and among Forest Holdings LLC, Forest Holdings (ERISA) LLC, FBR Capital Markets Corporation, FBR TRS Holdings and Friedman, Billings, Ramsey Group, Inc. (incorporated by reference to Exhibit 10.9 to the Current Report on Form 8-K filed on July 26, 2006).

10.20		Professional Services Agreement, dated as of July 20, 2006, by and between Crestview Advisors L.L.C. and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.10 to the Current Report on Form 8-K filed on July 26, 2006).*

10.21		Registration Rights Agreement, dated as of July 20, 2006, by and among Forest Holdings LLC, Forest Holdings (ERISA) LLC and FBR Capital Markets Corporation (incorporated by reference to Exhibit 10.11 to the Current Report on Form 8-K filed on July 26, 2006).

10.22		Stock Option Agreement, dated as of July 20, 2006, by and between FBR Capital Markets Corporation and Forest Holdings LLC (incorporated by reference to Exhibit 10.12 to the Current Report on Form 8-K filed on July 26, 2006).

10.23		Stock Option Agreement, dated as of July 20, 2006, between FBR Capital Markets Corporation and Forest Holdings (ERISA) LLC (incorporated by reference to Exhibit 10.13 to the Current Report on Form 8-K filed on July 26, 2006).

10.24		FBR Capital Markets Corporation 2006 Long-Term Incentive Plan (incorporated by reference to Exhibit 10.14 to the Current Report on Form 8-K filed on July 26, 2006).*

10.25		Form of FBR Capital Markets Corporation Incentive Stock Option Agreement (incorporated by reference to Exhibit 10.15 to the Current Report on Form 8-K filed on July 26, 2006).*

10.26		Form of FBR Capital Markets Corporation Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.16 to the Current Report on Form 8-K filed on July 26, 2006).*

10.27		FBR Capital Markets Corporation 2007 Employee Stock Purchase Plan.*†

11.01		Statement regarding Computation of Per Share Earnings (included in Part II, Item 8 and Note 2 to the Registrant’s Consolidated Financial Statements on page F-18).

12.01		Statement regarding Computation of Ratio of Earnings to Fixed Charges.†

21.01		List of Subsidiaries of the Registrant.†

23.01		Consent of PricewaterhouseCoopers LLP.†

24.01		Power of Attorney (included on the signature page of this Annual Report on Form 10-K)†

114


Exhibit Number		Exhibit Title
31.01		Section 302 Certification of Chief Executive Officer.†

31.02		Section 302 Certification of Chief Financial Officer.†

32.01		Section 906 Certification of Chief Executive Officer.†

32.02		Section 906 Certification of Chief Financial Officer.†

*	Management agreement or compensatory plan or arrangement.

†	Filed herewith.

115

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.


Signature	Title	Date

/S/ ERIC F. BILLINGS ERIC F. BILLINGS	Chairman, Chief Executive Officer and Director (Principal Executive Officer)	March 1, 2007

/S/ KURT R. HARRINGTON KURT R. HARRINGTON	Executive Vice President and Chief Financial Officer (Principal Financial Officer)	March 1, 2007

/S/ ROBERT J. KIERNAN ROBERT J. KIERNAN	Senior Vice President, Controller and Chief Accounting Officer (Principal Accounting Officer)	March 1, 2007

/S/ DANIEL J. ALTOBELLO DANIEL J. ALTOBELLO	Director	March 1, 2007

/S/ PETER A. GALLAGHER PETER A. GALLAGHER	Director	March 1, 2007

/S/ STEPHEN D. HARLAN STEPHEN D. HARLAN	Director	March 1, 2007

/S/ RUSSELL C. LINDNER RUSSELL C. LINDNER	Director	March 1, 2007

/S/ RALPH S. MICHAEL III RALPH S. MICHAEL III	Director	March 1, 2007

/S/ W. RUSSELL RAMSEY W. RUSSELL RAMSEY	Director	March 1,2007

/S/ WALLACE L. TIMMENY WALLACE L. TIMMENY	Director	March 1, 2007

/S/ JOHN T. WALL JOHN T. WALL	Director	March 1, 2007

116

FINANCIAL STATEMENTS OF FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

Index to Friedman, Billings Ramsey Group, Inc. Consolidated Financial Statements


		Page
Report of Independent Registered Public Accounting Firm		F-2

Consolidated Balance Sheets as of December 31, 2006 and 2005		F-4

Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004		F-5

Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2006, 2005 and 2004		F-6

Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004		F-7

Notes to Consolidated Financial Statements		F-8

F-1

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of

Friedman, Billings, Ramsey Group, Inc.:

We have completed integrated audits of Friedman, Billings, Ramsey Group, Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Friedman, Billings, Ramsey Group, Inc. and its subsidiaries (the “Company”) at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Notes 2 and 13 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation in 2006.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control–Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting

F-2

includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

/s/ PricewaterhouseCoopers LLP

Baltimore, Maryland

February 27, 2007

F-3

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share amounts)


	December 31,
	2006			2005
ASSETS
Cash and cash equivalents	$	189,956		$	238,615
Restricted cash		132			6,101
Receivables:
Due from servicer		64,740			129,578
Interest		68,981			83,614
Other		83,528			46,327
Investments:
Mortgage-backed securities, at fair value		6,870,661			8,002,561
Loans held for investment, net		—			6,841,266
Loans held for sale, net		5,367,934			963,807
Long-term investments		185,492			347,644
Reverse repurchase agreements		—			283,824
Trading securities, at fair value		18,180			1,032,638
Due from clearing broker		28,999			71,065
Derivative assets, at fair value		36,875			70,636
Goodwill		162,765			162,765
Intangible assets, net		21,825			26,485
Furniture, equipment, software and leasehold improvements, net of accumulated depreciation and amortization of $36,841 and $24,295, respectively		44,111			46,382
Prepaid expenses and other assets		208,339			82,482

Total assets	$	13,352,518		$	18,435,790

LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Trading account securities sold short but not yet purchased, at fair value	$	202		$	150,547
Commercial paper		3,971,389			6,996,950
Repurchase agreements		3,059,330			2,698,619
Derivative liabilities, at fair value		44,582			31,952
Dividends payable		8,743			34,588
Interest payable		12,239			12,039
Accrued compensation and benefits		57,227			82,465
Accounts payable, accrued expenses and other liabilities		81,819			82,576
Temporary subordinated loan payable		—			75,000
Securitization financing, net		4,486,046			6,642,198
Long-term debt		324,453			324,686

Total liabilities		12,046,030			17,131,620

Minority Interest		135,443			—
Commitments and Contingencies (Note 12)
Shareholders’ Equity:
Preferred Stock, $0.01 par value, 25,000,000 shares authorized, none issued and outstanding		—			—
Class A Common Stock, $0.01 par value, 450,000,000 shares authorized, 161,487,096 and 159,373,483 shares issued, respectively		1,615			1,594
Class B Common Stock $0.01 par value, 100,000,000 shares authorized 13,225,249 and 13,480,249 shares issued and outstanding, respectively		132			135
Additional paid-in capital		1,562,497			1,547,128
Employee stock loan receivable including accrued interest (1,600 and 551,342 shares, respectively)		(12	)		(4,018	)
Deferred compensation		—			(15,602	)
Accumulated other comprehensive loss, net of taxes		(15,136	)		(977	)
Accumulated deficit		(378,051	)		(224,090	)

Total shareholders’ equity		1,171,045			1,304,170

Total liabilities and shareholders’ equity	$	13,352,518		$	18,435,790

The accompanying notes are an integral part of these consolidated financial statements.

F-4

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands except per share amounts)


	Year Ended December 31,
	2006			2005			2004
Revenues:
Investment banking:
Capital raising	$	190,187		$	356,753		$	398,183
Advisory		24,148			17,759			30,115
Institutional brokerage:
Principal transactions		5,814			17,950			20,444
Agency commissions		101,009			82,778			89,650
Mortgage trading interest		51,147			30,859			—
Mortgage trading net investment loss		(3,301	)		(3,820	)		—
Asset management:
Base management fees		20,093			30,348			28,307
Incentive allocations and fees		1,327			1,929			10,940
Principal investment:
Interest		594,879			549,832			350,691
Net investment (loss) income		(184,552	)		(239,754	)		101,973
Dividends		14,551			36,622			14,644
Mortgage Banking:
Interest		88,662			78,007			—
Net investment income		83,786			13,741			—
Other		20,154			22,302			7,155

Total revenues		1,007,904			995,306			1,052,102
Interest expense		611,800			546,313			164,156
Provision for loan losses		15,740			14,291			—

Revenues, net of interest expense and provision for loan losses		380,364			434,702			887,946

Non-interest expenses:
Compensation and benefits		309,065			331,492			323,524
Professional services		59,722			66,550			50,467
Business development		42,150			46,648			44,955
Clearing and brokerage fees		11,820			8,882			9,123
Occupancy and equipment		50,051			34,044			14,458
Communications		24,398			20,634			13,959
Other operating expenses		89,377			70,679			22,740

Total non-interest expenses		586,583			578,929			479,226

Operating (loss) income		(206,219	)		(144,227	)		408,720
Other income:
Gain on sale of subsidiary shares		121,511			—			—

Net (loss) income before taxes and minority interest		(84,708	)		(144,227	)		408,720
Income tax (benefit) provision		(14,682	)		26,683			59,161
Minority interest in loss of consolidated subsidiary		(2,751	)		—			—

Net (loss) income	$	(67,275	)	$	(170,910	)	$	349,559

Basic (loss) earnings per share	$	(0.39	)	$	(1.01	)	$	2.09

Diluted (loss) earnings per share	$	(0.39	)	$	(1.01	)	$	2.07

Dividends declared per share	$	0.50		$	1.22		$	1.53

Basic weighted average shares outstanding		171,667,179			169,333,013			167,099,326

Diluted weighted average shares outstanding		171,667,179			169,333,013			168,489,578

The accompanying notes are an integral part of these consolidated financial statements.

F-5

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in thousands)


	Class A Number of Shares	Class A Amount		Class B Number of Shares		Class B Amount			Additional Paid-In Capital			Employee Stock Loan Receivable			Deferred Compensation, net			Accumulated Other Comprehensive Income (Loss)			Retained Earnings (Accumulated Deficit)			Total			Compre- hensive Income (Loss)
Balances, December 31, 2003	141,021,320	$	1,410	25,872,099		$	259		$	1,443,228		$	(8,277	)	$	(2,203	)	$	60,505		$	59,417		$	1,554,339

Net income	—		—	—			—			—			—			—			—			349,559			349,559		$	349,559
Conversion of Class B shares to Class A shares	942,500		10	(942,500	)		(10	)		—			—			—			—			—			—
Issuance of Class A common stock	2,003,385		20	—			—			40,003			—			(14,660	)		—			—			25,363
Repayment on employee stock purchase and loan plan receivable	—		—	—			—			—			3,796			—			—			—			3,796
Interest on employee stock purchase and loan plan	—		—	—			—			409			(409	)		—			—			—			—
Other comprehensive income:
Net Change in unrealized gain (loss) on available-for-sale investment securities (net of taxes of $1,978)	—		—	—			—			—			—			—			(76,392	)		—			(76,392	)		(76,392	)
Net change in unrealized gain (loss) on cash flow hedges	—		—	—			—			—			—			—			(22,275	)		—			(22,275	)		(22,275	)

Comprehensive income																											$	250,892

Dividends	—		—	—			—			—			—			—			—			(255,866	)		(255,866	)

Balances, December 31, 2004	143,967,205	$	1,440	24,929,599		$	249		$	1,483,640		$	(4,890	)	$	(16,863	)	$	(38,162	)	$	153,110		$	1,578,524

Net loss	—		—	—			—			—			—			—			—			(170,910	)		(170,910	)	$	(170,910	)
Conversion of Class B shares to Class A shares	11,449,350		114	(11,449,350	)		(114	)		—			—			—			—			—			—
Issuance of Class A common stock	3,956,928		40	—			—			63,211			—			1,261			—			—			64,512
Repayment on employee stock purchase and loan plan receivable	—		—	—			—			—			1,149			—			—			—			1,149
Interest on employee stock purchase and loan plan	—		—	—			—			277			(277	)		—			—			—			—
Other comprehensive income:
Net change in unrealized gain (loss) on available-for-sale investment securities (net of taxes of $1,978)	—		—	—			—			—			—			—			39,481			—			39,481			39,481
Net change in unrealized gain (loss) on cash flow hedges	—		—	—			—			—			—			—			(2,296	)		—			(2,296	)		(2,296	)

Comprehensive income (loss)																											$	(133,725	)

Dividends	—		—	—			—			—			—			—			—			(206,290	)		(206,290	)

Balances, December 31, 2005	159,373,483	$	1,594	13,480,249		$	135		$	1,547,128		$	(4,018	)	$	(15,602	)	$	(977	)	$	(224,090	)	$	1,304,170

Net loss	—		—	—			—			—			—			—			—			(67,275	)		(67,275	)	$	(67,275	)
Reclassification of deferred compensation to additional paid-in capital	—		—	—			—			(15,602	)		—			15,602			—			—
Conversion of Class B shares to Class A shares	255,000		3	(255,000	)		(3	)		—			—			—			—			—			—
Issuance of Class A common stock	1,858,613		18	—			—			20,793			—			—			—			—			20,811
Repayment on employee stock purchase and loan plan receivable	—		—	—			—			—			4,203			—			—			—			4,203
Interest on employee stock purchase and loan plan	—		—	—			—			197			(197	)		—			—			—			—
Stock compensation expense for stock options and employee stock purchase plan	—		—	—			—			4,976			—			—			—			—			4,976
Other comprehensive income:
Net change in unrealized gain (loss) on available-for-sale investment securities (net of taxes of $458)	—		—	—			—			—			—			—			10,463			—			10,463			10,463
Net change in unrealized gain (loss) on cash flow hedges	—		—	—			—			—			—			—			(24,622	)		—			(24,622	)		(24,622	)

Comprehensive income (loss)																											$	(81,434	)

Other	—		—	—			—			5,005			—			—			—			—			5,005
Dividends	—		—	—			—			—			—			—			—			(86,686	)		(86,686	)

Balances, December 31, 2006	161,487,096	$	1,615	13,225,249		$	132		$	1,562,497		$	(12	)	$	—		$	(15,136	)	$	(378,051	)	$	1,171,045

The accompanying notes are an integral part of these consolidated financial statements.

F-6

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)


	Year Ended December 31,
	2006			2005			2004
Cash flows from operating activities:
Net (loss) income	$	(67,275	)	$	(170,910	)	$	349,559
Non-cash items included in earnings—
Gain on sale of subsidiary stock		(121,511	)		—			—
Lower of cost or market write-down for securitized mortgage loans		149,691			—			—
Unrealized and realized losses (gains) from investments		40,263			256,706			(107,152	)
Premium amortization on mortgage-backed securities and loans held for investment		35,712			85,456			78,777
Derivative contracts marked-to-market		11,956			(5,127	)		(1,910	)
Amortization of premium on interest rate cap		11,055			—			—
Depreciation and amortization		18,116			14,163			5,765
Income tax provision-deferred		(14,645	)		(8,212	)		(6,689	)
Loan provisions		59,546			33,202			—
Minority interest in loss of consolidated subsidiary		(2,751	)		—			—
Other		15,748			(6,116	)		192
Changes in operating assets:
Receivables—
Due from servicer		64,838			(128,745	)		—
Interest receivable		14,634			(33,770	)		(1,650	)
Other		(25,447	)		(22,756	)		(5,935	)
Due from clearing broker		42,065			24,182			(5,307	)
Origination and purchases of loans held for sale, net of fees		(7,604,602	)		(5,020,507	)		—
Cost basis on sale and principal repayments of loans held for sale		7,233,744			4,451,045			—
Trading securities		995,123			(1,024,894	)		(2,812	)
Prepaid expenses and other assets		(15,971	)		11,765			(17,856	)
Reverse repurchase agreements related to broker-dealer activities		147,918			(147,918	)		—
Changes in operating liabilities:
Trading account securities sold but not yet purchased		(150,345	)		133,371			7,651
Repurchase agreements related to broker-dealer activities, net		(929,363	)		929,363			—
Accounts payable and accrued expenses		(29,003	)		(35,527	)		56,527
Accrued compensation and benefits		(22,457	)		(31,470	)		30,317

Net cash (used in) provided by operating activities		(142,961	)		(696,699	)		379,477

Cash flows from investing activities:
Purchases of mortgage-backed securities		(7,924,138	)		(1,971,957	)		(7,574,376	)
Proceeds from sales of mortgage-backed securities		8,165,979			1,394,261			2,212,817
Receipt of principal payments on mortgage-backed securities		892,101			3,965,138			4,212,133
Proceeds (purchases) of reverse repurchase agreements, net		135,902			47,469			(183,375	)
Purchases of long-term investments		(49,479	)		(72,145	)		(208,464	)
Proceeds from sales of long-term investments		208,648			94,602			190,111
Purchases and originations of loans held for investment, including loans reclassified to held for sale		(1,289	)		(7,646,625	)		—
Receipt of principal payments from loans held for investment, including loans reclassified to held for sale		2,108,137			751,506			—
Proceeds from sales of loans held for investment reclassified to held for sale		351,662			99,159			—
Proceeds from sales of real estate owned		36,155			—			—
Purchases of fixed assets		(11,571	)		(32,025	)		(15,860	)
Proceeds from disposals of fixed assets		—			—			22
Purchase of First NLC Financial Services, LLC, net of cash		—			(64,912	)		—

Net cash provided by (used in) investing activities		3,912,107			(3,435,529	)		(1,366,992	)

Cash flows from financing activities:
Proceeds from issuance of long-term debt		—			195,000			72,500
Repayments of long-term debt		(970	)		(970	)		—
(Proceeds from/repayments of) repurchase agreements, net		1,290,432			(2,181,478	)		(1,628,107	)
(Repayments of) proceeds from commercial paper, net		(3,025,561	)		(297,999	)		2,901,984
Repayments of temporary subordinated loan		(75,000	)		(200,000	)		—
Proceeds from temporary subordinated loan		—			275,000			—
Proceeds from sale of subsidiary stock, net of issuance costs		259,738			—			—
Dividends paid		(112,774	)		(237,333	)		(249,731	)
Proceeds from issuance of common stock		4,700			5,632			18,756
Proceeds from securitization financing, net		34,782			7,140,458			—
Repayments of securitization financing		(2,197,355	)		(512,376	)		—
Payments for purchases of derivatives with financing element		—			(62,371	)		—
Proceeds from the issuance of derivatives with financing element		—			21,760			—
Proceeds from repayment of employee stock loan receivable		4,203			1,149			3,796

Net cash (used in) provided by financing activities		(3,817,805	)		4,146,472			1,119,198

Net (decrease) increase in cash and cash equivalents		(48,659	)		14,244			131,683
Cash and cash equivalents, beginning of year		238,615			224,371			92,688

Cash and cash equivalents, end of year	$	189,956		$	238,615		$	224,371

Supplemental Cash Flow Information:
Cash payments for interest	$	632,048		$	543,185		$	148,391
Cash payments for taxes	$	7,897		$	50,622		$	64,722

Note:

See Note 16 for supplemental cash flow information, non-cash transactions.

The accompanying notes are an integral part of these consolidated financial statements.

F-7

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share amounts)

Note 1. Organization and Nature of Operations:

Organization

On March 31, 2003, Friedman, Billings, Ramsey Group, Inc., a Virginia Corporation (the Company or FBR Group) merged with FBR Asset Investment Corporation (FBR Asset). The merger was accounted for as a purchase of FBR Asset by FBR Group using the purchase method of accounting. Upon completion of the merger, the parent Company, FBR Group, elected Real Estate Investment Trust (REIT) status for U.S. federal income tax purposes. Also upon completion of the merger, the Company created FBR TRS Holdings, Inc. (FBR TRS Holdings), a taxable REIT subsidiary holding Company, under which the Company conducts its investment banking, institutional brokerage, asset management and mortgage banking business in taxable REIT subsidiaries.

The Company conducts its mortgage-backed securities (MBS) and merchant banking investment business at the parent company REIT level. Through its qualified REIT subsidiary, MHC I, Inc. (MHC), a wholly owned subsidiary of FBR Group, the Company invests in non-conforming mortgage loans.

FBR TRS Holdings, a Virginia corporation, is a holding Company of which the principal operating subsidiaries are FBR Capital Markets Corporation (FBR Capital Markets), FBR Investment Services, Inc. (FBRIS), Money Management Advisors, Inc. (MMA), FBR Bancorp, Inc. (FBR Bank) and FNLC Financial Services, Inc. (FNLC). FBR Capital Markets, a Virginia corporation formed in 2006, is a holding Company of which the principal operating companies are Friedman, Billings, Ramsey & Co., Inc. (FBR & Co.), Friedman, Billings, Ramsey International, Ltd. (FBRIL), FBR Investment Management, Inc. (FBRIM) and FBR Fund Advisers, Inc. (FBRFA). As a result of a July 2006 private equity offering (see Note 3), FBR Capital Markets is a majority-owned subsidiary of FBR TRS Holdings.

FBR & Co. and FBRIS are registered broker-dealers and members of the National Association of Securities Dealers, Inc. They act as introducing brokers and forward all transactions to clearing brokers on a fully disclosed basis. FBR & Co. and FBRIS do not hold funds or securities for, nor owe funds or securities to, customers. During the periods presented, FBR & Co.’s capital raising and advisory activities were concentrated primarily on financial services, real estate, energy, healthcare and technology companies.

FBRIM is a registered investment adviser that manages and acts as general partner, managing member or manager of various proprietary hedge and private equity funds. FBRIM also manages separate investment accounts. FBRFA is a registered investment adviser that manages The FBR Family of Funds.

In December 2004, FBR formed FNLC to assist in the acquisition of First NLC Financial Services, LLC (First NLC). In February 2005, the Company consummated the acquisition of First NLC (see Note 4). First NLC originates, acquires, underwrites and funds non-conforming mortgage loans secured primarily by single-family residences, then sells those loans to institutional loan purchasers or to MHC for retention in the Company’s mortgage loan portfolio.

Nature of Operations

The Company’s principal business activities, including investing as principal in MBS, non-conforming mortgage loans and merchant banking opportunities, capital raising, securities sales and trading, merger and acquisition and advisory services, proprietary investments, mortgage banking, and venture capital and other asset management services, are all linked to the capital markets.

F-8

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

With the acquisition of First NLC and the formation of MHC, the Company’s real-estate related investment portfolio includes non-conforming mortgage loans. The Company originates, acquires, finances and sells non-conforming mortgage loans. Non-conforming mortgage loans include loans to borrowers who do not meet the conforming underwriting guidelines of Fannie Mae, Freddie Mac or Ginnie Mae because of higher loan-to-value ratios, the nature or absence of income documentation, limited credit histories, high levels of consumer debt, past credit difficulties or other factors. Non-conforming loans also include loans to more creditworthy borrowers where the size of the loan exceeds conforming underwriting guidelines. The Company finances these investments through warehouse repurchase agreements and issuance of long-term asset-backed securities.

The Company invests in MBS and mortgage loans that, together with the Company’s other real estate-related assets represent qualifying REIT assets under the U.S. federal tax code. The portfolio of residential mortgage-backed assets is managed to provide a risk-adjusted return on capital. The Company principally invests in adjustable-rate MBS of varying initial fixed periods in order to maintain a low effective duration. The Company finances these investments primarily by entering into repurchase agreements with broker dealers and through Georgetown Funding, LLC, an asset-backed commercial paper program that it administers. The Company also invests in merchant banking opportunities, including equity securities, mezzanine debt and senior loans.

The Company constantly evaluates the rates of return that can be achieved in each investment category in which it participates. Since the merger, MBS investments have provided higher relative rates of return than most other investment opportunities we have evaluated. Consequently, during this time the Company has maintained a high allocation of assets and capital in this sector.

The Company intends to continue to evaluate investment opportunities against the returns available in each of its investment alternatives and endeavor to allocate assets and capital with an emphasis toward the highest risk-adjusted return available. This strategy will cause the Company to have different allocations of capital in different environments.

In addition, the Company’s investment banking and institutional brokerage business activities are primarily focused on small- and mid-cap stocks in the financial services, real estate, technology, energy, healthcare, consumer and diversified industries sectors. By their nature, the Company’s business activities are conducted in markets which are highly competitive and are not only subject to general market conditions, volatile trading markets and fluctuations in the volume of market activity but to the conditions affecting the companies and markets in the Company’s areas of focus.

The Company’s revenues from investment banking, incentive allocations or fees from asset management, and principal investment activities, are subject to substantial fluctuations due to a variety of factors that cannot be predicted with great certainty, including the overall condition of the economy and the securities markets as a whole and of the sectors on which the Company focuses. Fluctuations also occur due to the level of market activity, which, among other things, affects the flow of investment dollars and the size, number and timing of transactions. As a result, net income (loss) and revenues in any particular period may vary significantly from period to period and year to year.

The financial services industry continues to be affected by a competitive environment. In order to compete in this increasingly competitive environment, the Company continually evaluates its businesses across varying

F-9

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

market conditions for profitability and alignment with long-term strategic objectives, including the diversification of revenue sources. The Company believes that it is important to diversify and strengthen its revenue base by increasing the segments of its business that offer a recurring and more predictable source of revenue.

Concentration of Risk

A substantial portion of the Company’s investment banking revenues in a year may be derived from a small number of transactions or issues or may be concentrated in a particular industry. For the years ended December 31, 2006, 2005, and 2004, investment banking revenue accounted for 56.3%, 86.2%, and 48.2%, respectively, of the Company’s net revenue.

Properties securing the mortgage loans in the Company’s portfolio are geographically dispersed throughout the United States. As of December 31, 2006, approximately 31%, 13%, 7% and 6% of the properties were located in California, Florida, Illinois, and New York, respectively. The remaining properties securing the Company’s mortgage loan portfolio did not exceed 5% of the total portfolio in any other state.

Note 2. Summary of Significant Accounting Policies:

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries as well as variable interest entities where the Company is determined to be the primary beneficiary in accordance with Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable Interest Entities an Interpretation of ARB No. 51”. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain amounts in the consolidated financial statements and notes for prior periods have been reclassified to conform to the current year’s presentation.

Use of Estimates

The preparation of the Company’s financial statements, in conformity with accounting principles generally accepted in the United States of America, requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although we base our estimates and assumptions on historical experience, when available, and on various other factors that we believe to be reasonable under the circumstances, management exercises significant judgment in the final determination of our estimates. Actual results may differ from these estimates.

Cash Equivalents

Cash equivalents include demand deposits with banks, money market accounts and highly liquid investments with original maturities of three months or less that are not held for sale in the ordinary course of business. As of December 31, 2006 and 2005, approximately 58% and 61%, respectively, of the Company’s cash equivalents were invested in money market funds that invest primarily in U.S. Treasuries and other government securities backed by the U.S. government.

F-10

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Restricted Cash

Restricted cash includes amounts required to be held as collateral for certain commercial paper arrangements and cash held in escrow for borrowers related to the origination of mortgage loans. The cash held in escrow for borrowers are used to pay taxes and insurance premiums on behalf of the borrowers pending sale of the related loans.

Mortgage Loans Held-for-Sale

Securitizations

F-11

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

of the securitization, in accordance with Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (SFAS 140). The transfers of loans are accounted for as sales, when control over the assets has been surrendered. Control over the transferred assets is deemed to be surrendered when (1) the loan has been isolated from the Company, (2) the transferee has the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loan, and (3) the Company does not maintain effective control over the transferred loan through either (a) an agreement that both entitles and obligates the Company to repurchase or redeem them before their maturity or (b) the ability to unilaterally cause the holder to return the specific loan. For the sales securitizations, the Company derecognizes the loans transferred into the securitization and records retained financial and servicing assets or liabilities, if any and recognizes gain or loss on sale from the transaction. For the financing securitizations, the trusts do not meet the various qualifying special purpose entity criteria under SFAS 140 and the Company has a continuing interest. Accordingly, the Company records the loans held as collateral as assets and the asset-backed securities as debt liabilities.

When the Company sells mortgage loans in securitizations, it may retain one or more residual interests in the securitization receivables. Gain or loss on sale of the receivables depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer. Fair value is determined based on quoted market prices, if available. However, quotes are generally not available for retained interests, so the Company generally estimates fair value on the present value of future expected cash flows estimated using management’s best estimates of the key assumptions—credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved.

Securities and Principal Investments

Mortgage-backed security transactions are recorded as purchases and sales on the date the securities are settled unless the transaction qualifies as a regular-way trade, in which case the transactions are accounted for as purchases or sales on a trade date basis. Any amounts payable or receivable for unsettled trades are recorded as “securities sold” or “securities purchased” in the Company’s balance sheets.

Long-term investments in marketable equity securities and MBS are held in non-broker-dealer entities and are classified as either available-for-sale or trading investments pursuant to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” These investments are carried at fair value with resulting unrealized gains and losses on available-for-sale securities reflected in accumulated other comprehensive income (loss) in the balance sheets and unrealized gains and losses on trading securities reflected in net investment income in the statements of operations.

Investments in proprietary investment funds including hedge, private equity and venture funds, in which FBR is the general partner or has a significant limited partner interest, managing member or manager, are accounted for similar to the equity method and the Company’s proportionate share of income or loss (income allocation including realized and unrealized gains and losses) is reflected in net investment income on principal investments in the statements of operations.

F-12

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Trading securities owned by the Company’s broker-dealer subsidiaries and securities sold but not yet purchased are recorded on a trade-date basis and carried at fair value. The resulting realized and unrealized gains and losses are reflected in principal transactions in the statements of operations.

Realized gains and losses on sales of non-mortgage-backed securities are determined using the specific identification method. Realized gains and losses on mortgage-backed securities transactions are determined based on average cost. Declines in the value of available-for-sale investments below the Company’s cost basis that are determined to be other than temporary are reclassified from accumulated other comprehensive income (loss) and included in net investment income (loss) in the statements of operations. Declines in the value of cost method investments below the Company’s basis that are determined to be other than temporary are included in net investment income (loss) in the statement of operations.

Substantially all financial instruments used in the Company’s trading and investing activities are carried at fair value or amounts that approximate fair value. Fair value is based generally on listed market prices or broker- dealer price quotations. The fair value of the Company’s mortgage-backed securities is based on market prices provided by certain independent dealers who make markets in these financial instruments. The fair values reported reflect estimates and may not necessarily be indicative of the amounts the Company could realize in a current market transaction. To the extent that prices are not readily available, fair value is based on internal valuation models and estimates made by management, as discussed below.

In connection with certain capital raising transactions, the Company has received and holds warrants for the stock of the issuing companies, which are generally exercisable at the respective offering price of the transaction. Similarly, the Company may receive and hold shares of the issuing companies. For restricted warrants and shares, including private company warrants and shares, these investments by their nature, have limited or no price transparency. Such investments are initially carried at cost as an approximation of fair value. Adjustments to carrying value may be made if there are third-party transactions evidencing a change in value. Downward adjustments also may be made, in the absence of third-party transactions, if the Company determines based on valuation models and estimates that the expected realizable value of the investment is less than the carrying value. In reaching that determination, the Company may consider factors such as, but not limited to, the financial performance of the companies relative to projections, trends within sectors, underlying business models and expected exit timing and strategy. Due to the restrictions on the warrants and the underlying securities, and the subjectivity of these valuations, these warrants may have nominal values. The Company values warrants to purchase publicly traded stocks, where the restriction periods have lapsed, using an option valuation model.

Hedging Activities

In the normal course of the Company’s operations and to hedge the interest rate risk associated with its short- and long-term borrowings, the Company is a party to various financial instruments that are accounted for as derivatives in accordance with SFAS No. 133, “Accounting for Derivative Instruments and for Hedging Activities,” as amended (SFAS 133). These instruments include interest rate caps, Eurodollar futures contracts, and interest rate swaps. Certain of these derivatives have qualified for hedge accounting treatment, and are accounted for as cash flow hedges. These derivatives are intended to provide income and cash flow to offset the potential for reduced net interest income and cash flow under certain interest rate environments.

F-13

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

In accounting for such derivatives as cash flow hedges, the fair values of the Company’s derivative instruments are included on the consolidated balance sheets. To the extent these hedges are effective, changes in the fair value of the derivative instruments are reported in accumulated other comprehensive income (loss) and reclassified to earning in the periods in which the earnings are affected by the hedged cash flows. Changes in the fair value of the derivative instruments related to hedge ineffectiveness and activity not qualifying for hedge treatment are recorded in current period earnings.

If the hedged risk is extinguished or is not probable of occurring, the Company typically terminates any applicable hedges and recognizes any remaining unrealized gain (loss) included in the accumulated other comprehensive income (loss) balance to income or expense. However, if the Company continues to hold the derivatives, they continue to be recorded on the balance sheet at fair value with any changes being recorded to current period earnings.

Intangible Assets

The Company accounts for its intangible assets consisting of goodwill recorded as a result of the merger with FBR Asset and acquisition of First NLC (see Note 4), acquired mutual fund management contracts and broker relationships acquired in connection with the First NLC acquisition (see Note 4) in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). Under SFAS 142, the goodwill recorded is not amortized but is tested at least annually for impairment. The values of acquired management contracts and broker relationships are amortized in proportion to their expected economic benefit of 15 years and 10 years, respectively, and tested for impairment by comparing expected future gross cash flows to the asset’s carrying amount. If the expected gross cash flows are less than the carrying amount, the asset is impaired and is written-down to its fair value.

Furniture, Equipment, Software and Leasehold Improvements

Furniture and equipment are depreciated using the straight-line method over their estimated useful lives of three to fifteen years. Leasehold improvements are amortized using the straight-line method over the shorter of the useful life or lease term. Amortization of purchased software is recorded over the estimated useful lives of three to five years.

F-14

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Repurchase Agreements

Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities subsequently will be repurchased plus accrued interest.

Investment Banking Revenues

Capital raising revenues represent fees earned from private placements and from public offerings of securities in which the Company acts as underwriter. These revenues are comprised of selling concessions, underwriting fees, and management fees. Advisory revenues represent fees earned from mergers and acquisitions, mutual conversions, financial restructuring and other advisory services provided to clients. Capital raising revenues are recorded as revenue at the time the underwriting or private placement is completed. Advisory fees are recorded as revenue when the related service has been rendered and the client is contractually obligated to pay. Certain fees received in advance of services rendered are recognized as revenue over the service period.

Institutional Brokerage Agency and Principal Revenues

Agency commissions consist of commissions earned from executing the trade of stock exchange-listed securities and other transactions as an agent and principal transactions consist of sales credits and trading gains or losses from equity security transactions. Revenues generated from securities transactions and related commission income and expenses are recorded on a trade date basis.

Asset Management Revenues

The Company records two types of asset management revenue:

(1) Certain of the Company’s subsidiaries act as investment advisers and receive management fees for the management of proprietary investment funds and mutual funds, based upon the amount of capital committed or assets under management. This revenue is recognized over the period in which services are performed and is recorded in base management fees in the Company’s statements of operations.

(2) The Company also receives incentive income based upon the operating results of the funds. Incentive income represents a share of the gains in the investment, and is recorded in incentive allocations and fees in the statements of operations. The Company recognizes incentive income from the funds based on what would be due to the Company if the fund terminated on the balance sheet date. Incentive allocations may be based on unrealized gains and losses, and could vary significantly based on the ultimate realization of the gains or losses. The Company may therefore reverse previously recorded incentive allocation in future periods.

Interest Income

Interest income includes contractual interest payments adjusted for the amortization of premiums and discounts and other deferred costs in accordance with SFAS 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Directs Costs of Leasing.” Interest on loans from borrowers not expected to service the debt and interest on loans that are contractually past due 90 or more days is charged-off, or an allowance is established based upon management’s periodic evaluation. The allowance is established by a charge to interest income equal to all interest previously accrued and unpaid, and income is subsequently recognized only to the extent that cash payments are received until the borrower’s ability to make periodic interest and principal payments is adequate, in which case the loan is returned to accrual status.

F-15

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Gain on Sale of Loans, Net

Gain on sale of loans is the difference between the sale proceeds and the net carrying amount of the loans less a provision for repurchase and premium recapture obligations and is recorded in Mortgage Banking net investment income in the statements of operations. Gain on sale of loans is recognized when the Company transfers ownership of the loan to the purchaser and the funds are collected. Loan sales are on a servicing-released basis. The Company reduces its gain on sale of loans to record liabilities (1) for loans sold which may be required to be repurchased due to breaches of representations and warranties or if a borrower fails to make one or more of the first loan payments due on the loan and (2) for premium recapture in instances where the sold loan is repaid within a specified period subsequent to sale.

Transfers of financial assets (mortgage loans) are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the loan has been isolated from the Company, (2) the transferee has the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loan, and (3) the Company does not maintain effective control over the transferred loan through either (a) an agreement that both entitles and obligates the Company to repurchase or redeem them before their maturity or (b) the ability to unilaterally cause the holder to return the specific loan.

Investment Funds

The Company’s subsidiary FBRIM, through various wholly-owned limited liability corporations is the general partner, managing member, or manager of various hedge and private equity funds. Under the terms of the funds’ applicable governance agreements, FBRIM can be removed as the general partner, managing member, or manager of these entities by a simple majority vote of the unaffiliated limited partners or non-managing members. Accordingly, the Company accounts for its investments in these entities similar to the equity method of accounting. The Company records allocations for its proportionate share of the earnings or losses (including realized and unrealized gains and losses) of the applicable hedge and private equity funds. Income or loss allocations are recorded in net investment income in the Company’s statements of operations. The funds record their investments at fair value with changes in fair value reported in the funds’ earnings at each reporting date. Accordingly, capital accounts at each reporting date include all applicable allocations of the funds’ realized and unrealized gains and losses.

Compensation

A significant component of compensation expense relates to incentive bonuses. Incentive bonuses are accrued based on the contribution of key business units using certain pre-defined formulas. The Company’s compensation accruals are reviewed and evaluated on a quarterly basis.

Stock-Based Compensation

The Company accounts for stock-based compensation in accordance with SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). The Company adopted SFAS 123R on January 1, 2006 using the modified-prospective transition method. SFAS 123R requires companies to recognize expense in the income statement for the grant-date fair value of awards of equity instruments to employees. Pursuant to SFAS 123R, expense is recognized over the period during which employees are required to provide service. The expense is recorded using an estimated forfeiture of awards on the date of grant, rather than recognizing forfeitures as incurred as was permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). Under the modified prospective transition method, compensation cost is recognized after the date of adoption for the

F-16

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

portion of outstanding awards granted prior to the adoption of SFAS 123 for which service has not yet been rendered. In addition, under the modified prospective transition method, results for years ended December 31, 2005 and 2004 were not restated.

Adoption of SFAS 123R included the following changes to the presentation:

(a)

Prior to adopting SFAS 123R we presented the cash flows related to income tax deductions in excess of compensation cost recognized on stock issued under restricted stock vesting and stock options exercised during the period as operating cash flows in the Consolidated Statement of Cash Flows. SFAS 123R requires excess benefits to be classified as financing cash flows.

(b)

In addition, as a result of adopting SFAS 123R, certain balance amounts associated with share-based compensation costs have been reclassified within the equity section of the balance sheet. This change in presentation had no effect on our total equity. Effective January 1, 2006, deferred compensation (representing unearned costs of restricted stock awards) and Common stock issuable are presented on a net basis as a component of Additional paid-in capital.

Prior to the adoption of SFAS 123R, the Company accounted for stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” Pursuant to SFAS 123, prior to the adoption of SFAS 123R in January 2006, the Company continued to apply the provisions of Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees.” Under APB 25, compensation expense was recorded for the difference, if any, between the fair market value of the common stock on the date of grant and the exercise price of the option.

Sales of Subsidiary Shares

The Company accounts for sales of stock by its subsidiaries in accordance with Staff Accounting Bulletin No. 51, “Accounting for Sales of Stock of a Subsidiary” (SAB 51). Pursuant to SAB 51, the Company recognizes gains on issuances of subsidiary stock in the statement of operations.

Income Taxes

The parent company, FBR Group, has elected to be taxed as a REIT under the Internal Revenue Code. To qualify for tax treatment as a REIT, the parent company must meet certain income and asset tests and distribution requirements. The parent company generally will not be subject to federal income tax at the parent level to the extent that it distributes its taxable income to its shareholders and complies with certain other requirements.

Income generated by the Company’s taxable REIT subsidiaries will generally be taxed at normal corporate income tax rates. Deferred tax assets and liabilities represent the differences between the financial statement and income tax bases of assets and liabilities at the Company’s taxable REIT subsidiaries, using enacted tax rates. The measurement of net deferred tax assets is adjusted by a valuation allowance if, based on management’s evaluation, it is more likely than not that they will not be realized.

Other Comprehensive Income

Comprehensive income includes net income as currently reported by the Company on the consolidated statements of operations adjusted for other comprehensive income. Other comprehensive income for the Company represents (1) changes in unrealized gains and losses related to the Company’s mortgage-backed and equity securities accounted for as available-for-sale with changes in fair value recorded through shareholders’ equity and (2) changes in unrealized gains and losses related to cash flow hedges with changes in fair value recorded through shareholders’ equity to the extent the hedges are effective.

F-17

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Earnings Per Share

Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share includes the impact of dilutive securities such as stock options. The following table presents the computations of basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004:


	Year Ended December 31, 2006						Year Ended December 31, 2005						Year Ended December 31, 2004
	Basic			Diluted			Basic			Diluted			Basic		Diluted
Weighted average shares outstanding:
Common stock (in thousands)		171,667			171,667			169,333			169,333			167,099		167,099
Stock options (in thousands)		—			—			—			—			—		1,391

Weighted average common and common equivalent shares outstanding		171,667			171,667			169,333			169,333			167,099		168,490

Net (loss) earnings applicable to common stock	$	(67,275	)	$	(67,275	)	$	(170,910	)	$	(170,910	)	$	349,559	$	349,559

(Loss) earnings per common share	$	(0.39	)	$	(0.39	)	$	(1.01	)	$	(1.01	)	$	2.09	$	2.07

As of December 31, 2006, 2005 and 2004, respectively, 2,925,643, 3,740,068 and 4,035,976 options to purchase shares of common stock were outstanding (each including 1,600, 551,342 and 711,343 shares, respectively, associated with the Employee Stock Purchase and Loan Plan that are treated as options). For the years ended December 31, 2006, 2005 and 2004, 2,924,043, 3,188,726 and 40,000 of outstanding options were anti-dilutive, respectively. See Note 13 for detail of total stock options outstanding

Recent Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140” (SFAS 155). This Statement will be effective beginning in the first quarter of 2007. Earlier adoption is permitted. The statement permits interests in hybrid financial assets that contain an embedded derivative that would require bifurcation to be accounted for as a single financial instrument at fair value with changes in fair value recognized in earnings. This election is permitted on an instrument-by-instrument basis for all hybrid financial instruments held, obtained, or issued as of the adoption date. Based on its current activities, the Company does not expect that adoption of SFAS 155 will have a material effect on the consolidated financial statements.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140,” (SFAS 156) which permits entities to elect to measure servicing assets and servicing liabilities at fair value and report changes in fair value in earnings. Adoption of SFAS 156 is required for financial periods beginning after September 15, 2006. Based on its current activities, the Company does not expect the standard to have a material impact on the consolidated financial statements.

In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). This statement clarifies the definition of fair value, establishes a framework and hierarchy of fair value measurements, and expands disclosures about fair value measurements. This statement emphasizes that companies should use a market-based approach using similar assumptions that market participants would use in their assessment of the fair value of an asset or liability. These assumptions should include, but are not limited to, risks associated with

F-18

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

the asset or liability and restrictions on the sale or use of the asset. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently assessing the impact of adoption of SFAS 157.

In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 clarifies the accounting and reporting for income taxes where interpretation of the tax law may be uncertain. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of income tax uncertainties with respect to positions taken or expected to be taken in income tax returns. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of adoption of FIN 48.

In June 2005, the FASB ratified the consensus reached by the EITF on Issue 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (EITF 04-5). EITF 04-5 presumes that a general partner controls a limited partnership, and should therefore consolidate a limited partnership, unless the limited partners have the substantive ability to remove the general partner without cause based on a simple majority vote or can otherwise dissolve the limited partnership, or unless the limited partners have substantive participating rights over decision making. The Company adopted EITF 04-5 effective January 1, 2006. Adoption of this guidance did not have an impact on the consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (SAB 108). Due to diversity in practice among registrants, SAB 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether financial statement restatement is necessary. SAB 108 is effective for fiscal years ending after November 15, 2006, and early application is encouraged. The implementation of SAB 108 did not have an impact on the consolidated financial statements.

Note 3. FBR Capital Markets Corporation Offering:

On July 20, 2006, the Company closed a private offering to institutional investors by its newly formed taxable REIT subsidiary, FBR Capital Markets, and a concurrent private placement by FBR Capital Markets to two affiliates of Crestview Partners, a New York-based private equity firm (Crestview). These transactions in the aggregate resulted in the sale of 18,000,000 shares of common equity for $270,000 by FBR Capital Markets. Cash proceeds to FBR Capital Markets, after deducting a placement fee payable to an affiliate of Crestview Partners with respect to the shares purchased by the Crestview affiliates and other costs, were $259,738. In connection with the transactions, the Company completed the contribution to FBR Capital Markets of the Company’s investment banking, institutional brokerage and research and asset management businesses, including the existing subsidiaries FBR & Co., FBRIL, FBRIM and FBR Fund Advisors. As a result of these transactions, the Company retains a beneficial 71.9% ownership interest in FBR Capital Markets, and will continue to consolidate FBR Capital Markets for financial reporting purposes.

F-19

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

In addition, in connection with this private placement, pursuant to the guidance in Staff Accounting Bulletin No. 51, “Accounting for Sales of Stock of a Subsidiary,” the Company adopted an accounting policy to recognize gains and losses on issuances of subsidiary stock in the statement of operations. Accordingly, in July 2006, the Company recognized a net gain of $121,511 related to the sale of the FBR Capital Markets shares. The gain represents the increase in the value of the Company’s investment in FBR Capital Markets as a result of the share issuance and, based on the structure of the transaction, this gain was not taxable.

As part of these transactions, the Company and FBR Capital Markets entered into a series of agreements, including a contribution agreement, a corporate agreement, a services agreement, a management services agreement, a trademark license agreement and a tax sharing agreement. In addition, FBR Capital Markets and the Company entered into a series of agreements with affiliates of Crestview Partners, including an investment agreement, a governance agreement, a voting agreement, a registration rights agreement, a professional services agreement and option agreements to purchase additional shares. Pursuant to the option agreements, affiliates of Crestview may purchase up to 2,600,000 shares of FBR Capital Markets stock. Based on the provisions of EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s own Stock,” and the terms and conditions of these options, they have been accounted for as permanent equity.

Note 4. First NLC Financial Services, LLC

On February 16, 2005, the Company completed the acquisition of First NLC, a non-conforming residential mortgage loan originator located in Florida for a purchase price of $100,803 paid in a combination of cash and stock. First NLC currently operates in 45 states and originates loans through both wholesale and retail channels. First NLC is part of the Company’s mortgage banking segment and operates as a wholly-owned subsidiary. The Company expects that the acquisition of First NLC will assist in expanding and adding flexibility to the Company’s mortgage loan business by providing the ability to originate, price, portfolio and sell non-conforming mortgage loan assets based on market conditions.

The Company accounted for the acquisition of First NLC in accordance with SFAS No. 141, “Business Combinations” using the purchase method of accounting. Under the purchase method, net assets and results of operations of acquired companies are included in the consolidated financial statements from the date of acquisition. In addition, SFAS 141 provides that the cost of an acquired entity must be allocated to the assets acquired, including identifiable intangible assets and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of cost over the fair value of the net assets acquired must be recognized as goodwill.

The $100,803 purchase price included cash of $74,325, issuance of 1,297,746 shares of FBR Class A common stock at a price of $18.82 per share for a total of $24,420, and direct acquisition costs of $2,058. A summary of the fair values of the net assets acquired is as follows:


Cash	$	11,471
Interest receivable		1,107
Loans held for sale, net		508,443
Intangible asset		16,500
Other assets		10,029
Warehouse finance facilities		(483,164	)
Other liabilities		(18,335	)
Goodwill		54,752

Total purchase price, including acquisition costs	$	100,803

F-20

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Identified intangible assets represent the fair value of First NLC’s broker relationships. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” this intangible asset will be amortized over an estimated useful life of ten years based on the economic depletion of this asset. The expected pre-tax amortization expense for the years ended December 31, 2007, 2008, 2009, 2010, and 2011 are estimated to be $2,304, $1,925, $1,612, $1,354 and $1,141 respectively. The total amount of goodwill represents the purchase price of First NLC in excess of the fair value of the net assets acquired. Under SFAS No. 142, goodwill is not amortized. Instead, this asset is required to be tested at least annually for impairment. Both the identified broker relationship intangible asset and the goodwill are deductible for tax purposes.

The following presents unaudited pro forma consolidated results for the year ended December 31, 2005 and 2004, as though the acquisition had occurred as of January 1, 2004.


	Year Ended December 31,
	2005			2004
Gross revenues, as reported	$	995,306		$	1,052,102
Revenues, net of interest expense and provision for loan losses, as reported		434,702			887,946
Net (loss) income, as reported		(170,910	)		349,559
Gross revenues, pro forma		1,008,064			1,170,758
Revenues, net of interest expense and provision for loan losses, pro forma		444,758			1,021,465
Net (loss) income, pro forma		(172,169	)		382,421
(Loss) earnings per common share:
Basic, as reported	$	(1.01	)	$	2.09

Diluted, as reported	$	(1.01	)	$	2.07

Basic, pro forma	$	(1.02	)	$	2.29

Diluted, pro forma	$	(1.02	)	$	2.27

Note 5. Investments:

Institutional Brokerage Trading

In May 2005, the Company initiated certain fixed income trading activities primarily related to mortgage-backed, asset-backed and other structured securities, at its broker-dealer subsidiary FBR & Co. These activities continued through October 2006 when a decision was made to sell the Company’s positions and eliminate this trading desk. These activities included buying and selling mortgage-backed securities and other structured securities, in various financial transactions (which may include forward trades, dollar rolls and reverse repurchase transactions). The Company managed market risk associated with these securities positions primarily through forward purchases and sales of such securities. To accomplish this objective, the Company also used U.S. Treasury securities, agency debt securities, Eurodollar futures and options to buy or sell agency debt and mortgage-related securities. To manage institutional credit risk, the Company analyzed and monitored the financial condition and trading positions of all counterparties and established trading limits consistent with these reviews.

Trading account securities sold but not yet purchased represent obligations of the Company to deliver the specified security at the contracted price, and thereby, create a liability to purchase the security in the market at prevailing prices. In general, the corporate equity obligations relate primarily to over-allotments associated with the Company’s underwriting activities. These transactions when unrelated to over-allotments result in off-balance-sheet risk as the Company’s ultimate obligation to satisfy the sale of securities sold but not yet purchased may exceed the current value recorded in the consolidated balance sheets.

F-21

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

In conjunction with its fixed income trading activity, the Company had entered into reverse repurchase agreements with mortgage originators and other third parties that hold mortgage loans and mortgage securities. There were no such outstanding reverse repurchase agreements as of December 31, 2006. As of December 31, 2005 the outstanding balance of these reverse repurchase agreements was $147,918 and the weighted average coupon was 3.75%.

The Company receives collateral under reverse repurchase agreements. In many instances, the Company is permitted to rehypothecate securities received as collateral. At December 31, 2005, the Company had received securities as collateral that can be repledged, delivered or otherwise used with a fair value of $147,918. Of these securities received as collateral, those with a fair value of $147,502 were delivered or repledged, generally as collateral under repurchase agreements or to cover securities sold but not yet purchased positions as of December 31, 2005.

The weighted average coupon for fixed income trading securities owned and for fixed income securities sold but not yet purchased were 5.29% and 4.43%, respectively, as of December 31, 2005. The Company funds investments in such trading activities with repurchase agreement borrowings (see Note 8). As of December 31, 2005, $963,772 of these securities were pledged as collateral for repurchase agreements all of which can be rehypothecated by the repurchase agreement counterparties.


	December 31,
	2006				2005
	Owned		Sold But Not Yet Purchased		Owned		Sold But Not Yet Purchased
Government agency-backed securities	$	—	$	—	$	921,880	$	—
Government securities		—		—		498		147,502
Asset-backed securities		—		—		43,372		—
Corporate bond securities		613		2		1,299		2,867
Corporate equity securities		17,567		200		65,589		178

	$	18,180	$	202	$	1,032,638	$	150,547

F-22

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Principal Investments

Mortgage-related securities and long-term investments consisted of the following as of:


	December 31, 2006		December 31, 2005
Mortgage-Backed Investments:
Mortgage-backed available for sale securities:
Fannie Mae	$	3,343,756	$	5,825,114
Freddie Mac		2,543,311		1,645,293
Ginnie Mae		35,949		154,193

		5,923,016		7,624,600
Private-label mortgage-backed securities(1)		944,955		362,837

Total mortgage-backed available for sale securities(2)		6,867,971		7,987,437
Mortgage-backed trading securities:
Fannie Mae		—		15,124
Freddie Mac		2,690		—

Total mortgage-backed trading securities		2,690		15,124

Total mortgage-backed securities		6,870,661		8,002,561

Mortgage Loans:
Loans held for investment, net(3)		—		6,841,266
Loans held for sale, net(4)		5,367,934		963,807

Total mortgage loans		5,367,934		7,805,073
Reverse repurchase agreements		—		283,824

Total mortgage-related investments		12,238,595		16,091,458

Long-term Investments
Merchant Banking:
Marketable equity securities		90,655		217,153
Non-public equity securities		50,233		54,388
Preferred equity investment		2,500		5,000
Other		—		1,438
Investments funds		26,121		41,977
Residual interest in securitization		—		14,577
Investment securities—marked to market		12,623		6,810
Other investments		3,360		6,301

Total long-term investments		185,492		347,644

Total mortgage-related and long-term investments	$	12,424,087	$	16,439,102

(1)	Private-label mortgage-backed securities held by the Company as of December 31, 2006 and December 31, 2005 were primarily rated A- or higher by Standard & Poors.

(2)

The Company’s MBS portfolio is comprised of adjustable-rate MBS, substantially all of which are Hybrid ARM securities in which the coupon is fixed for three or five years before adjusting. The weighted-average coupon of the available-for-sale portfolio at December 31, 2006 and 2005 was 6.05% and 4.04%, respectively.

(3)	The weighted-average coupon of the Company’s mortgage loan portfolio held for investment at December 31, 2005 was 7.27%. During 2006, the loans held for investment were reclassified to held for sale.

(4)	The weighted-average coupon of the Company’s mortgage loan portfolio held for sale at December 31, 2006 and 2005 was 7.46% and 8.62%, respectively.

F-23

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Mortgage-Backed Securities and Long Term Investments

The Company’s available-for-sale securities consist primarily of mortgage-backed securities and equity investments in publicly traded companies. In accordance with SFAS 115, the securities are carried at fair value with resulting unrealized gains and losses reflected as other comprehensive income or loss. Gross unrealized gains and losses on these securities as of December 31, 2006 and 2005 were:


	2006
	Amortized Cost/Cost Basis		Unrealized					Fair Value
	Amortized Cost/Cost Basis		Gains		Losses			Fair Value
Mortgage-backed securities(1):
Available-for-sale	$	6,863,356	$	12,805	$	(8,190	)	$	6,867,971
Trading		2,690		—		—			2,690
Marketable equity securities		82,905		10,050		(2,300	)		90,655

	$	6,948,951	$	22,855	$	(10,490	)	$	6,961,316

(1)	The amortized cost of MBS includes net premium of $57,499 at December 31, 2006.


	2005
	Amortized Cost/Cost Basis		Unrealized					Fair Value
	Amortized Cost/Cost Basis		Gains		Losses			Fair Value
Mortgage-backed securities(2)
Available-for-sale	$	7,987,437	$	—	$	—		$	7,987,437
Trading		15,120		4		—			15,124
Marketable equity securities		215,349		15,958		(14,154	)		217,153

	$	8,217,906	$	15,962	$	(14,154	)	$	8,219,714

(2)	The amortized cost of MBS includes unamortized discount of $77,531 at December 31, 2005.

The following table provides further information regarding the duration of unrealized losses as of December 31, 2006:


	Continuous Unrealized Loss Position for
	Less Than 12 Months							12 Months or More
	Amortized Cost		Unrealized Losses			Fair Value		Amortized Cost		Unrealized Losses		Fair Value
Mortgage-backed Securities	$	3,146,303	$	(8,190	)	$	3,138,113	$	—	$	—	$	—
Marketable equity securities		13,927		(2,300	)		11,627		—		—		—

	$	3,160,230	$	(10,490	)	$	3,149,740	$	—	$	—	$	—

During 2006, the Company evaluated its portfolio of mortgage-backed securities for impairment. Based on its evaluation, the Company determined that the unrealized losses on mortgage-backed securities are due to interest rate increases and are not related to credit quality issues. All of the mortgage-backed securities held by the Company with unrealized losses are either guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae or have an investment grade rating by Standard & Poors. The Company does not deem these investments to be other-than-temporarily impaired because of the limited severity and duration of the impairments, and because the decline in market value is attributable to interest rate increases, and the Company has the intent and ability to hold these investments until a recovery of fair value occurs, which may be maturity.

F-24

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

The Company also evaluated its portfolio of marketable equity securities for impairment. For each of the securities with unrealized losses, at each reporting period the Company reviewed the underlying cause for the impairments, as well as the severity and durations of the impairments. The Company evaluated the near term prospects for each of the investments in unrealized loss positions in relation to the severity and duration of the impairment. Based on the severity and duration of certain of these unrealized losses, the Company recognized impairment losses on these investments because they are considered other-than-temporarily impaired. During the years ended December 31, 2006, 2005 and 2004, the Company recorded $63,252, $57,290 and $1,180 of such other-than-temporary impairment losses in the statements of operations relating to marketable equity securities. Regarding the remaining two marketable equity securities in unrealized loss positions as of December 31, 2006, considering the limited severity and duration of these unrealized losses and the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value to its cost basis, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2006. We will continue to evaluate these investments at each reporting period end. If we determine at a future date that an impairment is other-than-temporary, the applicable unrealized loss will be reclassified from accumulated other comprehensive loss and recognized as a loss in the statement of operations at the time the determination is made.

For investments carried at cost, except as noted herein, the Company did not identify any events or changes in circumstances that may have had a significant adverse affect on the fair value of these investments. During the years ended December 31, 2006, 2005 and 2004, the Company recorded impairment losses of $13,913, $17,162 and $-0-, respectively, in the statements of operations reflecting the Company’s evaluation of the estimated fair value of private equity investments. The Company also recorded $2,500, $-0- and $2,500 impairment losses during 2006, 2005, and 2004 respectively, reflecting the Company evaluation of the estimated fair value of a preferred equity investment. These impairment losses were due to circumstances arising during the respective years that had an adverse effect on the fair values of these securities.

During 2006, the Company received $10,977,609 from sales of mortgage-backed securities resulting in gross gains and losses of $31,855 and $(8,618), respectively, and received $133,564 from sales of marketable equity securities resulting in gross gains and losses of $26,434 and $(12), respectively. Included in MBS sold in 2006 and the related gains and losses are $2,456,185 of MBS purchased and classified as trading during the year. The Company recognized realized gain of $13,733 on trading securities. During 2005, the Company received $1,395,013 from sales of mortgage-backed securities resulting in gross gains and losses of $704 and $(9,798), respectively, and received $60,503 from sales of marketable equity securities resulting in gross gains and losses of $20,936 and $(127), respectively. Included in MBS sold in 2005 and the related gains and losses are $410,396 of MBS purchased and classified as trading during the year. The Company recognized realized losses of $(1,194) on trading securities

As of December 31, 2006 and 2005, $6,441,886 and $7,864,567 (each representing fair value excluding principal receivable), respectively, of the mortgage-backed securities were pledged as collateral for repurchase agreements and commercial paper borrowings. In addition, $36,475 and $68,890, respectively, of principal and interest receivables related to the securities collateralizing commercial paper borrowings have also been pledged as collateral for those borrowings.

F-25

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Accumulated Other Comprehensive Income (Loss)

The following provides detail of the amounts included in accumulated other comprehensive income (loss) and reclassified to earnings during the specified periods.


	Year ended December 31,
	2006			2005			2004
Beginning balance	$	(977	)	$	(38,162	)	$	60,505
Net unrealized investment gains (losses) during the period:
Unrealized holding losses (gains), net of taxes		(17,128	)		(221,296	)		9,890
Reclassification adjustment for recognized losses (gains) included in net income, net of taxes		27,591			260,777			(86,281	)
Net change in fair value related to cash flow hedging activities		1,418			20,152			(31,913	)
Net reclassifications to earnings—cash flow hedging activities		(26,040	)		(22,448	)		9,637

Ending balance	$	(15,136	)	$	(977	)	$	(38,162	)

Mortgage Loans

During the year ended December 31, 2006, the Company made a determination in evaluating its investment strategy and its intent related to its held-for-investment mortgage loan portfolio that it no longer intends to hold this portfolio for investment. Accordingly, these loans were reclassified to held for sale. As a result of this change, in accordance with SFAS No. 65, “Accounting for Certain Mortgage Banking Activities,” the Company recorded its investment in this loan portfolio at the lower of cost or market and for the year ended December 31, 2006, recognized a $149,823 write-down in the value of these loans.

Loans held for sale, net, was comprised of the following:


	December 31, 2006			December 31, 2005
Principal balance	$	5,410,982		$	969,491
Deferred origination costs, net and unamortized premiums		2,847			15,039
Allowance for lower of cost or market value		(45,895	)		(20,723	)

Loans held for sale, net	$	5,367,934		$	963,807

Mortgage loans 90 or more days past due totaled $557,136 and $188,744 as of December 31, 2006 and December 31, 2005, respectively. As of December 31, 2006, the Company has reserved $30,720 for past due interest on such delinquent loans.

During 2005, the Company purchased mortgage insurance on a portion of mortgage loans. The mortgage insurance insures the Company against certain losses on the covered loans, and assists the Company in reducing its credit risk by lowering the effective loan-to-value ratios on the applicable mortgage loans. As of December 31, 2006, $635,045 in principal balance of mortgage loans held by the Company was covered by such mortgage insurance.

The Company finances its mortgage loan portfolio through warehouse repurchase agreements and securitization financing transactions, which are described in Note 8. Substantially all of the mortgage loans held by the Company were pledged under such borrowings as of December 31, 2006 and December 31, 2005.

F-26

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Reverse Repurchase Agreements

Through Arlington Funding, LLC (Arlington Funding), a commercial paper conduit managed by the Company (see Note 8), the Company provides warehouse financing to mortgage originators. There was no outstanding balance of such financings as of December 31, 2006. As of December 31, 2005, the outstanding balance of such financings was $135,906. The Company funds its advances through commercial paper borrowings. As of December 31, 2005, the Company had received as collateral for the reverse repurchase agreements mortgage loans with a fair value of $140,676.

Investment Funds

The private investment funds from which the Company earns management, incentive and investment income are non-registered investment companies that record their investments in securities at fair value. Certain investments consist of equity investments in securities of development-stage and early-stage privately and publicly held companies. The disposition of these investments may be restricted due to the lack of a ready market or due to contractual or regulatory restrictions on disposition. In addition, these securities may represent significant portions of the issuer’s equity and carry special contractual privileges not available to other security holders. As a result of these factors, precise valuation for the restricted public securities and private company securities is a matter of judgment, and the determination of fair value must be considered only an approximation and may vary significantly from the amounts that could be realized if the investment were sold or from the value that would have been used had a ready market existed for the securities and those differences could be material.

FBRIM, through various wholly-owned limited liability corporations, is the general partner, managing member, or manager of various hedge and private equity funds. All of these entities were formed for the purpose of investing in public and private securities; therefore, their assets principally consist of investment securities accounted for at fair value. Under the terms of the funds’ applicable governance agreements, FBRIM can be removed as the general partner, managing member, or manager of these entities by a simple majority vote of the unaffiliated limited partners or non-managing members. The Company accounts for its investments in these entities similar to the equity method of accounting and the Company’s proportionate share of income or loss (income allocation including realized and unrealized gains or losses) is reflected in net investment income in the statement of operations.

In addition, as a significant investor in certain other investment funds, although we do not manage these funds, we also account for these investments similar to the equity method. The following table specifies the Company’s investments in such investment funds:


	December 31,
	2006		2005
Hedge funds	$	15,994	$	34,602
Private equity funds		3,737		3,969
Other		6,390		3,406

	$	26,121	$	41,977

F-27

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

The following table summarizes certain financial information regarding the Company’s investments in these investment funds.


	December 31,
	2006		2005			2004
Total assets	$	739,296	$	417,905		$	739,862
Total liabilities		150,960		50,874			34,281
Total equity		588,336		367,031			705,581
Total revenue		14,144		24,797			16,501
Total expenses		26,523		12,352			11,660
Realized gains		30,166		30,821			58,642
Unrealized (losses) gains		192,717		(73,056	)		17,761
Net income (losses)		200,738		(29,790	)		81,244

FBR Group’s share of total equity		26,121		41,977			70,434
FBR Group’s share of net income-net investment income		2,344		62			9,184
FBR Group’s share of net income-incentive allocations and fees		839		1,851			6,270

As of December 31, 2006 and 2005, the Company had receivables of $408 and $2,230, respectively, due from these affiliates.

Investment Securities—Marked to Market

Investment securities—marked to market include equity securities and warrants to purchase equity securities that were received in connection with investment banking transactions.

Note 6. Furniture, Equipment, Software and Leasehold Improvements:

Furniture, equipment, software and leasehold improvements, summarized by major classification, were:


	December 31,
	2006			2005
Furniture and equipment	$	30,539		$	30,802
Software		20,888			10,047
Leasehold improvements		29,525			29,828

		80,952			70,677
Less-accumulated depreciation and amortization		(36,841	)		(24,295	)

	$	44,111		$	46,382

For the years ended December 31, 2006, 2005, and 2004, depreciation expense was $13,538, $9,753, and $4,074, respectively.

F-28

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Note 7. Intangible Assets and Goodwill

The following table reflects the components of intangible assets as of the dates indicated:


	December 31, 2006			December 31, 2005
Management contracts:
Cost	$	18,465		$	19,929
Accumulated amortization		(7,465	)		(7,032	)

Net	$	11,000		$	12,897

Broker relationships:
Cost	$	16,500		$	16,500
Accumulated amortization		(5,675	)		(2,912	)

Net	$	10,825		$	13,588

Intangible assets, net	$	21,825		$	26,485

For the years ended December 31, 2006, 2005, and 2004, amortization expense recognized was $3,978, $4,170, and $1,298, respectively.

Estimated amortization expense for each of the next five years is as follows:


	Amount
2007	$	3,467
2008		3,088
2009		2,775
2010		2,517
2011		2,304

The carrying value of goodwill is $162,765 as of December 31, 2006 with $108,013 of this balance attributable to the Company’s merger with FBR Asset in 2003 and its principal investing segment. The remaining goodwill balance relates to the Company’s acquisition of First NLC in 2005 that resulted in $54,752 of goodwill that is attributable to the mortgage banking segment (see Note 4 for further information). In accordance with SFAS No. 142, the Company determined that the fair value of the reporting units to which goodwill relates exceeded the carrying value of such reporting units. Therefore, the Company has not recognized an impairment loss for the periods presented.

During the years ended December 31, 2006 2005, and 2004, the Company recorded impairment charges of $-0-, $249, and $388, respectively, relating to the acquired management contracts related to the asset management segment that are included in other operating expenses. In these cases the charges were recorded in response to decisions to close or agreements to sell specific mutual funds.

Note 8. Borrowings:

Commercial Paper and Repurchase Agreements

The Company issues commercial paper and enters into repurchase agreements to fund its investments in mortgage-backed securities and mortgage loans, as well as its warehouse lending and fixed income trading activities. Commercial paper issuances are conducted through Georgetown Funding Company, LLC (Georgetown Funding) and Arlington Funding.

F-29

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Georgetown Funding is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by mortgage-backed securities and entering into reverse repurchase agreements with the Company and its affiliates. The Company serves as administrator for Georgetown Funding’s commercial paper program and all of Georgetown Funding’s transactions are conducted with the Company. Through the Company’s administration agreement and repurchase agreements, the Company is the primary beneficiary of Georgetown Funding and consolidates this entity for financial reporting purposes. The commercial paper notes issued by Georgetown Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. The Company’s Master Repurchase Agreement with Georgetown Funding enables the Company to finance up to $12,000,000 of mortgage-backed securities.

Arlington Funding is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by non-conforming mortgages and providing warehouse financing in the form of reverse repurchase agreements to the Company and its affiliates and to mortgage originators with which the Company has a relationship. The Company serves as administrator for Arlington Funding’s commercial paper program and provides collateral as well as guarantees for commercial paper issuances. As part of those guarantees, the Company currently does not have a cash collateral obligation. Through these arrangements, the Company is the primary beneficiary of Arlington Funding and consolidates this entity for financial reporting purposes. The extendable commercial paper notes issued by Arlington Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. The Company’s financing capacity through Arlington Funding is $5,000,000.

The Company also has short-term financing facilities that are structured as repurchase agreements with various financial institutions to fund its portfolio of mortgage loans. The interest rates under these agreements are based on LIBOR plus a spread that ranges between 0.60% to 1.25% based on the nature of the mortgage collateral. As of December 31, 2006, the amount at risk under repurchase agreements is not greater than 10% of stockholders’ equity for any one counterparty.

The following tables provide information regarding the Company’s outstanding commercial paper, repurchase agreement borrowings, and mortgage financing facilities.


	December 31, 2006									December 31, 2005
	Commercial Paper			Repurchase Agreements			Short-Term Mortgage Financing Facilities(1)			Commercial Paper			Repurchase Agreements			Short-Term Mortgage Financing Facilities(1)
Outstanding balance	$	3,971,389		$	2,116,813		$	942,517		$	6,996,950		$	1,653,599		$	1,045,020
Value of assets pledged as collateral:
Agency mortgage-backed securities		4,209,851			1,844,447			—			7,155,926			1,388,609			—
Non-agency mortgage-backed securities		—			424,063			—			—			352,694			125,568
Mortgage loans		—			—			950,191			141,987			—			942,337
Weighted-average rate		5.41	%		5.34	%		6.05	%		4.37	%		4.39	%		5.16	%
Weighted-average term to maturity		18.3 days			21.9 days			NA			19.9 days			18.4 days			NA

(1)	Under these mortgage financing agreements, which expire or may be terminated by the Company or the counterparty within one year, the Company may finance mortgage loans for up to 180 days. The interest rates on these borrowings reset daily.

F-30

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)


	December 31, 2006									December 31, 2005
	Commercial Paper			Repurchase Agreements			Short-Term Mortgage Financing Facilities			Commercial Paper			Repurchase Agreements			Short-Term Mortgage Financing Facilities
Weighted-average outstanding balance during the year ended	$	2,610,719		$	839,446		$	1,043,776		$	7,923,351		$	2,401,180		$	2,286,890
Weighted-average rate during the year ended		5.17	%		5.15	%		5.79	%		3.33	%		3.01	%		4.40	%

Securitization Financing

The Company has issued asset-backed securities through securitization trusts to finance a portion of the Company’s portfolio of mortgage loans. The asset-backed securities are secured solely by the mortgages transferred to the trust and are non-recourse to the Company. The principal and interest payments on the mortgages provide the funds to pay debt service on the securities. This securitization activity is accounted for as a financing since the securitization trusts do not meet the qualifying special purpose entity criteria under SFAS 140, and because the Company maintains continuing involvement in the securitized mortgages through its ownership of certain interests issued by the trust. As of December 31, 2006, the Company has issued approximately $7,200,000 of asset-backed securities. In March 2006, the Company sold $44,170 of asset-backed securities to a third party at a discount of $9,400. Of these asset-backed securities issued by the Company, as described below, $4,486,046 and $6,642,198 is outstanding as of December 31, 2006 and 2005, respectively.

Interest rates on these securities reset monthly and are indexed to one-month LIBOR. The weighted average interest rate payable on the securities was 5.79% and 4.76% as of December 31, 2006 and 2005, respectively. Although the stated maturities for each of these securities are 30 years, the Company expects the securities to be fully repaid prior thereto due to borrower prepayments.

As of December 31, 2006 and 2005, the outstanding balance of the securities was as follows:


	December 31, 2006			December 31, 2005
Security balance	$	4,501,619		$	6,654,187
Discount on bonds, net		(15,573	)		(11,989	)

Balance of securitization financing, net	$	4,486,046		$	6,642,198

Current balance of loans and other assets collateralizing the securities	$	4,552,898		$	6,706,821

In addition to the discount, which represents the difference between the sales price of the securities and the face amount, the Company has deferred the costs incurred to issue the securities. These costs totaled $8,530 and $12,808 as of December 31, 2006 and 2005, respectively, and are included in prepaid expenses and other assets in the consolidated balance sheets. The discount and deferred costs are amortized as a component of interest expense over the life of the debt.

See also Note 9 for information regarding the effects of derivative instruments on the Company’s borrowing costs.

F-31

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Long Term Debt

As of December 31, 2006 and 2005, the Company had issued a total of $317,500 of long term debentures through TRS Holdings. The long-term debentures accrue and require payments of interest quarterly at an annual rate of three-month LIBOR plus 2.25% to 3.25%. The weighted average interest rate on these long term debentures was 8.01% as of December 31, 2006. All of these borrowings mature between 2033 and 2035. The Company had incurred costs related to the issuance of these debentures. These costs will be amortized over the five year period through the redemption date. As of December 31, 2006 and 2005, the unamortized balance of these issuance costs was $3,459 and $4,126, respectively. During the year ended December 31, 2006, the Company did not issue additional long-term debentures.

As of December 31, 2006 and 2005, the Company had additional outstanding long-term debt of $4,086 and $4,706, respectively associated with the Company’s 2001 acquisition of Money Management Associates, LP and Rushmore Trust and Savings. This note is collateralized by the capital stock of FBR Fund Advisors, Inc. and matures on January 2, 2011. Interest on this note is imputed at 9%.

Temporary Subordinated Loan

In December 2005, the Company through FBR & Co. obtained a $75,000 temporary subordinated loan from a subsidiary of its clearing broker. Proceeds of this borrowing are allowable for net capital purposes and were used by the Company in connection with regulatory capital requirements to support underwriting activity. Interest on this loan accrued at an annual rate of three-month LIBOR plus 4%, or 8.37%. The loan was repaid in January 2006.

Other

On October 20, 2006, the Company entered into a $180 million, 364-day senior secured credit agreement with various financial institutions. The facility is available for general corporate purposes, working capital and other potential short-term liquidity needs and replaces the Company’s previous senior unsecured facility that expired on that same date.

Note 9. Derivatives and Hedging Activities:

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative financial instruments in accordance with SFAS 133. These instruments include interest rate caps, Eurodollar futures contracts, U.S. Treasury futures contracts, swaptions, certain borrower interest rate lock agreements, certain commitments to purchase and sell mortgage loans and mortgaged-backed securities, and warrants to purchase common stock.

Derivative Instruments

The Company utilizes derivative financial instruments to hedge the interest rate risk associated with its borrowings. The Company also uses derivatives to economically hedge certain positions in mortgage-backed securities and mortgage loans. The derivative financial instruments include interest rate caps and Eurodollar futures contracts. As discussed below, certain of these derivatives are designated as cash flow hedges under SFAS 133 and others are not designated as cash flow hedges. The counterparties to these instruments are U.S. financial institutions.

F-32

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Interest rate caps are primarily used to hedge the interest rate exposure on the Company’s securitization borrowings. In exchange for a fee paid at inception of the agreement, the Company receives a floating rate based on one-month LIBOR whenever one-month LIBOR exceeds a specified rate (the “strike” rate). Eurodollar futures contracts are a proxy for the forward AA/AAA LIBOR-based credit curve and allow the Company the ability to lock in three-month LIBOR forward rates for its short-term borrowings based on the maturity dates of the contracts. The following table summarizes these derivative positions as of December 31, 2006 and December 31, 2005:


	December 31, 2006					December 31, 2005
	Notional Amount		Fair Value			Notional Amount		Fair Value
Cash flow hedges:
Interest rate cap agreements(1)	$	—	$	—		$	4,710,928	$	38,494
Eurodollar futures contracts(2)		25,790,000		(34,526	)		—		—
No hedge designation:
Interest rate cap agreements(3)		4,115,751		21,266			980,821		219

(1)	Comprised of six interest rate caps which mature between 2007 and 2010. The notional amounts of the caps amortize over the life of the agreements. The strike rates also vary over the life of the agreements between 4.08% and 10.50%.

(2)	The $25,790,000 total notional amount of Eurodollar futures contracts as of December 31, 2006 represents the accumulation of Eurodollar futures contracts that mature on a quarterly basis between 2007 and 2011 and hedge borrowings of between $2,685,000 and $100,000.

(3)	Comprised of nine interest rate caps maturing between 2007 and 2010 with strike rates between 3.84% and 10.50%.

During the year, the Company had designated certain interest rate caps and Eurodollar futures contracts as cash flow hedges of the variability in interest payments associated with the Company’s securitization borrowings. The notional amount and terms of each of these derivative instruments were matched against a like amount of current and/or anticipated borrowings and terms under the Company’s securitization financings. These instruments were highly effective hedges and qualified as cash flow hedges under SFAS 133. Accordingly, changes in the fair value of these derivatives were reported in other comprehensive income to the extent the hedge was effective, while changes in fair value attributable to hedge ineffectiveness are reported in earnings. The Company recorded $513 in losses related to ineffectiveness during the year ended December 31, 2006.

As a result of the reclassification of the Company’s mortgage loan portfolio to held-for-sale classification (see Note 5) and the Company’s current estimate of forecasted securitization borrowings, the Company de-designated these cash flow hedges effective September 30, 2006. The Company is continuing to defer in other comprehensive income the gains and losses from these cash flow hedge transactions related to those future periods where the occurrence of the forecasted transaction is still probable. These gains and losses will be reclassified to earnings in the periods in which the earnings are affected by the hedged cash flows.

In addition, during the third quarter of 2006, the Company also designated certain Eurodollar futures contracts as cash flow hedges of the variability in interest payments associated with the Company’s forecasted borrowings used to fund the purchase of securities for its MBS investment portfolio. Accordingly, changes in the fair value of these derivatives are reported in other comprehensive income to the extent the hedge was effective, while changes in fair value attributable to hedge ineffectiveness are reported in earnings. The Company recorded

F-33

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

$2,947 in losses related to ineffectiveness during the year ended December 31, 2006. The gains and losses on these cash flow hedge transactions that are reported in other comprehensive income are reclassified to earnings in the periods in which the earnings are affected by the hedged cash flows.

The net effect of the Company’s cash flow hedges on the variability in interest payments was to decrease interest expense by $23,384 for the year ended December 31, 2006. These hedging activities decreased interest expense by $7,531 during 2005. The total net loss deferred in accumulated other comprehensive income relating to these derivatives was $26,886 at December 31, 2006. Of this amount, a net expense of $1,578 is expected to flow through the Company’s statement of operations over the next twelve months.

The Company also uses derivative instruments, including certain interest rate caps, Eurodollar futures contracts, U.S. Treasury futures contracts and swaptions, to hedge certain mortgage-backed security and mortgage loan positions and related borrowings that are not designated as hedges under SFAS 133. For example, Eurodollar futures contracts have been used to hedge the financing for certain mortgage-backed security positions and commitments to purchase certain mortgage-backed securities. The Company also uses Eurodollar futures contracts to hedge its exposure on loan commitments. The changes in fair value on these derivatives are recorded to net investment income in the statement of operations. For the year ended December 31, 2006, the Company recorded net losses of $10,985 on these derivatives.

Commitments

The Company enters into commitments to (i) originate mortgage loans (referred to as interest rate lock agreements), (ii) purchase and sell mortgage loans, and (iii) purchase and sell MBS. As of December 31, 2006, the Company has $200,170 and $400,945 in commitments to originate and sell mortgage loans, respectively, and $250,785 in commitments to purchase hybrid-ARM securities. The Company had no outstanding commitments to purchase mortgage loans or sell MBS as of December 31, 2006.

As of December 31, 2006, $200,000 of the total commitments to sell mortgage loans are considered derivatives and accounted for under SFAS 133. There were no gains or losses resulting from these derivatives as the rates at which the Company has committed to sell the loans approximates their fair value at December 31, 2006.

As of December 31, 2006, the Company had made forward commitments to purchase $250,785 in hybrid-ARM securities. Of these commitments to purchase mortgage-backed securities $175,000 are designated as cash flow hedges of the anticipated purchases and as of December 31, 2006 were valued at $(519), which was deferred as a loss to accumulated other comprehensive income. Gains and losses on commitments deferred to other comprehensive income are transferred from accumulated other comprehensive income to earnings over the life of the hedged item after settlement of the forward purchase or immediately to earnings when the commitment is net settled in a pair-off transaction. There were $125,000 in purchase commitments that were paired-off during the year ended December 31, 2006 resulting in a $332 gain. There were no pair-off transactions for the year ended December 31, 2005.

As of December 31, 2006, the Company had no forward commitments to purchase Hybrid ARM securities to be designated as trading upon settlement.

F-34

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Stock Warrants

In connection with its capital raising activities, the Company may receive warrants to acquire equity securities. These instruments are accounted for as derivatives with changes in the fair value recorded to net investment income under SFAS 133. During 2006, 2005 and 2004, the Company recorded net gains and losses of $(249), $2,651 and $7,511, respectively, related to these securities. As of December 31, 2006, the Company held stock warrants with a fair value of $1,350.

Note 10. Income Taxes:

The parent company, FBR Group, has elected REIT status under the Internal Revenue Code. As a REIT, FBR Group is not subject to Federal income tax on earnings distributed to its shareholders. Most states recognize REIT status as well. Since FBR Group intends to distribute 100% of its REIT taxable income to shareholders, the Company has recognized no income tax expense on its REIT income. As of December 31, 2006, the parent company, FBR Group, has a capital loss carryforward of $182,336 that can be used to offset future capital gains through 2011.

To maintain tax qualification as a REIT, FBR Group must meet certain income and asset tests and distribution requirements. The REIT must distribute to shareholders at least 90% of its (parent company) taxable income. A predominance of the REIT’s gross income must come from real estate sources and other portfolio-type income. A significant portion of the REIT’s assets must consist of real estate and similar portfolio investments, including mortgage-backed securities. Beginning in 2001, the tax law changed to allow REITs to hold a certain percentage of their assets in taxable REIT subsidiaries. The income generated from the Company’s taxable REIT subsidiaries is taxed at normal corporate rates and will generally not be distributed to the Company’s shareholders. Failure to maintain REIT qualification would subject FBR Group to Federal and state corporate income taxes at regular corporate rates. The taxable REIT subsidiaries, including FBR TRS Holdings and FBR Capital Markets have elected to file consolidated Federal income tax returns.

During the years ended December 31, 2006, 2005 and 2004 the Company recorded $(14,682), $26,683 and $59,161, respectively of income tax (benefit) expense for income generated that was attributable to taxable REIT subsidiaries, net of tax effect on intercompany profits eliminated. The Company’s taxable REIT subsidiaries had taxable book income before income taxes of $73,857, $55,966 and $147,719, respectively, in 2006, 2005 and 2004.

The provision for income taxes consists of the following for the years ended December 31, 2006, 2005 and 2004:


	2006			2005			2004
Federal	$	(13,752	)	$	17,438		$	47,619
State		(1,759	)		8,691			9,384
Foreign		829			554			2,158

	$	(14,682	)	$	26,683		$	59,161

Current	$	(12,945	)	$	34,895		$	65,850
Deferred		(1,737	)		(8,212	)		(6,689	)

	$	(14,682	)	$	26,683		$	59,161

F-35

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Deferred tax assets and liabilities consisted of the following as of December 31, 2006 and 2005:


	2006			2005
Unrealized investment gains, recorded in accumulated other comprehensive loss	$	(528	)	$	(298	)
Unrealized investment gains		(7,701	)		(780	)
Accrued compensation		10,734			6,285
Depreciation and amortization		(1,895	)		(3,270	)
Mark-to-market and other than temporary impairments		2,614			3,113
Loan loss reserve accounts		4,343			2,335
Accrued expenses		4,606			2,897
Deferred intercompany gain		4,034			3,117
Other, net		1,107			(366	)
Net operating loss		7,824			70
Valuation allowance		(4,099	)		(70	)

Net deferred tax asset	$	21,039		$	13,033

The (benefit) provision for income taxes results in effective tax rates that differ from the Federal statutory rates. The reconciliation of income tax attributable to net income computed at Federal statutory rates to income tax (benefit) provision was:


	December 31,
	2006			2005		2004
Federal income tax at statutory rate	$	25,788		$	19,631	$	51,702
State income taxes, net of Federal benefit		(2,103	)		4,243		6,100
Gain on sale of subsidiary shares		(42,499	)		—		—
Effect of SFAS 123R		1,655			—		—
Effect of regulatory settlements		—			2,494		—
Other, net		138			315		1,359
Valuation allowance ⁽¹⁾		2,339			—		—

Effective income tax (benefit) provision	$	(14,682	)	$	26,683	$	59,161

⁽¹⁾	Relates primarily to the ability to utilize state net operating losses.

Note 11. Regulatory Capital Requirements:

FBR & Co. and FBRIS, are registered with the SEC and are members of the National Association of Securities Dealers, Inc. Additionally, FBRIL is registered with the Financial Services Authority (FSA) of the United Kingdom. As such, they are subject to the minimum net capital requirements promulgated by the SEC and FSA. As of December 31, 2006 and 2005, FBR & Co. had net capital of $94,591 and $128,370, respectively, that was $90,116 and $119,980, respectively, in excess of its required net capital of $4,475 and $8,390, respectively. As of December 31, 2006 and 2005, FBRIS and FBRIL had net capital in excess of required amounts.

F-36

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Note 12. Commitments and Contingencies:

Contractual Obligations

The Company has contractual obligations to make future payments in connection with long-term debt and non-cancelable lease agreements and other contractual commitments as well as uncalled capital commitments to various investment partnerships that may be called over the next ten years. The following table sets forth these contractual obligations by fiscal year:


	2007		2008		2009		2010		2011		Thereafter		Total
Long-term debt⁽¹⁾	$	970	$	970	$	970	$	970	$	970	$	319,603	$	324,453
Minimum rental and other contractual commitments⁽²⁾		24,397		24,566		17,778		16,883		15,258		47,607		146,489
Securitization financing on loans held for sale⁽³⁾		—		—		—		—		—		4,501,619		4,501,619
Capital commitments⁽⁴⁾		—		—		—		—		—		—		—

	$	25,367	$	25,536	$	18,748	$	17,853	$	16,228	$	4,868,829	$	4,972,561

⁽¹⁾

This table excludes interest payments to be made on the Company’s long-term debt securities issued through TRS Holdings. Based on the 3-month LIBOR of 5.36% as of December 31, 2006, plus a weighted average margin of 2.63%, estimated annualized interest on the current outstanding principal of $317,500 of long-term debt securities would be approximately $25,440 for the year ending December 31, 2007. These long-term debt securities mature in thirty years beginning in March 2033 through October 2035. Note that interest on this long-term debt floats based on 3-month LIBOR, therefore, actual coupon interest will differ from this estimate.

⁽²⁾	Equipment and office rent expense for 2006, 2005 and 2004 were $23,283, $18,355 and $8,394, respectively.

⁽³⁾	Although the stated maturities for these securities are thirty years, the Company expects the securities to be fully repaid prior to final maturity due to borrower prepayments and/or possible clean-up calls.

⁽⁴⁾	The table above excludes $5,987 of uncalled capital commitments to various investment partnerships that may be called over the next ten years. This amount was excluded because the Company cannot currently determine when, if ever, the commitments will be called.

The Company also has short-term commercial paper and repurchase agreement liabilities of $3,971,389 and $3,059,330, respectively, as of December 31, 2006. See Note 8 for further information.

Clearing Broker

FBR & Co. clears all of its securities transactions through a clearing broker on a fully disclosed basis. Pursuant to the terms of the agreements between FBR & Co. and the clearing broker, the clearing broker has the right to charge FBR & Co. for losses that result from a counterparty’s failure to fulfill its contractual obligations.

As the right to charge FBR & Co. has no maximum amount and applies to all trades executed through the clearing broker, the Company believes there is no maximum amount assignable to this right. At December 31, 2006, the Company has recorded no liabilities and during 2006 incurred no significant costs with regard to this right.

F-37

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Repurchase and Premium Recapture Obligations

The Company’s sales of mortgage loans are subject to standard mortgage industry representations and warranties that may require the Company to repurchase the mortgage loans due to breaches of these representations and warranties or if a borrower fails to make one or more of the first loan payments due on the loan. In addition, the Company is generally obligated to repay all or a portion of the original premium received on the sale of loans in the event that the loans are repaid within a specified time period subsequent to sale. The Company maintains a liability reserve for its repurchase and premium recapture obligations. The reserve is increased through charges to the gain (or loss) recorded at the time of sale. The reserve is reduced by charge-offs when loans are repurchased or premiums are repaid. Activity for the reserve was as follows for the period ended December 31, 2006 and 2005 (the Company did not maintain a reserve for repurchase and premium recapture obligations prior to the acquisition of First NLC in February 2005):


	December 31, 2006			December 31, 2005
Balance at beginning of period/at acquisition of First NLC	$	12,457		$	8,238
Provision		40,830			10,395
Charge-offs		(29,760	)		(6,176	)

Balance at end of period	$	23,527		$	12,457

Litigation

As of December 31, 2006, except as described below, the Company was not a defendant or plaintiff in any lawsuits or arbitrations, nor involved in any governmental or self-regulatory organization (SRO) matters that are expected to have a material adverse effect on the Company’s financial condition or statements of operations. The Company is a defendant in a small number of civil lawsuits and arbitrations (together, litigation) relating to its various businesses. In addition, the Company is subject to various reviews, examinations, investigations and other inquiries by governmental agencies and SROs. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on the Company’s financial condition or results of operations in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Many aspects of the Company’s business involve substantial risks of liability and litigation. Underwriters, broker-dealers and investment advisers are exposed to liability under Federal and state securities laws, other Federal and state laws and court decisions, including decisions with respect to underwriters’ liability and limitations on indemnification, as well as with respect to the handling of customer accounts. For example, underwriters may be held liable for material misstatements or omissions of fact in a prospectus used in connection with the securities being offered and broker-dealers may be held liable for statements made by their securities analysts or other personnel. In certain circumstances, broker-dealers and asset managers may also be held liable by customers and clients for losses sustained on investments. In recent years, there has been an increasing incidence of litigation and actions by government agencies and SROs involving the securities industry, including class actions that seek substantial damages. The Company is also subject to the risk of litigation, including litigation that may be without merit. As the Company intends to actively defend such litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against the Company could materially affect the Company’s operating results and financial condition.

The Company’s business (through its subsidiary First NLC and affiliated entities) includes the origination, acquisition, pooling, securitization and sale of non-conforming residential mortgage loans. Consequently, the

F-38

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Company is subject to additional federal and state laws in this area of operation, including laws relating to lending, consumer protection, privacy and unfair trade practices.

Putative Class Action Securities Lawsuits

Shareholders’ Derivative Action

The Company has been named a nominal defendant, and certain current and former senior officers and directors have been named as defendants, in three shareholders’ derivative actions. Two of these actions, brought by Lemon Bay Partners LLC and Walter Boyle, are pending in the United States District Court for the Southern District of New York and have been consolidated, for pre-trial purposes only, with the pending putative class action securities lawsuits under the name In re FBR Inc. Securities and Derivative Litig. The third, brought by Gary Walter and Harry Goodstadt, has been filed in the Circuit Court for Arlington County, Virginia. All three cases claim that certain of the Company’s current and former officers and directors breached their duties to the Company based on allegations substantially similar to those in the In re FBR Inc. Securities Litig. et al. putative class action lawsuits described above. The Company has not responded to any of these complaints and no discovery has commenced. The Company cannot predict the likely outcome of this action or its likely impact on us at this time. The Board of Directors has established a special committee whose jurisdiction includes the Boyle and Walter/Goodstadt matters as well as consideration of shareholder demand letters which contain similar allegations, and the special committee has been authorized to make final decisions whether such litigation is in the Company’s best interests.

Other Litigation

Our subsidiary, First NLC Financial Services, LLC (“First NLC”), has been named in a putative class action in the U.S. District Court for the Northern District of Illinois (Cerda v. First NLC Financial Services, LLC), which alleges violations of the Fair Credit Reporting Act, 15 U.S.C. § 1681 et seq. First NLC is contesting this lawsuit vigorously, but we cannot predict the likely outcome of this lawsuit or the likely impact on First NLC or on us at this time.

F-39

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

plaintiffs’ allegations in their entirety and intends to vigorously defend itself. This litigation is in its preliminary stages and the outcome of these types of cases is highly fact specific. We therefore cannot predict the likely outcome of this lawsuit or the likely impact on First NLC or on us at this time. We are aware that the number of cases involving alleged violations of the FSLA and state wage and hour laws have recently increased in the financial services industry and that a certain number of judgments and settlements involving these claims have already occurred.

Alleging claims similar to those in Stanfield, a group of plaintiffs who work (or worked) for First NLC as “funders” filed suit in the U.S. District Court for the Central District of California on January 30, 2007 (Sparrow-Milrot, et al. v. First NLC Financial Services, LLC, Case No. SA CV 07-0119 AHS RCX). Plaintiffs have not obtained class or collective action certification and First NLC has not answered the complaint. First NLC denies plaintiffs’ allegations in their entirety and intends to vigorously defend itself, but we cannot predict the likely outcome of this lawsuit or the likely impact on First NLC or on us at this time.

Regulatory Charges and Related Matters

As previously reported by the Company, one of the Company’s investment adviser subsidiaries, Money Management Associates, Inc. (MMA), is involved in an investigation by the SEC with regard to the adequacy of disclosure of risks concerning the strategy of a sub-advisor to a now-closed bond fund. The SEC staff has advised MMA that it is considering recommending that the SEC bring a civil action/and or institute a public administrative proceeding against MMA and one of its officers (who is not an officer of Friedman, Billings, Ramsey Group, Inc.) for violating and/or aiding and abetting violations of the federal securities laws. MMA and its officer have made a Wells submission and, if necessary, intend to defend vigorously any charges brought by the SEC. Based on management’s review with counsel, resolution of this matter is not expected to have a material adverse effect on the Company’s financial condition or results of operations. It is possible that the SEC may initiate proceedings as a result of its investigations, and any such proceedings could result in adverse judgments, injunctions, fines, penalties or other relief against MMA or one or more of its officers or employees.

Other Legal and Regulatory Matters

Except as described above, as of December 31, 2006, the Company was not a defendant or plaintiff in any lawsuits, arbitrations or regulatory actions that are expected to have a material adverse effect on the Company’s financial condition or results of operations. The Company is a defendant in a small number of civil lawsuits and

F-40

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

arbitrations relating to its various businesses, and is subject to various reviews, examinations, investigations and other inquiries by governmental agencies and SROs, none of which are expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Incentive Fees

The Company recognizes incentive income from the partnerships based on what would be due to the Company if the partnership terminated on the balance sheet date. Incentive allocations may be based on unrealized gains and losses, and could vary significantly based on the ultimate realization of the gains or losses. We may therefore reverse previously recorded incentive allocations in future periods relating to the Company’s managed partnerships. As of December 31, 2006, $35 was subject to such potential future reversal.

Note 13: Shareholders’ Equity:

The Company has authorized share capital of 450 million shares of Class A Common Stock, par value $0.01 per share; 100 million shares of Class B Common Stock, par value $0.01 per share; and 25 million shares of undesignated preferred stock. Holders of the Class A and Class B Common Stock are entitled to one vote and three votes per share, respectively, on all matters voted upon by the shareholders. Shares of Class B Common Stock convert to shares of Class A Common Stock at the option of the Company in certain circumstances including (i) upon sale or other transfer, (ii) at the time the holder of such shares of Class B Common Stock ceases to be affiliated with the Company and (iii) upon the sale of such shares in a registered public offering. The Company’s Board of Directors has the authority, without further action by the shareholders, to issue preferred stock in one or more series and to fix the terms and rights of the preferred stock. Such actions by the Board of Directors could adversely affect the voting power and other rights of the holders of common stock. Preferred stock could thus be issued quickly with terms that could delay or prevent a change in control of the Company or make removal of management more difficult. At present, the Company has no plans to issue any of the preferred stock.

Dividends

The Company declared the following distributions during the years ended December 31, 2006 and 2005:


Declaration Date	Record Date	Payment Date	Dividends Per Share
2006
December 13, 2006	December 29, 2006	January 31, 2007	$	0.05
September 13, 2006	September 29, 2006	October 31, 2006	$	0.05
June 8, 2006	June 30, 2006	July 28, 2006	$	0.20
March 15, 2006	March 31, 2006	April 28, 2006	$	0.20

2005
December 7, 2005	December 30, 2005	January 31, 2006	$	0.20
September 13, 2005	September 30, 2005	October 31, 2005	$	0.34
June 9, 2005	June 30, 2005	July 29, 2005	$	0.34
March 17, 2005	March 31, 2005	April 29, 2005	$	0.34

F-41

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Stock Compensation Plans

FBR Group Long-term Incentive Plan (FBR Group Long-Term Incentive Plan)

Under the FBR Group Long-Term Incentive Plan, the Company may grant options to purchase stock, stock appreciation rights, performance awards and restricted and unrestricted stock and other stock-based awards for up to 24,900,000 shares of Class A common stock to eligible participants in the Plan. Participants include employees, officers and directors of the Company and its subsidiaries. The FBR Group Long-Term Incentive Plan has a term of 10 years and options granted may have an exercise period of up to 10 years. Options may be incentive stock options, as defined by Section 422 of the Internal Revenue Code, or nonqualified stock options. The FBR Long-Term Incentive Plan replaced the FBR Group Stock and Annual Incentive Plan and the Non-Employee Director Stock Compensation Plan (the Prior Plans), and shares that remained available for issuance under the Prior Plans became available under the FBR Long-Term Incentive Plan.

Effective January 1, 2006, in accordance with SFAS No. 123R, the Company adopted a fair value based measurement method in accounting for all share based payment transactions with employees. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for options granted for the year ended December 31, 2006: dividend yield of 8.5%, expected volatility of 49%, risk-free interest rate of 4.7%, and an expected life of five years for all grants. The weighted average fair value of options granted during the year ended December 31, 2006 was $2.25.

A summary of option activity under the FBR Long-Term Incentive Plan and the FBR Group Stock and Annual Incentive Plan (the Stock Plans) as of December 31, 2006, and changes during the three year then ended is presented below:


	Number of Shares		Weighted-average Exercise Prices		Weighted-average Contractual Life
Share Balance as of December 31, 2003	3,441,142		$	11.05	5.0
Granted 2004	812,000			19.40
Forfeitures in 2004	(24,415	)		20.00
Exercised in 2004	(904,094	)		12.90


Share Balance as of December 31, 2004	3,324,633		$	17.39	3.4
Granted 2005	451,461			14.13
Forfeitures in 2005	(416,952	)		17.62
Exercised in 2005	(170,416	)		6.42


Share Balance as of December 31, 2005	3,188,726		$	17.47	2.7
Granted 2006	227,500			9.75
Forfeitures in 2006	(414,727	)		18.97
Exercised in 2006	(77,456	)		6.15


Share Balance as of December 31, 2006	2,924,043		$	16.92	1.9

The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004, was $277, $991 and $10,096, respectively.

F-42

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

As of December 31, 2006, there was $1,589 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Stock Plans relating to 602,000 nonvested options. The total unrecognized cost is expected to be recognized over a weighted-average period of 1.4 years.

FBR Capital Markets Corporation 2006 Long-Term Incentive Plan (FBR Capital Markets Long-Term Incentive Plan)

In connection with its formation, FBR Capital Markets (see Note 3) established the FBR Capital Markets Long-Term Incentive Plan. Under the FBR Capital Markets Long-Term Incentive Plan, FBR Capital Markets may grant options to purchase stock, stock appreciation rights, performance awards and restricted and unrestricted stock for up to 5,509,143 shares of common stock, subject to increase under certain provisions of the plan, to eligible participants. Participants include employees, officers and directors of the Company and its subsidiaries. The FBR Capital Markets Long-Term Incentive Plan has a term of 10 years and options granted may have an exercise period of up to 10 years. Options may be incentive stock options, as defined by Section 422 of the Internal Revenue Code, or nonqualified stock options.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for options granted for the year ended December 31, 2006: dividend yield of zero, expected volatility of 30%, risk-free interest rate of 4.8%, and an expected life of four and one-half years for all grants. The weighted average fair value of options granted during the year ended December 31, 2006 was $5.00.

A summary of option activity under the FBR Capital Markets Long-Term Incentive Plan as of December 31, 2006, and changes during the twelve months then ended, is presented below:


	Number of Shares		Weighted-average Exercise Prices		Weighted-average Remaining Contractual Life
Outstanding as of December 31, 2005	—		$	—
Granted	3,385,000			15.00
Cancelled	(9,000	)		15.00
Exercised	—			—

Outstanding as of December 31, 2006	3,376,000		$	15.00	5.6

Exercisable as of December 31, 2006	—		$	—	—

As of December 31, 2006, there was $14,809 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the FBR Capital Markets Long-Term Incentive Plan relating to 3,376,000 nonvested options. The total unrecognized cost is expected to be recognized over a weighted-average period of 2.6 years.

Stock Compensation Expense

Pursuant to SFAS 123R, compensation expense recognized in the statement of operations for stock options for the year ended December 31, 2006 was $3,657 and a related tax benefit of $758. In addition, in accordance with the provisions of SFAS 123R, the Company recognized compensation expense of $1,319 relating to shares offered under the Employee Stock Purchase Plan for the year ended December 31, 2006. The following table illustrates the effect on net income and earnings per share for the years ended December 31, 2005 and 2004, if the Company had applied the fair value recognition provisions of SFAS 123R to options granted under the Stock Plans. For purposes of this pro forma disclosure, the value of options is estimated using the Black-Scholes option pricing model with share-based awards amortized over the vesting periods pursuant to SFAS 123.

F-43

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)


	2005			2004
Net (loss) income, as reported	$	(170,910	)	$	349,559
Add: Stock-based employee compensation expense included in reported net income, net of tax effects		39			115
Deduct: Stock-based employee compensation, net of tax effects		2,329			2,047

Pro Forma net (loss) income	$	(173,200	)	$	347,627

Basic (loss) earnings per share—as reported	$	(1.01	)	$	2.09
Basic (loss) earnings per share—pro forma	$	(1.02	)	$	2.08
Diluted (loss) earnings per share—as reported	$	(1.01	)	$	2.07
Diluted (loss) earnings per share—pro forma	$	(1.02	)	$	2.06

Restricted Stock

The Company grants restricted common shares to employees that vest ratably over a three to four year period or cliff-vest after two to three years for various purposes based on continued employment over these specified periods. As of December 31, 2006 and December 31, 2005, a total of 1,819,431 and 2,038,340, respectively, shares of such FBR Group restricted Class A common stock was outstanding with unamortized deferred compensation of $9,878 and $15,602, respectively. As a result of adopting SFAS 123R, deferred compensation costs have been reclassified within the equity section of the balance sheet. This change in presentation had no net effect on the Company’s total equity. A summary of these unvested restricted stock awards as of December 31, 2006, and changes during the twelve months then ended is presented below:


	Number of Shares		Weighted-average Grant-date Fair Value		Weighted-average Remaining Vested Period
Share Balance as of December 31, 2003	414,500		$	10.53	2.3
Granted	879,490			23.70
Forfeitures	(39,034	)		17.91
Vestitures	(1,200	)		26.60

Share Balance as of December 31, 2004	1,253,756		$	19.90	2.0
Granted	1,349,263			17.05
Shares transferred to Trust	(452,856	)		26.62
Forfeitures	(84,157	)		18.30
Vestitures	(27,666	)		13.64

Share Balance as of December 31, 2005	2,038,340		$	16.40	1.8
Granted	781,597			9.50
Forfeitures	(169,278	)		15.34
Vestitures	(831,228	)		14.05

Share Balance as of December 31, 2006	1,819,431		$	14.69	1.6

For the years ended December 31, 2006, 2005 and 2004, the Company recognized $13,550, $13,864 and $6,590 of compensation expense related to this FBR Group restricted stock.

F-44

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

In addition, as part of the Company’s satisfaction of incentive compensation earned for past service under the Company’s variable compensation programs, employees may receive restricted Class A common stock in lieu of cash payments. These restricted Class A common stock shares are issued to an irrevocable trust and are not returnable to the Company. The Company issued 755,852 and 765,242 shares of FBR Group restricted common stock valued at $7,649 and $12,503 respectively, to the trust for the year ended December 31, 2006 and 2005, respectively, in settlement of such accrued incentive compensation. A summary of the undistributed restricted stock issued to the trust as of December 31, 2006, and changes during the twelve months then ended is presented below:


	Number of Shares		Weighted-average Grant-date Fair Value		Weighted-average Remaining Vested Period
Share Balance as of December 31, 2004	—		$	—	—
Shares transferred to Trust	452,856			26.62
Shares issued to Trust	765,242			16.34
Shares distributed from Trust	(19,784	)		22.37

Share Balance as of December 31, 2005	1,198,314		$	20.12	1.9
Shares issued to Trust	755,852			10.12
Shares distributed from Trust	(352,581	)		16.43

Share Balance as of December 31, 2006	1,601,585		$	16.20	1.5

Employee Stock Purchase Plan

The Company initiated the 1997 Employee Stock Purchase Plan (the Purchase Plan) on September 1, 1998. Under this Purchase Plan, eligible employees may purchase Class A common stock through payroll deductions at a price that is 85% of the lower of the market value of the common stock on the first day of the offering period or the last day of the offering period. As discussed above, in accordance with the provisions of SFAS 123R, effective January 1, 2006 the Company is required to recognize compensation expense relating to shares offered under the Purchase Plan. For the year ended December 31, 2006, the Company recognized such compensation expense of $1,319.

Director Stock Compensation Plan

Under the Non-Employee Director Stock Compensation Plan and the FBR Long-Term Incentive Plan, the Company may grant options, stock or restricted stock units (RSUs) in lieu of or in addition to annual director fees to non-employee directors. Prior to the merger, the Company had awarded stock options to directors, all of which vested upon the merger. Following the merger, the Board determined to make awards of RSUs instead of options, and approved annual awards of RSUs equal in value to $50 to each director to be made in conjunction with the annual shareholders meeting and, in the fourth quarter of 2004, increased such annual award value to $80. In addition, each of the Chairmen of the Board’s Committees receives one half of his quarterly fees for service as Chairmen in RSUs. These RSUs vest the day before the next annual meeting of shareholders, and are convertible to Class A Common Stock one year following completion of the director’s service on the Board. All options, stock and RSUs awarded to non-employee directors are non-transferable other than by will or the laws of descent and distribution. During 2006, 2005, and 2004, the Company granted 66,146 RSUs, 43,695 RSUs and 21,567 RSUs, respectively. For the year ended December 31, 2006, 2005, and 2004, the Company recognized $646, $483, and $405, respectively, of director fees related to these RSUs.

F-45

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Employee Stock Purchase and Loan Plan

On June 26, 2001 and August 10, 2001, the Company repurchased 4,228,000 and 772,000 shares, respectively, of Class B common stock from an executive officer of the Company for $5.50 per share. The shares were converted to Class A common stock and sold to other Company employees at the same price. Upon settlement of the repurchase and sales transactions on July 5, 2001 and August 15, 2001, respectively, the Company received 20% ($1.10 per share) of the purchase price in cash from the employees, and received five-year, limited recourse promissory notes from the employees with interest accruing at 6.5% accreting to principal for the remaining purchase price. The notes were collateralized by all of the stock purchased under the plan.

For accounting purposes, the portion of the employee share purchase financed by the Company (80%) is considered a stock option, and deducted from shareholders’ equity. These shares are deducted from shares outstanding in computing book value and basic earnings per share. Accordingly, as of December 31, 2006 and 2005, $12 and $4,018 financed (including accrued interest) by the Company, respectively and the 1,600 and 551,342 common shares, respectively related to the financing, are reflected as a receivable in shareholders’ equity. As the employees repay the loans, or the loans are sold, shareholders’ equity and shares outstanding will increase. In addition, the interest earned on the employee loans was added to paid-in-capital and excluded from net income. During the years ended December 31, 2006, 2005 and 2004, $124, $493 and $754, respectively, of compensation expense was recorded for dividends paid on the shares purchased with proceeds from the notes, and pledged to the Company as collateral.

Share Repurchases

In April 2003, the Company’s Board of Directors authorized a share repurchase program in which the Company may repurchase up to 14 million shares of the Company’s Class A common stock from time to time. In accordance with this repurchase program, a portion of the stock acquired may be used for the FBR Group stock-based compensation plans described previously. There were no other share repurchases during 2006, 2005, and 2004.

Note 14. Financial Instruments with Off-Balance-Sheet Risk and Credit Risk:

Financial Instruments

The Company invests in mortgage securities and equity securities that are primarily traded in United States markets. The Company funds its investments in mortgage securities and reverse repurchase agreements (associated with Arlington Funding) through repurchase agreement and commercial paper borrowings, respectively. Accordingly, the Company is subject to leverage and interest rate risk.

The Company’s asset management entities trade and invest in public and non-public securities. As of December 31, 2006 and 2005, as discussed above, the Company had not entered into any transactions involving financial instruments that would expose the Company to significant related off-balance-sheet risk.

In addition, in certain circumstances, the Company sells securities it does not currently own (securities sold, not yet purchased—see Note 5). When the Company sells a security short and borrows the security to make a delivery, a gain, limited to the price at which the Company sold the security short, or a loss, unlimited in size, will be realized upon the termination of the short sale.

F-46

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Market Risk

Market risk is primarily caused by movements in market prices of the Company’s trading and investment account securities and changes in value of the underlying securities of the investment partnerships in which the Company invests. The Company’s trading securities and investments are also subject to interest rate volatility and possible illiquidity in markets in which the Company trades or invests. The Company seeks to manage market risk through monitoring procedures. The Company’s principal transactions are primarily long and short equity and debt transactions.

Positions taken and commitments made by the Company, including those made in connection with venture capital and investment banking activities, have resulted in substantial amounts of exposure to individual issuers and businesses, including non-investment grade issuers, securities with low trading volumes and those not readily marketable. These issuers and securities expose the Company to a higher degree of risk than associated with investment grade instruments.

Credit Risk

The Company’s broker-dealer subsidiaries function as introducing brokers that place and execute customer orders. The orders are then settled by an unrelated clearing organization that maintains custody of customers’ securities and provides financing to customers.

Through indemnification provisions in agreements with clearing organizations, customer activities may expose the Company to off-balance-sheet credit risk. Financial instruments may have to be purchased or sold at prevailing market prices in the event a customer fails to settle a trade on its original terms or in the event cash and securities in customer margin accounts are not sufficient to fully cover customer obligations. The Company seeks to manage the risks associated with customer activities through customer screening and selection procedures as well as through requirements on customers to maintain margin collateral in compliance with various regulations and clearing organization policies.

The Company’s equity and debt investments include non-investment grade securities of privately held issuers with no ready markets. The concentration and illiquidity of these investments expose the Company to a higher degree of risk than associated with readily marketable securities.

The Company is also exposed to credit risk as a result of its investments in mortgage loans. The Company manages credit risk by purchasing and originating loans at favorable loan to value ratios and for a portion of the portfolio by purchasing mortgage insurance. In addition to monitoring procedures performed by management, the Company employs third parties to monitor loan servicer performance, including loan collection activities and management of defaulted loans. As of December 31, 2006, the Company had purchased mortgage insurance on $635,045 in principal balance of the remaining securitized loans held for sale previously designated as held for investment.

General Partnership and Managing Member Interests

As general partner of investment partnerships (or managing member of limited liability companies), certain of the Company’s subsidiaries may be exposed to liabilities that exceed the balance sheet value of the Company’s investment in the relevant vehicles. To limit the Company’s exposure to such excess liabilities the Company has formed limited liability companies, which are wholly owned by the relevant subsidiary, to hold the respective general partner or managing member interest. The hedge funds and other partnerships that the Company manages through subsidiaries as a general partner or managing member had $2,729 and $13,251 of liabilities as of December 31, 2006 and 2005, respectively, primarily margin debt, not reflected on our balance sheet.

F-47

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Note 15. Fair Value of Financial Instruments:

The estimated fair value amounts of the Company’s financial instruments have been determined using available market information and valuation methods that the Company believes are appropriate under the circumstances. These estimates are inherently subjective in nature and involve matters of significant uncertainty and judgment to interpret relevant market and other data. The use of different market assumptions and/or estimation methods may have a material effect on the estimated fair value amounts. The fair values reported reflect estimates and may not necessarily be indicative of the amounts the Company could realize in a current market transaction. The following describes the methods and assumptions used in estimating fair values:

Securities and Principal Investments in Debt and Equity securities, including Trading Account Securities Sold But Not Yet Purchased—Substantially all financial instruments used in the Company’s trading and investing activities are carried at fair value or amounts that approximate fair value. Fair value is based generally on listed market prices or broker-dealer price quotations. The fair value of the Company’s mortgage-backed securities are based on market prices provided by certain independent dealers who make markets in these financial instruments. To the extent that prices are not readily available, fair value is based on internal valuation models and estimates made by management. For example, investments in private securities and restricted securities have by their nature limited or no price transparency. Such investments are initially carried at cost as an approximation of fair value. Adjustments to carrying value may be made if there are third-party transactions evidencing a change in value. Downward adjustments also may be made, in the absence of third-party transactions, if the Company determines based on valuation models and estimates that the expected realizable value of the investment is less than the carrying value. In reaching that determination, the Company may consider factors such as, but not limited to, the financial performance of the companies relative to projections, trends within sectors, underlying business models and expected exit timing and strategy.

Mortgage Loans Held for Sale—In determining the lower-of-cost or market value of the securitized mortgage loans held for sale, the Company considers various factors affecting the overall value of the portfolio, including but not limited, to factors such as prepayment speeds, default rates, loss assumptions, geographic locations, collateral values, and mortgage insurance coverage. The Company utilizes the present value of expected cash flows considering the specific characteristics of each individual loan, aggregating the loans by specific securitization issuance, in determining the value of the portfolio. The Company also considers that these loans are collateral for securitization borrowings; therefore, taking into consideration the impact of any sale of the loan portfolio on the securitization borrowings, the related cash flows and the overall value of the residual interests in the securitization transactions that have been retained by the Company. Significant assumptions used by the Company in determining this value are supported by comparison to available market data for similar portfolios and transactions as well as a third party valuation of the residual interests in the securitization transactions.

For the non-securitized mortgage loans held for sale by First NLC, the Company determines fair value based on third party pricing quotes when available, current investor commitments and/or requirements for loans of

F-48

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

similar terms and credit quality or is estimated based on the same pricing models used by the Company to bid on whole loans in the open market. Such models incorporate aggregated characteristics of groups of loans including, collateral type, index, interest rate, margin, length of fixed interest rate period, life cap, periodic cap, underwriting standards, age and credit.

Derivatives—The carrying amounts represent fair value determined based on quoted market prices.

Temporary Subordinated Loan Payable—The carrying amount is a reasonable estimate of fair value because of the short-term nature of the borrowing.

Securitization Financing—Fair value is based on market values provided by certain independent dealers who make markets in these financial instruments.

Long-term Debt—The interest rates on these borrowings adjust quarterly to market rates, as such the carrying amount is a reasonable estimate of fair value.

Other—Cash and cash equivalents, restricted cash, interest receivable, reverse repurchase agreements, repurchase agreements, commercial paper, accounts payable, accrued expenses and other liabilities are reflected in the consolidated balance sheets at their amortized cost, which approximates fair value because of the short term nature of these instruments.

The estimated fair values of the Company’s financial instruments are as follows:


	December 31, 2006				December 31, 2005
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Financial assets
Cash and cash equivalents	$	189,956	$	189,956	$	238,615	$	238,615
Restricted cash		132		132		6,101		6,101
Non-interest bearing receivables		148,268		148,268		330,584		330,584
Mortgage-backed securities		6,870,661		6,870,661		8,002,561		8,002,561
Mortgage loans held for investment, net		—		—		6,841,266		6,638,239
Mortgage loans held for sale, net		5,367,934		5,367,934		963,807		963,807
Long-term investments		185,458		185,458		347,644		347,644
Reverse repurchase agreements		—		—		283,824		283,824
Trading securities		18,180		18,180		1,032,638		1,032,638
Derivative assets		36,875		36,875		70,636		70,636
Financial liabilities
Trading account securities sold short but not yet purchased		202		202		150,547		150,547
Commercial paper		3,971,389		3,971,389		6,996,950		6,996,950
Repurchase agreements		3,059,330		3,059,330		2,698,619		2,698,619
Derivative liabilities		44,582		44,582		31,952		31,952
Temporary subordinated loan payable		—		—		75,000		75,000
Securitization financing, net		4,486,046		4,486,046		6,642,198		6,634,932
Long-term debt		324,453		324,453		324,686		324,686

F-49

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)

Note 16. Supplemental Cash Flow Information—Non-cash Transactions:

The Company may receive shares and warrants in connection with certain capital raising activities. In 2006, 2005 and 2004, securities received in exchange for services provided were $-0-, $1,524 and $3,251, respectively.

In connection with its acquisition of First NLC (see Note 4), the Company issued 1,297,746 shares of its Class A common stock valued at $24,420.

The Company retained a residual interest and servicing rights valued at $14,577 and $6,177, respectively, related to the issuance of First NLC Trust 2005-4 Mortgage-Backed Certificates, Series 2005-4, in a non-cash transaction during the year ended December 31, 2005.

Note 17. Segment Information:

The Company considers its capital markets, asset management, principal investing, and mortgage banking operations to be four separately reportable segments.

The capital markets segment includes the Company’s investment banking and institutional brokerage areas. These businesses operate as a single integrated unit to deliver capital raising, advisory and sales and trading services to corporate and institutional clients. Asset management includes the Company’s fee based asset management operations. The Company’s principal investing segment includes mortgage related investment activities, and substantially all of the Company’s equity security investing activities. The Company’s mortgage banking segment which was initiated subsequent to the acquisition of First NLC (see Note 4) includes the origination and sale of non-conforming residential mortgage loans. Accordingly, there is no comparable financial information for the year ended December 31, 2004 for the mortgage banking segment.

The accounting policies of these segments are the same as those described in Note 2. The Company has developed systems and methodologies to allocate overhead costs to its business units and, accordingly, presents segment information consistent with internal management reporting. Revenue generating transactions between the individual segments have been included in the net revenue and pre-tax income of each segment. These transactions include investment banking activities provided by the capital markets segment to other segments and the sale of mortgage loans between the mortgage banking and principal investing segments. The Company’s net revenues from foreign operations totaled $22,197, $20,174, and $28,785 for the years ended December 31, 2006, 2005 and 2004, respectively. The following tables illustrate the financial information for the Company’s segments for the years indicated.


	Capital Markets			Asset Management			Principal Investing			Mortgage Banking			Intersegment Eliminations(1)		Consolidated Totals
2006
Net revenues	$	330,865		$	27,313		$	(90,488	)	$	112,674		$	—	$	380,364
Compensation and benefits		215,607			14,393			5,052			74,013			—		309,065
Total expenses		365,241			38,393			52,106			130,843			—		586,583
Operating loss		(34,376	)		(11,080	)		(142,594	)		(18,169	)		—		(206,219	)
Total assets		288,115			46,395			11,946,976			1,071,032			—		13,352,518
Total net assets		142,430			30,603			913,039			84,973			—		1,171,045

F-50

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Dollars in thousands, except per share amounts)


	Capital Markets		Asset Management			Principal Investing			Mortgage Banking			Intersegment Eliminations(1)			Consolidated Totals
2005
Net revenues	$	504,602	$	36,335		$	(149,558	)	$	52,658		$	(9,335	)	$	434,702
Compensation and benefits		249,504		18,403			16,521			47,064			—			331,492
Total expenses		424,926		37,727			30,350			85,926			—			578,929
Operating income (loss)		79,676		(1,392	)		(179,908	)		(33,268	)		(9,335	)		(144,227	)
Total assets		1,498,409		52,119			15,636,598			1,248,664			—			18,435,790
Total net assets		227,657		37,431			904,938			134,144			—			1,304,170

2004
Net revenues	$	542,668	$	45,170		$	300,108		$	—		$	—		$	887,946
Compensation and benefits		273,931		22,061			27,532			—			—			323,524
Total expenses		401,649		36,587			40,990			—			—			479,226
Operating income		141,019		8,583			259,118			—			—			408,720
Total assets		342,784		56,371			12,529,133			—			—			12,928,288
Total net assets		144,467		22,223			1,411,834			—			—			1,578,524

(1)	Intersegment Eliminations represent the elimination of intersegment transactions noted above.

Note 18. Quarterly Data (Unaudited):

The following tables set forth selected information for each of the fiscal quarters during the years ended December 31, 2006 and 2005. The selected quarterly data is derived from unaudited financial statements of the Company and has been prepared on the same basis as the annual, audited financial statements to include, in the opinion of management, all adjustments (consisting of only normal recurring adjustments) necessary for fair statement of the results for such periods.

Note: The sum of quarterly earnings per share amounts may not equal full year earnings per share amounts due to differing average outstanding shares amounts for the respective periods.


	Total Revenues		Net (loss) Income Before Income Taxes and Minority Interest			Net (loss) Income			Basic (loss) Earnings Per Share			Diluted (loss) Earnings Per Share
2006
First Quarter	$	338,699	$	24,835		$	26,554		$	0.16		$	0.16
Second Quarter		246,111		(29,007	)		(30,247	)		(0.18	)		(0.18	)
Third Quarter		82,442		(98,162	)		(67,392	)		(0.39	)		(0.39	)
Fourth Quarter		340,652		17,626			3,810			0.02			0.02

Total Year	$	1,007,904	$	(84,708	)	$	(67,275	)	$	(0.39	)	$	(0.39	)

2005
First Quarter	$	237,775	$	29,984		$	24,412		$	0.15		$	0.14
Second Quarter		312,084		66,406			53,243			0.31			0.31
Third Quarter		339,901		31,135			23,045			0.14			0.14
Fourth Quarter		105,546		(271,752	)		(271,610	)		(1.60	)		(1.60	)

Total Year	$	995,306	$	(144,227	)	$	(170,910	)	$	(1.01	)	$	(1.01	)

F-51