News Column

FBR & CO. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

The following discussion and analysis of the consolidated financial condition and results of operations of FBR & Co. and its subsidiaries (collectively, "we", "us", "our" or the "Company") should be read in conjunction with the unaudited consolidated financial statements and the notes thereto appearing elsewhere in this report on Form 10-Q and the audited consolidated financial statements and notes thereto appearing in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

The discussion of the Company's consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management's beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect the Company's future results, please see "Forward-Looking Statements" immediately preceding Part I of, and other items throughout, the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Please also see "Risk Factors" in Part I, Item 1A of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

Business Environment

In the first half of 2014, U.S. equity markets were up slightly following very strong performance for the full year 2013. Volatility remained low as investors were seemingly unconcerned with political disruptions in Europe and the Middle East and with a winter slowdown in economic activity domestically. Equity capital markets activity was quite strong as a result of a higher number of issuers seeking capital events and healthy levels of risk tolerance on the part of investors supported by consistently low volatility. During the first half of 2014 there were 141 IPOs completed in the U.S., an increase of more than 60% compared to the first half of 2013. Total domestic equity issuance was $129.5 billion, compared to $122.8 billion in the half of last year.

Overall, competition in our business remains intense. Large banks continue to tie lending activity to capital markets mandates and electronic or high-frequency trading continues to capture a significant share of trading volume. Both of these dynamics put pressure on high-touch, idea-driven firms like FBR. Institutional investors continue to narrow the list of broker-dealers with whom they maintain trading relationships, leading to consolidation of smaller firms and to the need for mid-size firms to work intensely to demonstrate relevance through quality and scale of research offerings in order to grow relationships.

We believe capital markets conditions remain favorable as positive fund flows and extraordinary low interest rates have combined to provide significant support to equity prices and high-yield bond prices. Over the last 18 months, investors have been increasingly focused on higher risk assets due to strong market performance and in order to achieve targeted investment returns. This move toward risk continues to be underpinned by the accommodating stance of the Federal Reserve. While the Federal Reserve has begun to reduce the monthly amount of its bond purchases, the market continues to benefit from a combination of low interest rates and significant bond market support. We believe that normalization of these policies is likely to lead to increased market volatility as markets adjust to consequent changes in interest rates and fund flows.

Executive Summary

For the second quarter of 2014 our revenues, net of interest expense, were $57.1 million, our pre-tax income was $9.0 million and our net income was $7.0 million. This compares to second quarter 2013 revenues of $67.2 million, pre-tax income from continuing operations of $14.6 million, and net income from continuing operations of $40.3 million. Our second quarter 2013 net income was $42.6 million and included $2.3 million of net income from discontinued operations. There were no comparable discontinued operations results in 2014.

The difference in our second quarter 2014 net income compared to 2013 is primarily due to the $25.7 million income tax benefit recognized in the second quarter of 2013 reflecting the reversal of a significant component of the valuation allowance that had been recorded against the Company's deferred tax assets as well

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as the utilization during 2013 of net operating loss carryforwards against 2013 projected taxable income. The valuation allowance reversal was recognized based on management's consideration of various factors, including the Company's improved operating performance, its cumulative operating results over the prior twelve quarters and the outlook regarding the Company's prospective operating performance.

Additionally, the decrease in our pre-tax income in the second quarter 2014 compared to 2013 was due to the net effects of a decrease in capital markets revenues partially offset by an increase in revenues from principal investments. Investment banking revenues during second quarter 2014 of $35.8 million compares to $52.0 million in 2013. The reduction in investment banking revenues in 2014 reflects the differences in the nature and size of the capital raising transactions completed in these periods. Our institutional brokerage revenues were $14.6 million in the second quarter of 2014 compared to $13.1 million in 2013 and our net revenues from principal investing were $6.2 million in the second quarter 2014 compared to $1.6 million in the second quarter of 2013. Our non-compensation fixed expenses were $10.9 million in the second quarter of 2014 compared to $10.2 million in 2013. Our compensation and benefits expense as a percentage of net revenues was 56% in both the second quarter of 2014 and 2013.

For the six months ended June 30, 2014, our revenues, net of interest expense, were $111.5 million, our pre-tax income was $18.0 million and our net income was $12.6 million compared to revenues of $185.2 million, pre-tax income from continuing operations of $50.5 million, and net income from continuing operations, reflecting a $24.2 million income tax benefit, of $74.8 million for the six months ended June 30, 2013. In addition, for the six months ended June 30, 2013, our income from discontinued operations, net of taxes, was $3.1 million. There are no comparable discontinued operations results in 2014.

Consistent with the discussion above the $24.2 million income tax benefit recognized in the six months ended June 30, 2013 reflects the reversal of a significant component of the valuation allowance that had been recorded against the Company's deferred tax assets as well as the utilization during 2013 of net operating loss carryforwards against 2013 projected taxable income.

Additionally, the decrease in our pre-tax income in the first six months of 2014 compared to 2013 was due to the net effects of a decrease in capital markets revenues partially offset by an increase in revenues from principal investments. Investment banking revenues during the first six months of 2014 of $72.4 million compares to $153.3 million in 2013. The reduction in investment banking revenues in 2014 reflects the differences in the nature and size of the capital raising transactions completed in these periods. Our institutional brokerage revenues were $29.7 million in the first six months of 2014 compared to $26.8 million in 2013 and our net revenues from principal investing were $8.6 million in the first six months of 2014 compared to $3.3 million in the first six months of 2013. Our non-compensation fixed expenses were $21.5 million in the first six months of 2014 compared to $21.3 million in 2013. Our compensation and benefits expense as a percentage of net revenues was 57% in the first half of 2014 compared to 56% in the first half of 2013.

The following is an analysis of our operating results by segment for the three and six months ended June 30, 2014 and 2013.

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Capital Markets

Our capital markets segment includes investment banking and institutional sales, trading and research. These business units operate as a single integrated segment to deliver capital raising, advisory and sales and trading services to corporate and institutional clients. Our investment banking and institutional brokerage businesses are focused on the consumer, diversified industrials, energy and natural resources, financial institutions, healthcare, insurance, real estate, and technology, media and telecommunications sectors. By their nature, our capital markets business activities are highly competitive and are subject to market conditions, as well as to the conditions affecting the companies and markets in our areas of focus. As a result, our capital markets revenues and profits are subject to significant volatility from period to period. The following tables provide a summary of our results within the capital markets segment (dollars in thousands).

Three Months Ended June 30, 2014 2013 Revenues: Investment banking $ 35,784$ 52,037 Institutional brokerage 14,643 13,122 Interest income, dividends and other 485 442 Total 50,912 65,601 Operating Expenses: Variable 21,140 29,464 Fixed 25,193 22,666 Total(1) 46,333 52,130 Pre-tax income $ 4,579$ 13,471



(1) For the three months ended June, 2014 and 2013, total operating expenses

includes the allocation of corporate overhead costs of $6,037 and $5,725,

respectively.

The pre-tax income from our capital markets segment decreased to $4.6 million for the second quarter of 2014 from $13.5 million for the second quarter of 2013. The decrease in our pre-tax income is primarily attributable to a $16.3 million decrease in investment banking revenues in 2014 compared to 2013. The impact of the decreased revenues was offset partially by an $8.3 million decrease in variable expenses. Specifically, variable expenses, including $16.0 million of variable compensation, decreased to $21.1 million in 2014 from $29.5 million in 2013 as a result of the decrease in revenues. Our total compensation and benefits costs as a percentage of revenues in this segment was 60.0% in 2014 compared to 57.3% in 2013. Fixed expenses increased $2.5 million, or 11.1%, in 2014 as a result of an increase in our average headcount in the second quarter of 2014 compared to 2013.

Investment banking revenues decreased $16.2 million to $35.8 million during the second quarter of 2014 from $52.0 million in the second quarter of 2013. Our second quarter 2014 investment banking revenues were generated from 15 client transactions representing $4.1 billion in transaction volume. Included in those transactions and representing $26.4 million of our capital raising revenue were two sole-managed institutional private placements. In comparison, our second quarter 2013 investment banking revenues were generated from 16 client engagements representing a range of private and public transactions across the industry groups that we cover. Included in those transactions and representing $39.7 million of our capital raising revenue were three sole-managed institutional private placements.

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The following table provides detail regarding the components of our institutional brokerage revenues (dollars in thousands).

Three Months Ended June 30, 2014 2013 Agency commissions $ 7,330$ 7,500 Principal transactions 6,270 4,798 Commissions for equity research 1,043 824 Total $ 14,643$ 13,122



Our institutional brokerage revenues increased $1.5 million to $14.6 million for the second quarter of 2014 from $13.1 million for the second quarter of 2013. The increase in revenue in 2014 reflects the impact of the fourth quarter 2013 group hire of 32 institutional brokerage sales, trading and research professionals on our brokerage activities in 2014 as well as our continued investment in research.

Six Months Ended June 30, 2014 2013 Revenues: Investment banking $ 72,423$ 153,327 Institutional brokerage 29,734 26,827 Net interest income, dividends and other 733 970 Total 102,890 181,124 Operating Expenses: Variable 40,684 86,780 Fixed 50,001 46,377 Total(1) 90,685 133,157 Pre-tax income $ 12,205$ 47,967



(1) For the six months ended June 30, 2014 and 2013, total operating expenses

includes the allocation of corporate overhead costs of $11,539 and $12,857,

respectively.

The pre-tax income from our capital markets segment decreased to $12.2 million for the six months ended June 30, 2014 from $48.0 million for the six months ended June 30, 2013. The decrease in our pre-tax results is primarily attributable to an $80.9 million decrease in investment banking revenues in 2014 compared to 2013. The impact of the decreased revenues was offset partially by a $46.1 million decrease in variable expenses. Specifically, variable expenses, including $32.1 million of variable compensation, decreased to $40.7 million in 2014 from $86.8 million in 2013 as a result of the decrease in revenues. Our total compensation as a percentage of revenues in this segment was 59.6% in 2014 compared to 56.9% in 2013. Fixed expenses increased $3.6 million, or 7.8%, in 2014 as a result of an increase in fixed compensation due to an increase in our average headcount.

Investment banking revenues decreased $80.9 million to $72.4 million during the first half of 2014 from $153.3 million during 2013. Our investment banking revenues in 2014 were generated from 31 client transactions representing $7.0 billion in transaction volume. Included in those transactions and representing $57.3 million of our capital raising revenue were five sole-managed institutional private placements. Our investment banking revenues in 2013 were generated from 34 client transactions with contributions from each of the Company's industry groups. Included in those transactions and representing $120.7 million of our capital raising revenue were five sole-managed institutional private placements. One of these private placements, representing $38.3

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million of that revenue was executed in the second quarter of 2012; however the issuer did not receive the required regulatory approvals necessary for us to recognize this revenue until the first quarter of 2013.

The following table provides detail regarding the components of our institutional brokerage revenues (dollars in thousands).

Six Months Ended June 30, 2014 2013 Agency commissions $ 14,685$ 14,936 Principal transactions 13,216 10,659 Commissions for equity research 1,833 1,232 Total $ 29,734$ 26,827



Our institutional brokerage revenues increased $2.9 million to $29.7 million for the six months ended June 30, 2014 from $26.8 million for the six months ended June 30, 2013. The increase in revenue in 2014 reflects the impact of the fourth quarter 2013 group hire of 32 institutional brokerage sales, trading and research professionals on our brokerage activities in 2014 as well as our continued investment in research.

Principal Investing

As of June 30, 2014, our principal investing activity consists of investments in non-registered investment funds, marketable equity securities, non-public equity securities, corporate debt investments and short-sales of U.S. Treasury securities. The following tables provide a summary of our results within the principal investing segment (dollars in thousands):

Three Months Ended June 30, 2014 2013 Revenues: Net investment income $ 9,091$ 1,209 Interest, dividends and other 178 432 Total revenues 9,269 1,641 Interest expense 3,083 - Revenues, net of interest expense 6,186 1,641 Operating Expenses: Variable 1,139 108 Fixed 651 372 Total(1) 1,790 480 Pre-tax income $ 4,396$ 1,161



(1) For the three months ended June 30, 2014 and 2013, total operating expenses

includes the allocation of corporate overhead costs of $117 and $111,

respectively.

The pre-tax income from our principal investing segment was $4.4 million for the second quarter of 2014 compared to $1.2 million in 2013. The increase in our pre-tax income was due to increased net investment income in 2014 compared to 2013 as a result of market appreciation. Net investment income for the second quarter of 2014 includes $2.4 million of unrealized gains from trading securities held for investment purposes, $2.2 million of net unrealized gains from investment funds, $2.1 million of realized gains from sales of investments, and $2.4 million of unrealized gains from short-sales of U.S. Treasury securities. These 2014

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revenues were partially offset by $3.1 million of interest expense related to short-sales of U.S. Treasury securities. Our 2013 net investment income includes $0.9 million of net unrealized gains from investment funds and $0.3 million of net realized and unrealized gains from trading securities held for investment purposes. There were no significant realized gains in the second quarter of 2013. Six Months Ended June 30, 2014 2013 Revenues: Net investment income $ 12,925$ 3,307 Interest, dividends and other 401 737 Total revenues 13,326 4,044 Interest expense 4,760 - Revenues, net of interest expense 8,566 4,044 Operating Expenses: Variable 1,358 758 Fixed 1,423 714 Total(1) 2,781 1,472 Pre-tax income $ 5,785$ 2,572



(1) For the six months ended June 30, 2014 and 2013, total operating expenses

includes the allocation of corporate overhead costs of $223 and $249,

respectively.

The pre-tax income from our principal investing segment increased to $5.8 million for the six months ended June 30, 2014 from $2.6 million for the six months ended June 30, 2013. The increase in our pre-tax income was due to increased net investment income in 2014 compared to 2013 as a result of market appreciation. Net investment income for the six months ended June 30, 2014 includes $3.8 million of net unrealized gains from investment funds, $2.9 million of net unrealized gains from trading securities held for investment purposes, $2.3 million of realized gains on sales of investments, and $3.9 million of unrealized gains from short-sales of U.S. Treasury securities. These 2014 revenues were partially offset by $4.8 million of interest expense related to short-sales of U.S. Treasury securities. Our 2013 net investment income includes $2.2 million of net unrealized gains from investment funds, $1.6 million of net realized and unrealized gains from trading securities held for investment purposes, and a $0.5 million impairment loss related to an available-for-sale investment security. There were no significant realized gains in the first six months of 2013.

Investments

The total value of our principal investments was $115.0 million as of June 30, 2014. Of this total, $93.3 million was held in non-registered investment funds that primarily invest in fixed income securities, $19.3 million was held in marketable and non-public equity securities and warrants, at fair value, and $2.4 million was held in non-public investments recorded at cost. The following table provides additional detail regarding our principal investments as of June 30, 2014 (dollars in thousands):

Carrying Value/ Fair Value Investments, at fair value: Investment funds, at fair value $ 93,290 Marketable and non-public equity securities and warrants, at fair value 19,248 Total $ 112,538 Investments, at cost: Non-public equity securities 2,428 Total investments $ 114,966 30



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In addition to these assets, during the first six months of 2014, as part of the Company's investing activities, the Company entered into two short-sales of $100 million face value each, 4.50% U.S. Treasury securities and one short-sale of a $75 million face value, 7.25% U.S. Treasury security. These positions are included in securities sold but not yet purchased on the Company's balance sheet as of June 30, 2014. These three securities mature in November 2015, February 2016 and May 2016, respectively. Proceeds from these short-sales, as well as related margin requirements, are held in a collateral account and are included in due from brokers, dealers and clearing organizations on the Company's balance sheet at June 30, 2014. The Company is obligated to fund the fixed-rate coupon interest on these securities while the short-positions are outstanding.

As of June 30, 2014, the $93.3 million of investment funds reflected investments in 18 non-registered investment funds that are valued at net asset value ("NAV") as determined by the fund administrators. The Company classifies these investments within Level 3 of the fair value hierarchy as the underlying securities held by these investment companies are primarily corporate and asset-backed fixed income securities and restrictions exist on the redemption of amounts invested by the Company. As a practical expedient, the Company relies on the NAV of these investments as their fair value. The NAVs that have been provided by investees are derived from the fair values of the underlying investments as of the reporting date. Considering the general lack of transparency necessary to conduct an independent assessment of the fair value of the securities underlying each of the NAVs provided by the fund administrators, our quarterly reporting process includes a number of assessment processes to assist the Company in the evaluation of the information provided by fund managers and fund administrators. These assessment processes include, but are not limited to regular review and discussion of each fund's performance with its manager and regular evaluation of performance against applicable benchmarks.

Discontinued Operations

The Company completed the sale of the FBR Funds, a family of mutual funds, in October 2012. Subsequent to the sale closing, the Company has had no continuing involvement in the management of these funds. As a result of this sale transaction, the Company has reported the results of its asset management operations as discontinued operations.

In accordance with the asset sale agreement, the Company received an initial payment upon closing in October 2012 and a subsequent payment upon the first anniversary of closing in October 2013, in each case based on a percentage of assets under management for the applicable funds. Additionally, the gain recorded on the asset sale in 2012 included an estimate of the contingent payment to be received in 2013. The Company valued this contingent payment at each reporting date during 2013, through the first anniversary of the closing in October 2013. These valuations were based on the Company's consideration of various factors outside of its control that could have had a significant effect on the value of prospective assets under management. For example, uncertainties related to fund performance, market conditions as well as investor demand for equity mutual funds. Other considerations included the Company's historical asset levels and potential asset attrition as a result of the sale transaction.

The Company's net income from discontinued operations during the first and second quarters of 2013 reflects the estimated change in value during the periods of the contingent payment that was due from this sale and recorded as a receivable at December 31, 2012. The increase in value during 2013 was due primarily to market appreciation of the funds during the period subsequent to the sale. The tax provision recognized in 2013 related primarily to state taxes on income that could not be offset by either net operating loss or capital loss carryforwards. Based on the Company's receipt of the applicable contingent sale proceeds during the fourth quarter of 2013, there are no comparable discontinued operations results in 2014.

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The results related to our asset management operations reflected in the consolidated statement of operations for the three and six months ended June 30, 2013, are presented in the following table (dollars in thousands).

Three Months Ended Six Months Ended June 30, June 30, 2013 2013 Revenues $ - $ - Gain on sale of assets, net 2,582 3,430 Expenses 215 223 Income from discontinued operations before income taxes 2,367 3,207 Income tax provision 51 85 Income from discontinued operations, net of taxes $ 2,316 $ 3,122 Results of Operations



Three months ended June 30, 2014 compared to three months ended June 30, 2013

We generated net income of $7.0 million in the second quarter of 2014 compared to $42.6 million in the second quarter of 2013. This decrease in net income was primarily the result of a $25.7 million tax benefit recognized in the second quarter of 2013, reflecting the reversal of a significant component of the valuation allowance that had been recorded against our deferred tax assets. In addition, the decrease is due to the net effects of a $16.3 million decrease in investment banking revenues in 2014 compared to 2013 partially offset by a $4.5 million increase in principal investment revenues.

Pre-tax income in our capital markets segment decreased to $4.6 million during the second quarter of 2014 from $13.5 million during the second quarter of 2013. This decrease in pre-tax income is due to the decrease in investment banking revenues discussed above. Pre-tax income in our principal investing segment was $4.4 million during the second quarter of 2014 compared to $1.2 million during 2013. Our net income for the second quarter 2013 also includes $2.3 million from discontinued operations while there were no comparable discontinued operations results in 2014.

Revenues, net of Interest Expense

Our revenues, net of interest expense, decreased 15.0% to $57.1 million during the second quarter of 2014 from $67.2 million during the second quarter of 2013 due to the changes in revenues and interest expense discussed below.

Capital raising revenues decreased 28.3% to $35.3 million in the second quarter of 2014 from $49.2 million in the second quarter of 2013. In the second quarter of 2014, we completed 15 client transactions, including two sole-managed private placements that generated $26.4 million of revenue in the period. In the second quarter of 2013, we completed 12 client engagements, representing a range of private and public transactions, including three sole-managed private placements that generated $39.7 million of revenue in the period.

Advisory revenues decreased 82.8% to $0.5 million in the second quarter of 2014 from $2.9 million in the second quarter of 2013. We did not complete any significant M&A or advisory assignments in the second quarter of 2014 compared to four completed assignments in the second quarter of 2013.

Institutional brokerage revenues increased 11.5% to $14.6 million in the second quarter of 2014 from $13.1 million in the second quarter of 2013. The increase in revenue in 2014 reflects the impact of the fourth quarter 2013 group hire of 32 institutional brokerage sales, trading and research professionals on our brokerage activities in 2014 as well as our continued investment in research.

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Net investment income increased $7.9 million to $9.1 million in the second quarter of 2014 compared to $1.2 million in the second quarter of 2013. Net investment income for the second quarter of 2014 includes $2.4 million of unrealized gains from trading securities held for investment purposes, $2.2 million of net unrealized gains from investment funds, $2.1 million of realized gains from sales of investments, and $2.4 million of unrealized gains from short-sales of U.S. Treasury securities. These 2014 revenues were partially offset by $3.1 million of interest expense related to short-sales of U.S. Treasury securities. Our 2013 net investment income includes $0.9 million of net unrealized gains from investment funds and $0.3 million of net realized and unrealized gains from trading securities held for investment purposes. There were no significant realized gains in the second quarter of 2013.

During the second quarter of 2014, we incurred $3.1 million of interest expense related to two short-sales of $100 million face value each, 4.50% U.S. Treasury securities and one short-sale of a $75 million face value, 7.25% U.S. Treasury security. The Company did not incur any interest expense during the second quarter of 2013.

Non-Interest Expenses

Total non-interest expenses decreased 8.6% to $48.1 million in the second quarter of 2014 from $52.6 million in the second quarter of 2013. The decrease was caused by the changes in non-interest expenses discussed below.

Compensation and benefits expenses decreased 15.3% to $32.1 million in the second quarter of 2014 from $37.9 million in the second quarter of 2013 as a result of a $7.9 million decrease in variable compensation. The reduction in variable compensation is due to the decrease in investment banking revenue in 2014 compared to the prior year. This decrease was partially offset by a $1.9 million increase in fixed compensation in 2014 compared to 2013 as a result of a higher average headcount in the second quarter of 2014 compared to the second quarter of 2013. Our compensation and benefits expense as a percentage of net revenues was 56% in both the second quarter of 2014 and 2013.

Professional services expenses increased 29.4% to $4.4 million in the second quarter of 2014 from $3.4 million in the second quarter of 2013. This increase is primarily due to an increase in costs associated with investment banking transactions. Despite the increase in investment banking revenue, our transaction related costs increased in 2014 compared to 2013 due to differences in the nature of the transactions in the two periods.

Business development expenses increased 19.2% to $3.1 million in the second quarter of 2014 from $2.6 million in the second quarter of 2013. This increase is primarily due to an increase in travel costs related to business promotion and investment banking transactions.

Clearing and brokerage fees decreased 15.4% to $1.1 million in the second quarter of 2014 from $1.3 million in the second quarter of 2013. The decrease in these costs is due primarily to the impact of cost reduction initiatives directed at reducing our brokerage execution costs.

Occupancy and equipment expenses decreased slightly to $3.0 million in the second quarter of 2014 from $3.1 million in the second quarter of 2013. The decrease in occupancy costs is primarily the result of reductions in depreciation expense associated with reduced capital expenditures over the past several years.

Communications expenses increased slightly to $2.9 million in the second quarter of 2014 from $2.8 million in the second quarter of 2013. The increase in these expenses is primarily due an increase in our average headcount in the second quarter of 2014 compared to the second quarter of 2013.

Other operating expenses increased slightly to $1.6 million in the second quarter of 2014 from $1.5 million in the second quarter of 2013. The increase in these expenses is primarily due an increase in license and registration fees.

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We recognized a tax provision of $2.0 million in the second quarter of 2014 compared to a $25.7 million tax benefit in the second quarter of 2013. As discussed below, our 2013 tax benefit reflects the reversal of a significant component of the valuation allowance that had been recorded against the Company's deferred tax assets as well as the utilization during 2013 of net operating loss carryforwards against 2013 projected taxable income. Our quarterly tax provision is determined pursuant to ASC 740, which requires using an estimated annual effective tax rate based on the forecasted taxable income for the full year. Our effective tax rate for the second quarter of 2014 was 22.3%. This tax rate differed from statutory tax rates primarily due to capital loss carryforwards subject to valuation allowance that are projected to be utilized during the year. The Company's effective tax rate for the second quarter of 2013 was (175.6)%. This tax rate differed from statutory tax rates primarily due to the effects of the valuation allowance reversal.

During the three months ended June 30, 2013, the Company released a significant component of its valuation allowance against its net deferred tax assets since, based on the application of the criteria in ASC 740, it concluded that it was more likely than not that the benefits of these assets would be realized in the future. Following the criteria in ASC 740, the Company reviews this valuation allowance on a quarterly basis assessing the positive and negative evidence to determine if it is more likely than not that some or all of the deferred tax assets will be realized. As of June 30, 2013 and subsequently, as described below, the Company's valuation allowance for its deferred tax assets relates to capital loss carryforwards and net unrealized losses on investments.

At December 31, 2013, the Company's net deferred tax assets totaled $49.2 million and were partially offset by a valuation allowance of $18.3 million. This valuation allowance related to capital loss carryforwards and net unrealized losses on investments and was determined based on the Company's application of the guidance in ASC 740 and its conclusion that that it was more likely than not that the benefits of these assets would not be realized in the future. Based on its assessment as of June 30, 2014, the Company determined that a valuation allowance related to its capital loss carryforwards and net unrealized losses on investments continued to be appropriate. As of June 30, 2014, these deferred tax assets and related valuation allowance totaled approximately $14.8 million. Recognition of these deferred tax assets will be dependent on the Company's ability to generate capital gains.

The Company believes there is potential for volatility in its 2014 effective tax rate from quarter-to-quarter due to the impact of any prospective changes in its forecasted earnings for the year as well as any capital gains generated that result in the use of capital loss carryforwards currently subject to a valuation allowance.

Discontinued Operations

Income from discontinued operations, net of taxes was $2.3 million during second quarter of 2013. For the three months ended June 30, 2013, the Company's net income from discontinued operations was the result of the change in the estimated value of the Company's receivable from the sale of the FBR Funds. Based on the Company's receipt of the contingent sale proceeds receivable during the fourth quarter of 2013, there were no comparable discontinued operations results in 2014.

Six months ended June 30, 2014 compared to six months ended June 30, 2013

We recognized net income of $12.6 million in the first six months of 2014 compared to a net income of $77.9 million in the first six months of 2013. This decrease in net income was primarily the result of both the tax benefit of $24.2 million recognized in 2013 compared to the $5.4 million tax provision in 2014 and an $80.9 million decrease in investment banking revenue in 2014 compared to 2013. The tax benefit recognized in the first half of 2013 reflects the reversal of a significant component of the valuation allowance that had been recorded against our deferred tax assets.

The pre-tax income in our capital markets segment decreased to $12.2 million during the first six months of 2014 from $48.0 million during the first six months of 2013. This decrease in pre-tax income is due primarily to

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the decrease in investment banking revenue discussed above. Offsetting this decrease was a $3.2 million increase in pre-tax income from our principal investing segment to $5.8 million in 2014 from $2.6 million in 2013. This increase in pre-tax income from our principal investing segment is due to an increase in net investment income in 2014 compared to 2013 as a result of market appreciation. Our 2013 net income also includes $3.1 million of net income from discontinued operations while there were no comparable discontinued operations results in 2014.

Revenues, net of Interest Expense

Our revenues, net of interest expense decreased 39.8% to $111.5 million during the first six months of 2014 from $185.2 million during the first six months of 2013 due to the changes in revenues and interest expense discussed below.

Capital raising revenues decreased 53.9% to $68.6 million in the first six months of 2014 from $148.9 million in the first six months of 2013. In the first six months of 2014, we completed 24 client engagements with contributions from each of the Company's industry groups, including six sole-managed private placements that generated $58.9 million of our capital raising revenue in the period. In the first six months of 2013, we completed 26 client engagements with contributions from each of the Company's industry groups, including five sole-managed private placements that generated $120.7 million of our capital raising revenue in the period. One of these private placements, representing $38.3 million of that revenue, was executed in the second quarter of 2012; however, the issuer did not receive the required regulatory approvals necessary for us to recognize this revenue until the first quarter of 2013.

Advisory revenues decreased 15.6% to $3.8 million in the first six months of 2014 from $4.5 million in the first six months of 2013. We completed seven assignments in the first six months of 2014 compared to eight assignments in the first six months of 2013.

Institutional brokerage revenues increased 10.8% to $29.7 million in the first six months of 2014 from $26.8 million in the first six months of 2013. The increase in revenue in 2014 reflects the impact of the fourth quarter 2013 group hire of 32 institutional brokerage sales, trading and research professionals on our brokerage activities in 2014 as well as our continued investment in research.

Net investment income increased 290.9% to $12.9 million in the first six months of 2014 from $3.3 million in the first six months of 2013. Net investment income for the six months ended June 30, 2014 includes $3.8 million of net unrealized gains from investment funds, $2.9 million of net unrealized gains from trading securities held for investment purposes, $2.3 million of realized gains on sales of investments, and $3.9 million of unrealized gains from short-sales of U.S. Treasury securities. These 2014 revenues were partially offset by $4.8 million of interest expense related to short-sales of U.S. Treasury securities. Our 2013 net investment income includes $2.2 million of net unrealized gains from investment funds, $1.6 million of net realized and unrealized gains from trading securities held for investment purposes, and a $0.5 million impairment loss related to an available-for-sale investment security. There were no significant realized gains in the first six months of 2013.

Interest, dividends and other revenues decreased 35.3% to $1.1 million in the first six months of 2014 from $1.7 million in the first six months of 2013. These revenues include interest from convertible and fixed income securities held on our trading desks as well as interest and dividends generated from our investing activities. The decrease in 2014 revenue was the result of differences in our trading desk and investment positions in these periods.

Non-Interest Expenses

Total non-interest expenses decreased 30.5% to $93.5 million in the first six months of 2014 from $134.6 million in the first six months of 2013. This decrease was caused by the changes in non-interest expenses described below.

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Compensation and benefits expenses decreased 39.2% to $63.4 million in the first six months of 2014 from $104.3 million in the first six months of 2013 as a result of a $45.0 million decrease in variable compensation. The decrease in variable compensation during 2014 was due to the significant decrease in investment banking revenue. The Company's compensation and benefits expenses were 57% of net revenues during the first six months of 2014 compared to 56% in the first half of 2013.

Professional services expenses increased 8.8% to $7.4 million in the first six months of 2014 from $6.8 million in the first six months of 2013 primarily due to increased recruiting costs incurred in 2014.

Business development expenses increased 14.9% to $5.4 million in the first six months of 2014 from $4.7 million in the first six months of 2013. This increase is the result of increased travel and business promotion costs related to business development activities.

Clearing and brokerage fees decreased 17.2% to $2.4 million in the first six months of 2014 from $2.9 million in the first six months of 2013. The decrease is due to the impact of cost reduction initiatives directed at reducing our brokerage execution costs.

Occupancy and equipment expenses decreased 3.1% to $6.2 million in the first six months of 2014 from $6.4 million in the first six months of 2013. The decrease in occupancy costs is primarily the result of reductions in depreciation expense associated with reduced capital expenditures over the past several years and reductions in our leased office space.

Communications expenses remained flat at $5.7 million in the first six months of 2014 compared to the first six months of 2013.

Other operating expenses decreased 18.9% to $3.0 million in the first six months of 2014 from $3.7 million in the first six months of 2013. The decrease in these expenses is primarily due a $0.5 million charge related to an arbitration settlement in 2013 that is not comparable to 2014 amounts.

We recognized a tax provision of $5.4 million in the first six months of 2014 compared to a tax benefit of $24.2 million in the first six months of 2013. As described below, our 2013 tax benefit reflects the reversal of a significant component of the valuation allowance that had been recorded against the Company's deferred tax assets as well as the utilization during 2013 of net operating loss carryforwards against 2013 projected taxable income. The Company's quarterly tax provision is determined pursuant to ASC 740, which requires using an estimated annual effective rate based on forecasted taxable income for the full year. The Company's effective tax rate for the first six months of 2014 was 30.0%. This tax rate differed from statutory tax rates primarily due to capital loss carryforwards subject to valuation allowance that are projected to be utilized during the year. The Company's effective tax rate for the first six months of 2013 was (48.0)%. This tax rate differed from statutory tax rates primarily due to the effects of the valuation allowance reversal.

During the six months ended June 30, 2013, the Company released a significant component of its valuation allowance against its net deferred tax assets since, based on the application of the criteria in ASC 740, it concluded that it was more likely than not that the benefits of these assets would be realized in the future. Following the criteria in ASC 740, the Company reviews this valuation allowance on a quarterly basis assessing the positive and negative evidence to determine if it is more likely than not that some or all of the deferred tax assets will be realized. As of June 30, 2013 and subsequently, as described below, the Company's valuation allowance for its deferred tax assets relates to capital loss carryforwards and net unrealized losses on investments.

At December 31, 2013, the Company's net deferred tax assets totaled $49.2 million and were partially offset by valuation allowance of $18.3 million. This valuation allowance related to capital loss carryforwards and net unrealized losses on investments and was determined based on the Company's application of the guidance in

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ASC 740 and its conclusion that that it was more likely than not that the benefits of these assets would not be realized in the future. Based on its assessment as of June 30, 2014, the Company determined that a valuation allowance related to its capital loss carryforwards and net unrealized losses on investments continued to be appropriate. As of June 30, 2014, these deferred tax assets and related valuation allowance totaled approximately $14.8 million. Recognition of these deferred tax assets will be dependent on the Company's ability to generate capital gains.

The Company believes there is potential for volatility in its 2014 effective tax rate from quarter-to-quarter due to the impact of any prospective changes in its forecasted earnings for the year as well as any capital gains generated that result in the use of capital loss carryforwards currently subject to a valuation allowance.

Discontinued Operations

Income from discontinued operations, net of taxes, was $3.1 million for the six months ended June 30, 2013. For the six months ended June 30, 2013, the Company's net income from discontinued operations was the result of the change in the estimated value of the Company's receivable from the sale of the FBR Funds. Based on the Company's receipt of the contingent sale proceeds receivable during the fourth quarter of 2013, there were no comparable discontinued operations results in 2014.

Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing funding for investments, and for other general business purposes. Regulatory requirements applicable to our broker-dealer subsidiary require minimum capital levels. The primary sources of funds for liquidity consist of existing cash balances (i.e., available liquid capital not invested in our operating businesses), proceeds from sales of securities, internally generated funds, dividends on equity securities that we own, and credit provided by margin accounts, banks, clearing brokers, and affiliates of our principal clearing broker. Potential future sources of liquidity for us include internally generated funds, borrowing capacity through margin accounts, corporate lines of credit and other credit facilities which we may enter into in the future, and future issuances of common stock, preferred stock or debt securities.

Cash Flows

As of June 30, 2014, our cash and cash equivalents totaled $176.9 million representing a net decrease of $31.1 million for the first six months of 2014. The decrease is attributable to cash used in investing activities of $27.9 million, cash used in financing activities of $15.8 million, offset by $12.6 million of cash provided by operating activities. Due to the cyclical nature of our industry and the industries in which we provide services, we maintain liquid capital to cover potential cash outflows in periods of decreased revenues and earnings.

Net cash provided by operating activities of $12.6 million during the first six months of 2014, compares to $83.2 million of cash provided by operating activities during the first six months of 2013. As described below, the difference in operating cash activities in 2014 compared to 2013 is primarily due to the differences in net income and the changes in accrued compensation during these periods. The cash provided by operating activities during the first six months of 2014 resulted primarily from operating income during the period. The cash provided by operating activities during the first six months of 2013 reflects our cash operating income during the period and the impact of a $45.9 million increase related to accrued compensation.

Net cash used in investing activities of $27.9 million during the first six months of 2014 compares to $20.9 million used in investing activities during the first six months of 2013. The $27.9 million used in the first six months of 2014 reflects principal investments purchased during the period, including $28.5 million of investment funds and $13.0 million of trading securities, as well as $9.8 million related to short-sales of U.S. Treasury securities. These items were offset by $26.6 million of proceeds from securities sold during the first six months of 2014. The $20.9 million used in the first six months of 2013 reflects principal investments purchased during the period, including $9.1 million of investment funds and $20.3 million of trading securities, offset by proceeds from securities sold during the period.

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Net cash used in financing activities of $15.8 million during the first half of 2014 compares to $10.5 million used during the first half of 2013. The 2014 activity primarily reflects the repurchase of 0.7 million shares of our common stock for $17.3 million. The 2013 activity primarily represents the repurchase of 0.7 million shares of our common stock for $12.3 million.

Sources of Funding

We believe that our existing cash and cash equivalents balances (totaling $176.9 million at June 30, 2014) comprised primarily of investments in money market funds investing in short-term U.S. Treasury securities, cash flows from operations, borrowing capacity, other sources of liquidity and execution of our financing strategies will be sufficient to meet our cash requirements. We have obtained, and believe we will be able to continue to obtain, short-term financing, such as margin financing and temporary subordinated 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 many of our investments could be sold, in most circumstances, to provide cash.

We monitor and manage our leverage and liquidity risk through various committees and processes we have established. We assess our leverage and liquidity risk based on considerations and assumptions of market factors, as well as factors specific to us, including the amount of our available liquid capital (i.e., the amount of our cash and cash equivalents not invested in our operating business).

Assets and Liabilities

As of June 30, 2014, our principal assets consisted of cash and cash equivalents, due from brokers, dealers and clearing organizations, and financial instruments at fair value. As of June 30, 2014 and December 31, 2013, our liquid assets consisted primarily of cash and cash equivalents of $176.9 million and $208.0 million, respectively.

The increase in our total assets to $746.1 million as of June 30, 2014 compared to $410.6 million as of December 31, 2013, was primarily the result of a $325.4 million increase in due from brokers, dealers and clearing organizations, and a $45.7 million increase in financial instruments, at fair value. These increases were partially offset by the $31.1 million decrease in cash noted above, a $5.3 million decrease in cost-method investments and a $3.5 million decrease in deferred tax assets, net of valuation allowance and other assets.

Regarding our due from brokers, dealers and clearing organizations balance, during the first six months of 2014, as part of the Company's investing activities, the Company entered into two short-sales of $100 million face value each, 4.50% U.S. Treasury securities in the first quarter 2014 and one short-sale of a $75 million face value, 7.25% U.S. Treasury security in the second quarter of 2014. Proceeds from these short-sales, as well as related margin requirements, totaling $308.5 million, are held in a collateral account and are included in due from brokers, dealers and clearing organizations in the Company's balance sheet. The remainder of our due from and to brokers, dealers, and clearing organizations balances primarily represent unsettled trades associated with our credit sales and trading platform and also includes unsettled equity, option and convertible securities trades. Such credit transactions include corporate bond and syndicated loan trades. The total amount of outstanding unsettled trade receivables and payables related to these instruments was $18.5 million and $17.6 million, respectively, as of June 30, 2014 compared to $4.9 million and $4.7 million, respectively, as of December 31, 2013. Due to the extended settlement nature of most par and distressed bank loan transactions, we are subject to certain market and counterparty credit risks. See our discussion related to these risks included in the Quantitative and Qualitative Disclosures about Market Risk.

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As of June 30, 2014, our $115.0 million of investments primarily consisted of investments in non-registered investment funds, marketable equity securities, and non-public equity securities. These investments are funded in cash and are not financed with debt.

The increase in our total liabilities to $448.2 million as of June 30, 2014 compared to $119.8 million as of December 31, 2013 was primarily the result of a $319.0 million increase in securities sold but not yet purchased. The increase in securities sold but not yet purchased reflects the two short-sales of $100 million face value each, 4.50% U.S. Treasury securities and one short-sale of $75 million face value, 7.25% U.S. Treasury security. These three securities mature in November 2015, February 2016 and May 2016, respectively. The Company is obligated to fund the fixed-rate coupon interest on these securities while the short-positions are outstanding.

Regulatory Capital

FBRCM, our broker-dealer subsidiary, is registered with the SEC and is a member of the FINRA. As such, FBRCM is subject to the minimum net capital requirements promulgated by the SEC. As of June 30, 2014, FBRCM had total regulatory net capital of $72.9 million, which exceeded its required net capital of $4.8 million by $68.1 million. Regulatory net capital requirements increase when the broker-dealer is involved in underwriting activities based upon a percentage of the amount being underwritten.

Share Repurchases

During the six months ended June 30, 2014, we repurchased 0.7 million shares of our common stock in open market transactions at weighted average share prices of $26.18 per share, for a total cost of $17.3 million. As of June 30, 2014, we have a remaining authority to repurchase up to 1.0 million additional shares.

Off-Balance Sheet Arrangements

Institutional Brokerage

Through indemnification provisions in agreements with clearing organizations, customer activities may expose us 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 on 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. We seek 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.

Other

On March 27, 2014, the Company entered into a Transaction Agreement with Lazard Capital Markets LLC ("LCM") pursuant to which FBRCM agreed to purchase LCM's securities lending business (the "Transaction Agreement"). Pursuant to the Transaction Agreement, the Company issued to certain counterparties of LCM guarantees of LCM's obligations under securities loan agreements up to an aggregate of $75 million.

As of June 30, 2014, the Company had issued such guarantees to counterparties of LCM up to an aggregate of $75 million. Based on the nature of the related securities loan agreements, including the applicable collateral and other capital that support LCM's obligations under these securities loan agreements, the Company has valued these guarantees at zero as of June 30, 2014. To-date, the Company has not incurred any costs relative these guarantees. The Company's purchase of LCM's securities lending business closed on August 4, 2014 (see "Recent Developments"). The guarantees discussed above will terminate in connection with the closing of the transaction.

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On July 24, 2014, the Company commenced a modified "Dutch auction" tender offer to purchase up to one million shares, or about 9.9%, of its outstanding common stock, at a price of not less than $28.00 and not more than $29.00 per share.

Securities Lending

On August 4, 2014, the Company completed the purchase of LCM's securities lending business. Pursuant to the terms of the Transaction Agreement, the Company made an initial cash payment at closing and is obligated to make additional payments to LCM that are contingent on the performance of the business over the next 18 months. The Company is currently in the process of assessing the value of this contingent consideration.


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