**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**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, 2005**                                                                                                             |
| or                                                                                                                                                               |
| **o**                                                                                                                                                            | **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: 001-32542**

**KKR FINANCIAL CORP.**

(Exact name of registrant as specified in its charter)

| **Maryland**                                  |   | **20-1426618**       |
|-----------------------------------------------|--------|----------------------|
| (State  or other jurisdiction of              |   | (I.R.S.  Employer    |
| incorporation  or organization)               |   | Identification  No.) |
| **Four Embarcadero Center,  Suite 2050** |   |                 |
| **San Francisco, CA**                         |   | **94111**            |
| (Address of principal executive offices)      |   | (Zip Code)           |

 

Registrant’stelephone number, including area code: **(415) 315-3620**

Securities registeredpursuant to Section 12(b) of the Act:

| Title  of each class              |       | Name  of each exchange on which registered |
|-----------------------------------|------------|--------------------------------------------|
| **Common Stock ($.01 par value)** | ** ** | **New York Stock Exchange**                |

 

Securities registered pursuant to section 12(g) ofthe Act: None

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.o Yes   x No

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.o Yes   x No

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.x Yes   o No

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.o

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

Largeaccelerated filer          **o**    Accelerated filer          **o**    Non-acceleratedfiler          **x**

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act).o Yes   x No

The aggregate market value of the voting common stockheld by non-affiliates of the registrant as of June 30, 2005 was $1,917,790,700,based on the closing price of the common stock on such date as reported on theNew York Stock Exchange.

The number of shares of the registrant’s common stockoutstanding as of March 24, 2006 was 80,374,061.

**DOCUMENTS INCORPORATEDBY REFERENCE**

Portions of the registrant’s Proxy Statement for the2006 Annual Stockholders’ Meeting to be held May 3, 2006 and to be filedwithin 120 days after the close of the registrant’s fiscal year areincorporated by reference into Part III of this Annual Report on Form 10-K.

 

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**KKRFINANCIAL CORP.2005 FORM 10-K ANNUAL REPORTTABLE OF CONTENTS**

|            | ** ** |                                                                                                                    | ** ** | **Page** | ** ** |
|------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
|       | ** ** | **Part I**                                                                                                    |       |     |       |
| Item 1.    |       | Business                                                                                                           |       | 1        |       |
| Item 1A.   |       | Risk  Factors                                                                                                      |       | 12       |       |
| Item 1B.   |       | Unresolved Staff Comments                                                                                          |       | 37       |       |
| Item 2.    |       | Properties                                                                                                         |       | 37       |       |
| Item  3.   |       | Legal  Proceedings                                                                                                 |       | 37       |       |
| Item 4.    |       | Submission of Matters to a Vote of Security Holders                                                                |       | 37       |       |
| ** ** | ** ** | **Part II**                                                                                                   |       |     |       |
| Item 5.    |       | Market for Registrant’s Common Equity, Related  Shareholder Matters and Issuer Purchases of Equity Securities |       | 38       |       |
| Item 6.    |       | Selected Consolidated Financial Data                                                                               |       | 39       |       |
| Item 7.    |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                   |       | 41       |       |
| Item 7A.   |       | Quantitative and Qualitative  Disclosures about Market Risk                                                        |       | 72       |       |
| Item 8.    |       | Financial Statements and  Supplementary Data                                                                       |       | 72       |       |
| Item 9.    |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                         |       | 72       |       |
| Item 9A.   |       | Controls and Procedures                                                                                            |       | 72       |       |
| Item  9B.  |       | Other  Information                                                                                                 |       | 74       |       |
| ** ** | ** ** | **Part III**                                                                                                  |       |     |       |
| Item 10.   |       | Directors and Executive Officers of the Registrant                                                                 |       | 74       |       |
| Item 11.   |       | Executive Compensation                                                                                             |       | 74       |       |
| Item 12.   |       | Security Ownership of Certain Beneficial Owners and  Management and Related Shareholder Matters                    |       | 74       |       |
| Item 13.   |       | Certain Relationships and Related Transactions                                                                     |       | 74       |       |
| Item 14.   |       | Principal Accountants Fees and Services                                                                            |       | 74       |       |
| ** ** | ** ** | **Part IV**                                                                                                   |       |     |       |
| Item 15.   |       | Exhibits and Financial Statement Schedules                                                                         |       | 74       |       |

 

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*Except where the context suggests otherwise, the terms“we,” “us” and “our” refer to KKR Financial Corp. and its subsidiaries; the “Manager”refers to KKR Financial Advisors LLC and “KKR” refers to Kohlberg KravisRoberts & Co. L.P. and its affiliated companies.*

**CAUTIONARY STATEMENT FOR PURPOSES OF THE “SAFE HARBOR”PROVISIONS OFTHE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

Certain informationcontained in this Annual Report on Form 10-K constitutes “forward-looking”statements within the meaning of Section 27A of the Securities Act of1933, as amended, or the Securities Act, and Section 21E of the SecuritiesExchange Act of 1934, as amended, or the Exchange Act, that are based on ourcurrent expectations, estimates and projections. Pursuant to those sections, wemay obtain a “safe harbor” for forward-looking statements by identifying thoseand by accompanying those statements with cautionary statements, which identifyfactors that could cause actual results to differ from those expressed in theforward-looking statements. Statements that are not historical facts, includingstatements about our beliefs and expectations, are forward-looking statements.The words “believe,” “anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,”“estimate,” and “project,” and similar words identify forward-lookingstatements. Such statements are not guarantees of future performance, events orresults and involve potential risks and uncertainties. Accordingly, actualresults and the timing of certain events could differ materially from thoseaddressed in forward-looking statements due to a number of factors including,but not limited to, changes in interest rates and market values, changes inprepayment rates, general economic conditions, and other factors not presently identified.Other factors that may impact our actual results are discussed under “RiskFactors” in Item 1A of this Annual Report on Form 10-K. We do notundertake, and specifically disclaim, any obligation to publicly release theresult of any revisions that may be made to any forward-looking statements toreflect the occurrence of anticipated or unanticipated events or circumstancesafter the date of such statements.

**WEBSITE ACCESS TO COMPANY’S REPORTS**

Our Internet website address is *www.kkrfinancial.com*. Our annual reportson Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to those reports filed orfurnished pursuant to section 13(a) or 15(d) of the Exchange Actare available free of charge through our website as soon as reasonablypracticable after they are electronically filed with, or furnished to, the SEC.Our Corporate Governance Guidelines, Board of Directors committee charters(including the charters of the Audit Committee, Compensation Committee, andNominating and Corporate Governance Committee) and code of ethics are availableat that same location on our website.

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**PART I**

**Item 1.        BUSINESS**

**Our Company**

We are a specialty finance company that invests inmultiple asset classes and uses leverage to generate competitive leveragedrisk-adjusted returns. We seek to achieve our investment objective byallocating capital primarily to the following asset classes: (i) residentialmortgage loans and mortgage-backed securities; (ii) corporate loans anddebt securities; (iii) commercial real estate loans and debt securities;and (iv) asset-backed securities. We also invest opportunistically inother types of investments from time to time, including investments in marketableand non-marketable equity securities.

Our objective is to provide competitive returns to ourinvestors through a combination of dividends and capital appreciation. As partof our multi-asset class strategy, we seek to invest opportunistically in thoseasset classes that can generate favorable leveraged risk-adjusted returns, subjectto maintaining our status as a real estate investment trust, or REIT, and ourexemption from regulation under the Investment Company Act of 1940, or theInvestment Company Act. The implementation of our multi-asset class strategyalso diversifies our investment portfolio. Investing in multiple asset classesdoes not, however, reduce or eliminate many of the risks associated with ourinvestment portfolio such as geographic concentration risk, asset classconcentration risk, market risk and credit risk.

Our income is generated primarily from the differencebetween the interest and dividend income earned on our investments and the costof our borrowings, plus (i) realized and unrealized gains and losses on ourfree-standing derivatives, (ii) realized gains and losses from the sales ofinvestments, and (iii) fee income.

We are externally managed and advised by KKR FinancialAdvisors LLC pursuant to a management agreement. Our Manager is an affiliate ofKKR, a leading sponsor of private equity funds and one of the oldest and mostexperienced private equity firms specializing in leveraged buyouts. Certainindividuals associated with KKR serve on our board of directors and our Manager’sinvestment committee.

We are a Maryland corporation that is taxed as a REITfor federal income tax purposes. We were organized in July 2004 andcompleted our initial private placement of shares of our common stock in August 2004.

On June 29, 2005, wecompleted our initial public offering, or IPO, of 37,500,000 shares of ourcommon stock and received approximately $848.8 million of net proceedstherefrom. Our common stock is listed on the NYSE under the symbol “KFN” andbegan trading on June 24, 2005.

**Our Manager**

We are externally managed and advised by KKR FinancialAdvisors LLC, an affiliate of KKR, pursuant to a management agreement. OurManager was formed in July 2004. All of our executive officers areemployees of our Manager or one or more of its affiliates. The executiveoffices of our Manager are located at Four Embarcadero Center, Suite 2050,San Francisco, California 94111 and the telephone number of our Manager’sexecutive offices is (415) 315-3620.

Pursuant to the terms ofthe management agreement, our Manager provides us with our management team,along with appropriate support personnel. Our Manager is responsible for ouroperations and performs all services and activities relating to the managementof our assets, liabilities and operations. Our Manager is at all times subjectto the direction of our board of directors and has only such functions andauthority as we delegate to it. As of February 28, 2006, affiliates of ourManager had 44 employees.

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**Our Strategy**

We seek to achieve our investment objective byallocating capital primarily to the following four targeted asset classes: (i)residential mortgage loans and mortgage-backed securities; (ii) corporate loansand debt securities; (iii) commercial real estate loans and debt securities;and (iv) asset-backed securities. We also invest opportunistically in othertypes of investments from time to time, including investments in marketable andnon-marketable equity securities. Our objective is to provide competitivereturns to our investors through a combination of dividends and capitalappreciation. As part of our multi-asset class strategy, we seek to investopportunistically in those asset classes that can generate favorable leveragedrisk-adjusted returns, subject to maintaining our status as a REIT, and ourexemption from regulation under the Investment Company Act. The implementationof our multi-asset class strategy also diversifies our investment portfolio.Investing in multiple asset classes does not, however, reduce or eliminate manyof the risks associated with our investment portfolio such as geographicconcentration risk, asset class concentration risk, market risk and creditrisk.

Our Manager utilizes its access to the resources andprofessionals of KKR, along with the same philosophy of value creation KKRemploys in managing private equity funds, in order to create a portfolio thatis designed to provide competitive returns to investors. We make asset classallocation decisions based on various factors including: relative value,leveraged risk-adjusted returns, current and projected credit fundamentals,current and projected macroeconomic considerations, current and projectedsupply and demand, credit and market risk concentration considerations,liquidity, all-in cost of financing and financing availability, and maintainingour REIT status.

From time to time, we make certain investments,including debt, equity and derivative investments, utilizing KKR TRS Holdings,Inc., our domestic taxable REIT subsidiary. We will opportunistically pursuethis strategy whenever we are constrained by the rules related to maintainingour REIT status and, in the case of non-real estate or derivative investments,whenever the projected returns on these investments, net of income taxes, arecomparable to the projected leveraged risk-adjusted returns on investments madein the REIT. We are not required to distribute the earnings of our domestictaxable REIT subsidiary; accordingly, we may retain in our domestic taxableREIT subsidiary some or all of the net income earned by our domestic taxableREIT subsidiary.

We use leverage in order to increase potential returnsto our stockholders. The use of leverage may also have the effect of increasinglosses when economic conditions are unfavorable. Our investment policiesrequire no minimum or maximum leverage and our Manager and its investmentcommittee have the discretion, without the need for further approval by ourboard of directors, to increase the amount of leverage we incur above ourtargeted range.

Our strategy in each asset class is as follows:

**ResidentialMortgage Loans and Mortgage-Backed Securities.**   Ourinvestments in this asset class principally consist of (i) adjustable rate andhybrid adjustable rate residential mortgage-backed securities, backed by primeand super-prime credit quality non-agency residential mortgages, (ii)agency-backed adjustable rate and hybrid adjustable rate residentialmortgage-backed securities, and (iii) prime and super-prime credit qualityadjustable rate or hybrid adjustable rate mortgage loans. We currently investin prime and super-prime credit quality mortgage loans and non-agencymortgage-backed securities. We define “prime” credit quality as a mortgagewhere the borrower’s original FICO® score is between 680-710, and define“super-prime” credit quality as a mortgage where the borrower’s original FICO®score is greater than 710. We do own mortgage loans where the borrower’soriginal FICO® score is below 600. We do not currently invest in sub-prime ornon-prime mortgage loans or mortgage-backed securities, although we may do soin the future. Hybrid adjustable rate mortgage-backed securities and mortgageloans have interest rates that have an initial fixed period (typically three,five, seven or ten years) and thereafter reset at regular intervals in a mannersimilar to adjustable rate mortgage-backed securities and 

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mortgage loans.Agency-backed securities include mortgage-backed securities, which representthe entire ownership interest in pools of mortgage loans secured by residentialreal property and are guaranteed as to principal and interest by federallychartered entities such as the Federal National Mortgage Association, betterknown as “Fannie Mae,” the Federal Home Loan Mortgage Corporation, better knownas “Freddie Mac,” and, in the case of the Government National Mortgage Association,better known as “Ginnie Mae,” by the U.S. government. A majority of the residentialmortgage-backed securities, or RMBS, in which we invest consists of non-agencyadjustable rate and three- and five-year hybrid adjustable-rate mortgage-backedsecurities. We also invest in mortgage loans purchased directly from selectfinancial institutions. We base our decision on whether to invest in adjustablerate or hybrid adjustable rate mortgage loans and mortgage-backed securities onvarious factors including, but not limited to, relative value, supply anddemand, costs of hedging, forward London Inter-Bank Offered Rate, or LIBOR,interest rate volatility and the overall shape of the U.S. Treasury andinterest rate swap yield curves.

The agency mortgage-backed securities market is verylarge; however, only a very small portion meets our investment criteriaprimarily due to the fact that (i) many of the agency mortgage-backedsecurities do not fulfill the “whole-loan” requirement of the Investment CompanyAct, and (ii) only a small portion of the market of agency mortgage-backedsecurities have market prices that meet our purchase price objectives given ourbias of minimizing purchase premiums on investments with prepayment risk or nocall protection. Accordingly, we may not be able to find sufficient quantitiesof RMBS to purchase in order to achieve our investment objectives.

**CorporateLeveraged Loans and High Yield Securities.**   Weinvest in debt obligations of corporations, partnerships and other entities inthe form of first and second lien loans, mezzanine loans and bridge facilities,which we collectively refer to as leveraged loans given the high proportion ofdebt typically in their capital structure, as well as in high yield debtsecurities. These entities may be owned by KKR and/or other private equityinvestors. Many of the leveraged loans and high yield securities in which weinvest have an explicit rating from one or more nationally-recognizedstatistical rating agencies. The majority of our investments in leveraged loansand high yield securities are rated between Ba1 and B3 by Moody’s InvestorsServices, Inc., or Moody’s, and between BB+ and B- by Standard & Poor’sRatings Service, or Standard & Poor’s. We also invest in leveraged loansand high yield securities that are rated below B3 by Moody’s and B- by Standard& Poor’s and/or that do not have an explicit rating from one or morenationally-recognized statistical rating agencies.

**CommercialReal Estate Debt.****  **Weinvest in debt secured by commercial real estate or issued by owners oroperators of commercial real estate properties. These investments include commercialmortgage-backed securities, or CMBS, mezzanine loans, bridge loans and debt andpreferred stock issued by public and private commercial real estate companiesand REITs. Most of the CMBS in which we invest are rated between A1 and B3 byMoody’s and between A+ and B- by Standard & Poor’s and most of themezzanine loans and bridge loans in which we invest are rated B3 or lower byMoody’s and B- or lower by Standard & Poor’s and/or may not have anexplicit rating from one or more nationally-recognized statistical ratingagencies.

**Asset-BackedSecurities.**   We invest in investment grade andnon-investment grade asset-backed securities. We also make investments ininvestment grade and non-investment grade collateralized debt obligations, orCDOs, and collateralized loan obligations, or CLOs, backed by high yieldsecurities, corporate leveraged loans, CMBS, and/or asset-backed securities. Mostof the asset-backed securities in which we invest are rated between A1 and B1by Moody’s and between A+ and B+ by Standard & Poor’s.

**Marketable andNon-Marketable Equity Securities.**   To a lesserextent, subject to maintaining our qualification as a REIT, invest from time totime in common stock and preferred stock of private and public companies thatmay or may not be related to the real estate business. A material amount of ourequity investments may include private equity investments in companiesaffiliated with KKR. 

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**OurInvestment Process**

**Our Manager evaluates each one ofour investment opportunities based on its leveraged risk-adjusted returnsubject to our current investment guidelines. Our investment process issummarized as follows:**

**·    **asset allocation;

**·**     investmentsourcing and screening;

**·**     creditresearch and due diligence;

**·**     InvestmentCommittee review and approval;

**·**     recurringmonitoring; and

**·**     buy orsell based on price targets and relative value parameters.

***Asset Allocation.******  ***Our Manager utilizes the samephilosophy employed by KKR’s investment professionals in managing privateequity funds with the objective of creating a portfolio that is designed toprovide competitive leveraged risk-adjusted returns to our stockholders. OurManager uses a combination of “top-down” and “bottom-up” analyses. Our top-downapproach utilizes macro analysis of relative asset valuations, economicoutlook, interest rate expectations, credit fundamentals and technical factorsto target specific industries and asset classes. Our bottom-up approachincludes rigorous analysis of credit, industry trends and dynamics anddislocation events to select specific credits in which to invest.

***Investment Sourcingand Screening.****  *OurManager sources transactions through a variety of channels, including itsrelationships with KKR, corporate executives, commercial and investment banks, financialsponsors and intermediaries. The investment professionals of our Manager screenthe sourced opportunities and make the decision whether to proceed to duediligence based on the industry, credit structure, relative value, andprojected leveraged risk-adjusted return. We believe that our Manager’sinvestment selection process benefits from its access to the resources andprofessionals of KKR.

***Credit Research andDue Diligence.***   When conducting duediligence, our Manager evaluates critical business and financial riskconsiderations, as well as tax, accounting, environmental and legal issues, indetermining whether or not to proceed with an investment. The Manager’sinvestment evaluation utilizes a relative value framework and rigorous creditanalysis focused on credit fundamentals rather than the momentum of the overallmarkets and emphasizes free cash flow computed under base and stress casescenarios, normalized levels of capital expenditures, stability of margins,structure, competitive position, management track record and industry trends.

Our Manager leverages KKR’s relationships with accountants,consultants, lawyers, investment banks and industry experts when conducting duediligence. In addition, when KKR has conducted due diligence prior to referringan investment opportunity to us, subject to KKR’s contractual obligations andapplicable securities laws, our Manager may benefit from the due diligencealready conducted by KKR.

***InvestmentCommittee Review and Approval.***   For eachproposed investment, our Manager’s investment committee reviews each of ourManager’s investment memoranda and related financial projections foropportunities that have been previously evaluated and approved by theinvestment professionals of our Manager. Our Manager reviews potentialinvestment opportunities and many investment opportunities are not pursued. Forinvestment opportunities that fulfill our investment objectives the Managerprepares a credit memorandum summarizing the credit underwriting and duediligence performed and submits the credit memorandum to the investmentcommittee. The investment memorandum summarizes the factors relevant to thespecific investment, including pricing (including applicable interest anddefault rates), term, collateral (if any), financial condition and historicalfinancial data, quality of issuer’s management team, leverage, debt servicecoverage, covenants, industry overview, competitive position within theindustry, ratings, trends (company- and industry-specific) and other relevantinformation regarding the issuer and 

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includes a summary of thediligence performed by the investment professional in preparing the memorandumand evaluating the investment opportunity. Investment opportunities mustreceive a unanimous approval by the investment committee to be consummated.

Our Manager’s investment committee has approved amajority of the investments it has reviewed. The investment committee hasdecided on limited occasions, however, not to approve a specific investmentbased on concerns raised by members of the investment committee relating to thesubject company, specific investment terms or industry. In addition, theinvestment committee has delayed certain investments subject to the performanceof further satisfactory due diligence.

Our Manager’s investment committee reviews investmentopportunities for us and for the entities established by us to implement our securitizationfinancings, but not for any other clients of our Manager or any other KKRaffiliates.

***Monitoring.***   OurManager monitors our portfolio using daily, quarterly and annual analyses inorder to make decisions regarding the portfolio investments.

·       Dailyanalysis includes morning market meetings, industry and company pricing runs,industry and company reports and discussions with KKR industry and operatingcompany personnel on an as-needed basis;

·       Quarterlyanalysis includes the preparation of quarterly operating results,reconciliation of actual results to projections, updates to the financial model(baseline and stress case) and investment committee portfolio review; and

·       Annualanalysis consists of the preparation of annual credit memoranda, review andsign-off of updated annual credit memoranda by the investment professionals ofthe Manager.

***Buy and SellDiscipline.***   Our Manager does not make buy orsell decisions based on price momentum models or philosophy. Our Manager makespurchase and sale decisions based on achieving price targets, changes in creditfundamentals, changes in industry fundamentals, changes in managementcredibility, relative asset-class valuations, macro-economic factors andtechnical factors. Returns on our investments consist primarily of interestincome, dividend income and related fees, as opposed to capital gains.

***InvestmentGuidelines.***   We have established and complywith investment policies and procedures and investment guidelines that arereviewed and approved by our Manager’s investment committee and our board ofdirectors. The investment committee meets as frequently as necessary in orderfor us to achieve our investment objectives. We review our investment portfolioand related compliance with our investment policies and procedures andinvestment guidelines at each regularly scheduled board of directors meeting.

Our board ofdirectors and our Manager’s investment committee have adopted the followingguidelines, among others, for our investments and borrowings:

·       noinvestment shall be made that would cause us to fail to qualify as a REIT forfederal income tax purposes;

·       noinvestment shall be made that would cause us to be regulated as an investmentcompany under the Investment Company Act;

·       withthe exception of real estate and lodging, no industry shall represent greaterthan 20% of the securities in our portfolio; and

·       themaximum aggregate investment in non-securitized residential mortgages islimited to four times consolidated stockholders’ equity computed in accordancewith GAAP.

These investment guidelines may be changed by amajority of our board of directors without the approval of our stockholders.

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Our board of directors hasalso adopted a separate set of investment guidelines and procedures to governour relationship with KKR. We have also adopted compliance policies to governour interaction with KKR, including when KKR is in receipt of materialnon-public information. 

**Our Financing Strategy**

We use leverage in order to increase potential returnsto our stockholders. Our use of leverage may, however, also have the effect ofincreasing losses when economic conditions are unfavorable. As of December 31,2005, our leverage was 8.1 times the amount of our equity. Our investmentpolicies require no minimum or maximum leverage and our Manager and itsinvestment committee will have the discretion, without the need for furtherapproval by our board of directors, to increase the amount of our leverage.

We finance the majority of our residential mortgageloans and mortgage-backed security investments on a non-term financing basisthrough the use of repurchase agreements. With repurchase agreements, we borrowagainst mortgage loans, the mortgage-backed securities, high yield securities,asset-backed securities, and/or preferred stock securities we own. Under theseagreements, we sell our mortgage loans, mortgage-backed securities, high yieldsecurities, asset-backed securities, and/or preferred stock securities to acounterparty and agree to repurchase the same securities from the counterpartyat a price equal to the original sales price plus an interest factor. Theserepurchase agreements are accounted for as debt, secured by the underlyingassets. During the period of a repurchase agreement, we receive the principaland interest on the related collateral and pay interest to the counterparty.

Our repurchase agreementcounterparties are commercial and investment banks with whom we have agreementsin place that cover the terms of our transactions. All our repurchase agreementcounterparties are approved by our Manager.

***Asset-BackedCommercial Paper***

In addition to usingrepurchase agreements, we finance a portion of our residential mortgage loansand residential mortgage-backed securities using our $5 billion asset-backed securedliquidity note facility that closed on September 30, 2005. This facilityprovides us with an alternative source of funding our residentialmortgage-backed securities by issuing asset-backed secured liquidity notes thatare rate A-1+, P-1, and F1+, by Standard and Poor’s, Moody’s, and Fitch Inc,respectively. Issuances of asset-backed secured liquidity notes are recorded asborrowings on our Consolidated Balance Sheet.

**WarehouseFacilities**

In addition to repurchaseagreements and asset-backed secured liquidity notes, we rely on warehousecredit facilities for capital needed to fund our investments in adjustable rateand hybrid adjustable rate mortgage loans, commercial real estate loans, andleveraged loans. These facilities are typically lines of credit from commercialand investment banks that we can draw from to fund our investments. Warehousefacilities are typically collateralized loans made to investors who invest insecurities and loans that in turn pledge the resulting securities and loans tothe warehouse lender. Third-party custodians, usually banks, typically hold thesecurities and loans funded with the warehouse facility borrowings, includingthe securities, loans, notes, mortgages and other important loan documentation,for the benefit of the lender who is deemed to own the securities and loansand, if there is a default under the warehouse, for the benefit of thewarehouse lender. We have established formal relationships with multiplecounterparties for the purpose of maintaining financing relationships onfavorable terms.

**Collateralized Debt Obligations and Collateralized LoanObligations**

We finance ournon-residential real estate assets on a term financing basis using collateralizeddebt obligations, or CDOs, collateralized loan obligations, or CLOs, and othermatch-funded financing 

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structures.CDOs and CLOs are multiple class debt securities, or bonds, secured by pools ofassets, such as leveraged loans, high yield securities, commercial real estateloans, commercial real estate mortgage-backed securities and asset-backedsecurities. Like typical securitization structures, in a CDO and CLO (i) theassets are pledged to a trustee for the benefit of the holders of the bonds,(ii) one or more classes of the bonds are rated by one or more rating agenciesand (iii) one or more classes of the bonds are marketed to a wide variety offixed income investors, which enables the sponsor to achieve a relatively lowcost of long-term financing. Unlike typical securitization structures, theunderlying assets may be sold, subject to certain limitations, without acorresponding pay-down of the CDO and CLO provided the proceeds are reinvestedin qualifying assets. As a result, CDOs and CLOs enable the sponsor to activelymanage, subject to certain limitations, the pool of assets. We believe CDO andCLO financing structures are an appropriate term financing vehicle for ourtargeted non-residential real estate asset classes, because they enable us toobtain long-term cost of funds and minimize the risk that we have to refinanceour liabilities prior to the maturities of our investments while giving us theflexibility to manage credit risk.

During the year endedDecember 31, 2005, we closed two $1.0 billion collateralized loan obligationtransactions through which we have issued $1.5 billion in collateralized loanobligation senior secured notes to finance investments in corporate loans andsecurities.

**OurHedging and Interest Rate Risk Management Strategy**

Repurchase agreementsgenerally have maturities of 30 days and the weighted average life of themortgage-backed securities we own is generally longer. The difference inmaturities, in addition to reset dates and reference indices, creates potentialinterest rate risk.

We use interest ratederivatives to hedge all or a portion of our interest rate risk associated withour borrowings. The tax laws applicable to REITs generally restrict our abilityto enter into hedging transactions.

We engage in a variety ofinterest rate management techniques that seek to mitigate changes in interestrates or potentially other influences on the values of our assets. Our interestrate management techniques may include:

**·****     **interestrate swaps;

**·****     **interestrate swaptions;

**·****     **interestcancelable swaps;

**·****     **interestrate caps;

**·****     **interestrate corridors;

**·****     **eurodollarfutures contracts and options on such contracts; and

**·****     **otherinterest rate and non-interest rate derivatives.

These techniques may also be used in an attempt toprotect us against declines in the market value of our assets that result fromgeneral trends in debt markets.

We enter into interest rate swap agreements to offsetthe potential adverse effects of rising interest rates under certain short-termborrowings. The interest rate swap agreements have historically been structuredsuch that we receive payments based on a variable interest rate and makepayments based on a fixed interest rate. The variable interest rate on whichpayments are received is calculated based on various reset mechanisms forLIBOR. The repurchase agreements generally have maturities of 30 days and carryinterest rates that correspond to LIBOR rates for those same periods. The swapagreements are intended to fix our borrowing cost and are not held forspeculative or trading purposes.

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Interest rate management techniques do not eliminate interestrate and basis risk but seek to mitigate interest rate risk. For example, ifboth long-term and short-term interest rates were to increase significantly, itcould be expected that:

**·****     **theweighted average life of the mortgage-backed securities would be extendedbecause prepayments of the underlying mortgage loans would decrease; and

**·****     **themarket value of fixed rate mortgage-backed securities would decline aslong-term interest rates increased.

In order for our interest rate derivatives to qualifyas fair value or cash flow hedges under SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities,” or SFAS No. 133, we mustfulfill many complex requirements including, but not limited to, hedgecorrelation requirements.

As stated above, our income is generated primarilyfrom the net interest spread on our investment portfolio. Set forth below arefactors that may adversely impact our net interest spread.

**MatchFunding.**   We expect to use long-term financing ona match funded basis to minimize interest rate risk in our portfolio. Matchfunding is the financing of our investments on a basis where the duration ofthe investments approximates the duration of the borrowings used to finance theinvestments. For any period during which our investment portfolio and relatedborrowings are not match funded, we may be exposed to the risk that ourinvestment portfolio will reprice more slowly than the borrowings that we useto finance a significant portion of our investment portfolio. Increases ininterest rates under these circumstances, particularly short-term interestrates on our short-term borrowings, may significantly adversely affect the netinterest income that we earn on our investment portfolio.

**Prepayments.**   Prepaymentrates experienced on loans and securities in our investment portfolio may beinfluenced by changes in the overall level of interest rates, changes in theshape of the yield curve, and a variety of economic, geographic and otherfactors beyond our control, and consequently, we can not predict prepaymentrates with certainty. The yield on our investment portfolio may be affected bythe difference between the actual prepayment rates that we realize on ourinvestment portfolio and the prepayment rates that we project on our investmentportfolio.

**Hedging.**   Weuse interest rate derivatives to hedge a portion of the interest rate riskassociated with our borrowings. There are limitations to our ability to hedgeall of the negative consequences associated with changes in interest rates andprepayment rates. Furthermore, we are subject to the costs associated withhedging which include the premiums paid for any interest rate derivatives andthe cost of swapping floating rate borrowings to fixed rate borrowings.

**CreditLosses.**   We will experience credit losses on ourinvestment portfolio and such credit losses will have an adverse affect on ourinvestment portfolio performance.

**Leverage.****  **We use borrowings to finance a significant portion ofour investment portfolio. The use of leverage involves risks, including therisk that losses are materially increased or magnified and increasing liquidityrisk in the event that one or more of our financing counterparties terminateour financings and/or require us to provide additional collateral to securetheir financing facilities.

**Investment Company Act Exemption**

We operate our business so as to be exempt fromregulation under the Investment Company Act. We monitor our portfolio ofinvestments periodically to confirm that we and each of our subsidiariescontinue to qualify for the applicable exemptions from the definition of aninvestment company under the Investment Company Act. We monitor our portfolioso that at least 55% of our assets are considered to be “qualifying real estateassets,” and so that at least an additional 25% of our investments constitute “realestate-related assets” or additional qualifying real estate assets, therebyallowing us to qualify for the 

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exemption from thedefinition of an investment company provided in Section 3(c)(5)(C) of theInvestment Company Act. We measure and satisfy the tests with respect to ourassets on an unconsolidated basis.

We generally expect that a substantial majority of ourinvestments in mortgage loans, mortgage-backed securities and commercial realestate debt will be considered qualifying real estate assets under the Section3(c)(5)(C) exemption from the Investment Company Act. We also generally expectthat any RMBS or CMBS in which we invest that do not constitute qualifying realestate assets will constitute real estate-related assets. The treatment ofCDOs, asset-backed securities, leveraged loans and stressed and distressed debtsecurities as qualifying real estate assets or real estate-related assets willbe based on the characteristics of the underlying collateral and our rightswith respect to the collateral, including whether we have foreclosure rightswith respect to the underlying real estate collateral. We do not generallyexpect that our investments in corporate leveraged loans, mezzanine loans, highyield corporate bonds, asset-backed securities or private equity willconstitute qualifying real estate assets or real estate-related assets.

Maintaining our exemptionfrom regulation under the Investment Company Act limits our ability to makecertain favorable investments.

**Management Agreement**

A management agreement governs the relationshipbetween our Manager and us and describes the services to be provided by ourManager and its compensation for those services. Our Manager’s management ofour business is under the direction of our board of directors and themanagement agreement requires our Manager to manage our business affairs inconformity with the policies and the investment guidelines that are approved andmonitored by our board of directors. Among other things, our Manager isresponsible for (i) the selection, purchase and sale of our portfolioinvestments, (ii) our financing and risk management activities, and (iii) providingus with investment advisory services.

The initial term of the management agreement expireson December 31, 2006 and is automatically renewed for a one-year term eachanniversary date thereafter. Our independent directors review our Manager’sperformance annually and, following the initial term, the management agreementmay be terminated annually (upon 180 days notice) upon the affirmative vote ofat least two-thirds of our independent directors, or by a vote of the holdersof a majority of the outstanding shares of our common stock, based upon (i) unsatisfactoryperformance by the Manager that is materially detrimental to us or (ii) adetermination that the management fees payable to our Manager are not fair,subject to our Manager’s right to prevent such a termination pursuant to clause(ii) by accepting a mutually acceptable reduction of management fees. Anysuch termination would require us to pay a substantial termination fee to ourManager.

We may also terminate the management agreement withoutpayment of the termination fee with 30 days’ prior written notice for cause,which is defined as (i) our Manager’s continued material breach of anyprovision of the management agreement following a period of 30 days afterwritten notice thereof, (ii) our Manager’s fraud, misappropriation offunds, or embezzlement against us, (iii) our Manager’s gross negligence inthe performance of its duties under the management agreement, (iv) thecommencement of any proceeding relating to our Manager’s bankruptcy orinsolvency, (v) the dissolution of our Manager or (vi) a change ofcontrol of our Manager. Cause does not include unsatisfactory performance, evenif that performance is materially detrimental to our business. Our Manager mayterminate the management agreement, without payment of the termination fee, inthe event we become regulated as an investment company under the InvestmentCompany Act. Furthermore, our Manager may decline to renew the management agreementby providing us with 180 days written notice. Our Manager may also terminatethe management agreement upon 60 days written notice if we default in theperformance of any material term of the agreement and the default continues fora period of 30 days after written notice to us, whereupon we would be requiredto pay our Manager a termination fee.

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OurManager is entitled to receive a base management fee from us, incentivecompensation based on certain performance criteria and a termination fee if wedecide to terminate the management agreement without cause or if our Managerterminates the management agreement due to our default. We believe that thebase management fee and incentive compensation that our Manager is entitled toreceive are comparable to the base management fee and incentive compensationreceived by managers of comparable externally managed REITs. The followingtable summarizes the fees payable to our Manager pursuant to the managementagreement:

| **Fee**             | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **Summary Description** |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|
| Base Management Fee |       | The base  management fee is payable monthly in arrears in an amount equal to 1¤12  of our equity (as defined in the management agreement) multiplied by 1.75%.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| Incentive Fee       |       | The incentive fee  is payable quarterly in an amount equal to the product of: (i) 25% of  the dollar amount by which (a) our Net Income, before the incentive fee,  per weighted average share of common stock for such quarter, exceeds  (b) an amount equal to the product of (A) the weighted average of  the price per share of the common stock in our August 2004 private  placement and the prices per share of our common stock in any subsequent  offerings by us multiplied by (B) the greater of (1) 2.00% and  (2) 0.50% plus one-fourth of the ten-year U.S. treasury rate for such  quarter multiplied by (ii) the weighted average number of shares of  common stock outstanding in such quarter.

“Net Income” is  determined by calculating the net income available to owners of common stock  before non-cash equity compensation expense, computed in accordance with  accounting principles generally accepted in the United States of America, or  GAAP. |
| Termination Fee     |       | A termination fee is  payable by us for termination without cause or non-renewal by us of the  management agreement or if our Manager terminates the management agreement  due to our default and shall be equal to four times the sum of the average  annual base management fee and the average annual incentive fee for the two  12-month periods immediately preceding the date of termination,  calculated as of the end of the most recently completed fiscal quarter prior  to the date of termination.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |

 

An affiliate of ourManager has entered into separate management agreements with the respectiveinvestment vehicles for each of our first two collateralized loan obligationtransactions and is entitled to receive fees for the services performed ascollateral manager. To date, the collateral manager has waived approximately $1.5 millionof management fees payable to it from KKR Financial CLO 2005-1, Ltd., whichcovers the period commencing in March 2005 and ending in April 2006 and haswaived approximately $0.8 million of management fees payable to it fromKKR Financial CLO 2005-2, Ltd., which covers the period commencing November2005 and ending in May 2006. The waivers for KKR Financial CLO 2005-1, 

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Ltd. andKKR Financial CLO 2005-2, Ltd., expire in April 2006 and May 2006,respectively, and there is no guarantee that the collateral manager will waivesuch management fees subsequent to those dates.

**Competition**

Our net income depends, inlarge part, on our ability to acquire assets at favorable spreads over ourborrowing costs. A number of entities compete with us to make the types ofinvestments that we plan to make. We compete with other REITs, financialcompanies, public and private funds, commercial and investment banks andcommercial finance companies. For additional information concerning thecompetitive risks we face, see Item 1A., “Risk Factors—Risks Related toOur Operation and Business Strategy—We operate in a highly competitive marketfor investment opportunities.”

**Staffing**

We do not have any employees. We are managed by KKRFinancial Advisors LLC, our Manager, pursuant to the management agreementbetween our Manager and us. Our Manager is 100% owned by KKR Financial LLC andall of our executive officers are employees and/or officers of KKR FinancialLLC. As of February 28, 2006, KKR Financial LLC had 42 full-time employees andtwo founders.

As ofFebruary 28, 2006, a break-down of KKR Financial LLC’s 42 full-time employeesand two founders by functional area is summarized in the table below: 

| **Number of  Individuals** | ** ** | **Functional  Area**                                                 |
|----------------------------|------------|----------------------------------------------------------------------|
| 2                          |       | Executive Management                                                 |
| 15                         |       | Due Diligence, Investment Management and  Asset-Liability Management |
| 20                         |       | Finance, Information Systems, and Human Resources                    |
| 7                          |       | Administration                                                       |

 

**Tax Status**

We are taxed as a REIT forfederal income tax purposes. To qualify as a REIT, we must meet various tax lawrequirements, including, among others, requirements relating to the nature ofour assets, the sources of our income, the timing and amount of distributionsthat we make and the composition of our stockholders. As a REIT, we generallyare not subject to federal income tax on income that we distribute to ourstockholders on a current basis. If we fail to qualify as a REIT in any taxableyear, we will be subject to federal income tax at regular corporate rates, andwe may be precluded from qualifying as a REIT for the subsequent four taxableyears following the year during which we lost our qualification. Further, evento the extent that we qualify as a REIT, we will be subject to tax at normalcorporate rates on net income or capital gains not distributed to ourstockholders, and we may be subject to other taxes, including payroll taxes,and state and local income, franchise, property, sales and other taxes.Moreover, our domestic taxable REIT subsidiary, including KKR TRSHoldings, Inc., is subject to federal income taxation and to various othertaxes. Any dividends received from us, with limited exceptions, will not beeligible for taxation at the preferred capital gain rates that currently applyto dividends received by individuals, trusts and estates from taxablecorporations.

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**Restrictionson Ownership of Our Capital Stock**

Due to limitations on theconcentration of ownership of a REIT imposed by the Internal Revenue Code of1986, as amended, or the Internal Revenue Code, our charter, among otherlimitations, generally prohibits any stockholder from beneficially orconstructively owning more than 9.8% in value or in number of shares, whicheveris more restrictive, of any class or series of the outstanding shares of ourcapital stock. Our board of directors has discretion to grant exemptions fromthe ownership limit, subject to terms and conditions as it deems appropriate.

**Distribution Policy**

We generally need todistribute annually at least 90% of our net taxable income each year (subjectto certain adjustments) so that we can qualify as a REIT under the InternalRevenue Code. Up to 20% of the value of a REIT’s assets may consist ofinvestments in the securities of one or more taxable REIT subsidiaries. Adomestic taxable REIT subsidiary, such as KKR TRS Holdings, Inc., mayretain its taxable income, and its earnings are subject to the 90% distributionrequirement only to the extent the domestic taxable REIT subsidiary actuallydistributes its earnings to the REIT. However, a foreign taxable REITsubsidiary, such as KKR Financial CLO 2005-1, Ltd., KKR Financial CLO2005-2, Ltd., KKR Financial CLO 2006-1, Ltd., and KKR Financial CDO 2005-1,Ltd., generally is deemed to distribute its earnings to the REIT on an annualbasis for federal income tax purposes, and its earnings are subject to the 90%distribution requirement, regardless of whether it actually distributes itsearnings. We may, under certain circumstances, make a distribution of capitalor of assets. Distributions will be made at the discretion of our board ofdirectors and may not be in even amounts throughout our fiscal year.

**ITEM 1A.**        RISKFACTORS

*You should carefully consider therisks described below. In addition, the risks described below are not the onlyones facing us. We have only described the risks we consider to be material.However, there may be additional risks that are viewed by us as not material orare not presently known to us.*

*If anyof the risks described below were to occur, our business, financial condition,liquidity and results of operations could be materially and adversely affected.If this were to occur, the price of our common stock could decline, and youcould lose all or part of your investment.*

**Risks Related to Our Management and Our Relationshipwith Our Manager**

***We are dependent on our Manager and may not find asuitable replacement if our Manager terminates the management agreement.***

We have no employees. Our Manager,and its officers and employees, allocate a portion of their time to businessesand activities that are not related to, or affiliated, with us and,accordingly, do not spend all of their time managing our activities and ourinvestment portfolio. We expect that the portion of our Manager’s time that isallocated to other businesses and activities will increase in the future andmay be material. We have no separate facilities and are completelyreliant on our Manager, which has significant discretion as to theimplementation and execution of our business strategies and risk managementpractices. We are subject to the risk that our Manager will terminate themanagement agreement and that no suitable replacement will be found. We believethat our success depends to a significant extent upon the experience of ourManager’s executive officers, whose continued service is not guaranteed.

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***The departure of any of the senior management of ourManager or the loss of our access to KKR’s investment professionals andprincipals may adversely affect our ability to achieve our investmentobjectives.***

We depend on thediligence, skill and network of business contacts of the senior management ofour Manager. We also depend on our Manager’s access to the investmentprofessionals and principals of KKR and the information and deal flow generatedby the KKR investment professionals and principals during the normal course oftheir investment and portfolio management activities. The senior management ofour Manager evaluates, negotiates, structures, closes and monitors ourinvestments. Our future success will depend on the continued service of thesenior management team of our Manager. The departure of any of the seniormanagers of our Manager, or of a significant number of the investmentprofessionals or principals of KKR, could have a material adverse effect on ourability to achieve our investment objectives. In addition, we can offer noassurance that our Manager will remain our Manager or that we will continue to haveaccess to KKR’s investment professionals or principals or its information anddeal flow.

***If our Manager ceases to be our Manager pursuant tothe management agreement, financial institutions providing our creditfacilities may not provide future financing to us.***

The financial institutionsthat finance our investments pursuant to our repurchase agreements, warehousefacilities and our revolving credit facility may require that our Managermanage our operations pursuant to the management agreement as a condition tomaking continued advances to us under these credit facilities. Additionally, ifour Manager ceases to be our Manager, each of these financial institutionsunder these credit facilities may terminate their facility and their obligationto advance funds to us in order to finance our future investments. If ourManager ceases to be our Manager for any reason and we are not able to obtainfinancing under these credit facilities, our growth may be limited or we may beforced to sell our investments at a loss.

***Our Manager has limited experience in managing a REIT,and our investment focus will differ from those of other KKR funds.***

Government regulationsimpose numerous constraints on the operations of REITs. Our Manager’s limitedexperience in managing a portfolio of assets under such constraints may hinderits ability to achieve our investment objectives. In addition, maintaining ourREIT qualifications will limit the types of investments we are able to make.Finally, even though our Manager is affiliated with KKR, our investment focusdiffers from those of other entities that are or have been managed by KKRinvestment professionals. In particular, entities managed by KKR have notexecuted business strategies that involve investing in real estate related debtinstruments. Our investors are not acquiring an interest in any of KKR’sprivate equity funds and the returns that are realized by our investors may bematerially different than the returns realized by investors in KKR’s privateequity funds.

***Our board of directors has approved very broadinvestment guidelines for our Manager and does not approve each investmentdecision made by our Manager.***

Our Manager is authorizedto follow very broad investment guidelines. Our directors periodically review andapprove our investment guidelines. Our board does not review all of ourproposed or completed investments, however. Furthermore, transactions enteredinto by our Manager may be difficult or impossible to unwind. Our Manager hasgreat latitude within the broad parameters of the investment guidelines indetermining the types of assets it may decide are proper investments for us bythe time they are reviewed by the director.

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***Our incentive fee may induce our Manager to makecertain investments, including speculative investments.***

The managementcompensation structure to which we have agreed with our Manager may cause ourManager to invest in high risk investments or take other risks. In addition toits management fee, our Manager is entitled to receive incentive compensationbased in part upon our achievement of specified levels of net income. Inevaluating investments and other management strategies, the opportunity to earnincentive compensation based on net income may lead our Manager to place undueemphasis on the maximization of net income at the expense of other criteria,such as preservation of capital, maintaining sufficient liquidity, and/ormanagement of credit risk or market risk, in order to achieve higher incentivecompensation. Investments with higher yield potential are generally riskier ormore speculative. This could result in increased risk to the value of our investmentportfolio.

***There are potential conflicts of interest in ourrelationship with our Manager and its affiliates, including KKR, which couldresult in decisions that are not in the best interests of our stockholders.***

We are subject to potential conflicts of interestarising out of our relationship with our Manager and its affiliates. As of February 28,2006, our Manager and its affiliates collectively owned approximately 12.0% ofour common stock on a fully diluted basis and received their pro rata portionof the distributions we made to our stockholders and will receive their prorata portion of future distributions, if any. Saturnino S. Fanlo, our chiefexecutive officer, and David A. Netjes, our chief financial officer and chiefoperating officer, also serve in those capacities for our Manager and as of February 28,2006 beneficially owned 4.5% and 4.4% of our common stock, respectively. Inaddition, as of February 28, 2006, our chairman, Paul M. Hazen, who servesas a member of our Manager’s investment committee, and one of our directors,Scott C. Nuttall, who serves as a member of our Manager’s investment committee andis an executive at KKR, beneficially owned 4.5% and 4.2% of our common stock,respectively. Furthermore, our Manager is wholly owned by KKR Financial LLC andKKR Financial LLC is owned by KKR and Saturnino S. Fanlo and David A. Netjes,the chief executive officer and the chief financial officer and chief operatingofficer, respectively, of both our Manager and us. As a result, our managementagreement with our Manager was negotiated between related parties, and itsterms, including fees payable, may not be as favorable to us as if it had beennegotiated with an unaffiliated third party. In addition, our Manager owes nofiduciary obligation to our stockholders.

***We expect that affiliates of our Manager and KKR willcompete with us and there may be conflicts arising from allocation ofinvestment opportunities.***

Our management agreementwith our Manager does not prevent our Manager and its affiliates from engagingin additional management or investment opportunities, although the agreementgenerally restricts our Manager and its affiliates from raising, sponsoring oradvising any new investment fund, company or other entity, including a realestate investment trust, that invests primarily in domestic mortgage-backedsecurities; provided that for purposes of the foregoing limitation, anyportfolio company of any private equity fund controlled by KKR shall not bedeemed to be an affiliate of our Manager. As a result, we expect that our Manager andits affiliates, including KKR, will engage from time to time in additionalmanagement or investment opportunities that have overlapping objectives withus.  In particular, we have been informedby our Manager that one of its affiliates is expecting to establish and managea separate investment fund that will invest in the same non-mortgage-backedsecurities investments that we invest in, including other fixed incomeinvestments and KKR private equity investments. With respect to any competingentities, our Manager and its affiliates will face conflicts in the allocationof investment opportunities. Such allocation is at the discretion of ourManager and there is no guarantee that this allocation would be made in thebest interest of our stockholders.

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***Termination by us of the management agreement with ourManager without cause is difficult and costly.***

The management agreementprovides that it may only be terminated by us without cause annually afterDecember 31, 2006 upon the affirmative vote of at least two-thirds of ourindependent directors, or by a vote of the holders of a majority of theoutstanding shares of our common stock, based upon (1) unsatisfactoryperformance by our Manager that is materially detrimental to us or (2) adetermination that the management fee payable to our Manager is not fair,subject to our Manager’s right to prevent such a termination under this clause(2) by accepting a mutually acceptable reduction of management fees. OurManager will be provided 180 days’ prior notice of any such termination andwill be paid a termination fee equal to four times the sum of the averageannual base management fee and the average annual incentive fee for the two 12-monthperiods immediately preceding the date of termination, calculated as of the endof the most recently completed fiscal quarter prior to the date of termination.These provisions would result in substantial cost to us if we terminate themanagement agreement, thereby adversely affecting our ability to terminate ourManager without cause.

***Certain of ourinvestments may create a conflict of interest with KKR and other affiliates.***

Subject to complying withour investment guidelines, our Manager may at times cause us to invest incorporate leveraged loans, high yield securities and equity securities ofcompanies affiliated with KKR. To the extent KKR is the owner of all or amajority of the outstanding equity securities, KKR may have the ability toelect all of the members of the board of directors of a company we invest inand thereby control its policies and operations, including the appointment ofmanagement, future issuances of common stock or other securities, the paymentsof dividends, if any, on its common stock, the incurrence of debt by it,amendments to its certificate of incorporation and bylaws and entering intoextraordinary transactions, and KKR’s interests may not in all cases be alignedwith our interests. In addition, KKR may have an interest in pursuingacquisitions, divestitures and other transactions that, in their judgment,could enhance their equity investment, even though such transactions mightinvolve risks to holders of indebtedness. For example, KKR could cause acompany in which we invest to make acquisitions that increase its indebtednessor to sell revenue generating assets. In addition, with respect to companies inwhich we have an equity investment, to the extent that KKR is the controllingshareholder it will be able to determine the outcome of all matters requiringstockholder approval and will be able to cause or prevent a change of controlof the company we invest in or a change in the composition of its board ofdirectors and could preclude any unsolicited acquisition of that companyregardless as to whether we agree with such determination. So long as KKRcontinues to own a significant amount of the voting power of a company weinvest in, even if such amount is less than 50%, it will continue to influencestrongly, or effectively control, that company’s decisions. As a result, ourinterests with respect to the management, investment decisions, or operationsof those companies may at times be in direct conflict with those of KKR. Inaddition, to the extent that affiliates of our Manager or KKR invest incompanies in which we have an investment, similar conflicts between ourinterests and theirs may arise.

***We will competewith other investment entities affiliated with KKR for access to its investmentprofessionals and principals.***

KKR manages severalprivate equity funds, and we believe that KKR and its affiliates will establishand manage other investment entities in the future. If any such investmententities have an investment focus similar to our focus, we may compete withthose entities for access to the benefits that our relationship with KKRprovides to us. In particular, during 2005 we entered into several private equityinvestments pursuant to which we are co-investing alongside KKR private equityfunds.  Our ability to continue to engagein these types of opportunities in the future depends, to a significant extent,on the contractual obligations that KKR has to the limited partners of itsprivate equity funds with respect to co-investment opportunities as well as oncompeting demands for these investment opportunities by other investmententities established by KKR and its affiliates.

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***Our access to confidential information may restrictour ability to take action with respect to some investments, which, in turn,may negatively affect the potential return to stockholders.***

We, directly or throughour Manager, may obtain confidential information about the companies in whichwe have invested or may invest. If we do possess confidential information aboutsuch companies, there may be restrictions on our ability to make, dispose of,increase the amount of, or otherwise take action with respect to, an investmentin those companies. Our relationship with KKR could create a conflict ofinterest to the extent our Manager becomes aware of inside informationconcerning investments or potential investment targets. We have implementedcompliance procedures and practices designed to ensure that inside informationis not used for making investment decisions on our behalf. We cannot assureyou, however, that these procedures and practices will be effective. Inaddition, this conflict and these procedures and practices may limit thefreedom of our Manager to make potentially profitable investments, which couldhave an adverse effect on our operations.

***Our Manager’sliability is limited under the management agreement, and we have agreed toindemnify our Manager against certain liabilities.***

Pursuant to the management agreement, our Manager willnot assume any responsibility other than to render the services called forthereunder and will not be responsible for any action of our board of directorsin following or declining to follow its advice or recommendations. Our Managerand its members, managers, officers and employees will not be liable to us, anysubsidiary of ours, our directors, our stockholders or any subsidiary’sstockholders for acts performed in accordance with and pursuant to themanagement agreement, except by reason of acts constituting bad faith, willfulmisconduct, gross negligence, or reckless disregard of their duties under themanagement agreement. We have agreed to indemnify our Manager and its members,managers, officers and employees and each person controlling our Manager withrespect to all expenses, losses, damages, liabilities, demands, charges andclaims arising from acts of such indemnified party not constituting bad faith,willful misconduct, gross negligence, or reckless disregard of duties,performed in good faith in accordance with and pursuant to the managementagreement.

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**Risks Related toOur Operation and Business Strategy**

***We have a limitedoperating history and limited experience as a REIT.***

We have a limitedoperating history and experience as a REIT. We are subject to all of thebusiness risks and uncertainties associated with any business, including therisk that we will not achieve our investment objectives and that the value ofyour investment could decline substantially. There can be no assurance that wewill be able to generate sufficient revenue from operations to pay ouroperating expenses and make or sustain distributions to stockholders.

***Our internalcontrols over financial reporting contain material weaknesses. If we fail toremedy these weaknesses or otherwise fail to achieve and maintain effective internalcontrols on a timely basis, our internal controls would be consideredineffective for purposes of Section 404 of the Sarbanes-Oxley Act of 2002.Ineffective internal controls also could have an adverse effect on our futureoperations.***

We are a public reportingcompany subject to the rules and regulations established from time to timeby the Securities and Exchange Commission, or SEC, and New York Stock Exchange.These rules and regulations, among other things, will require us toestablish and periodically evaluate procedures with respect to internalcontrols over financial reporting. In connection with its audit of ourconsolidated financial statements for the period ended December 31, 2004,our independent registered public accounting firm on March 8, 2005identified to us three matters involving our internal controls over financialreporting that it considered to be reportable conditions under standardsestablished by the American Institute of Certified Public Accountants, whichreportable conditions in its judgment constituted material weaknesses. Underthese standards, in each of these areas the design or operation of our internalcontrols did not reduce to a relatively low level the risk that misstatementscaused by error or fraud in amounts that would be material may occur and not bedetected within a timely period.

The first reportablecondition related to our failure to have well-established internal controlsover our financial closing and reporting process. Specifically, through the March 8,2005 letter date, several of our Manager’s employees in the areas of accountingand financial reporting had been with our Manager for a limited period of time,and additional internal controls needed to be established with respect to thesegregation of duties of these individuals in the posting and review ofindividual journal entries. Moreover, additional specific internal controlswere required regarding verification and reconciliation of our general ledgeras our financial statements are closed on a monthly basis. The secondreportable condition related to our reliance on data gathering and processingmethods based upon information gathered after transaction dates that entail agreater risk of error. Specifically, in preparation of our financial statementsand underlying records, we relied on custodian statements, bank statements andother information gathered after the transaction dates to identify transactionsand amounts that needed to be recorded. These data-gathering and processingmethods entail greater risk of error than do methods involving timelyprocessing of transactions. The third reportable condition related to ourfailure to be as self sufficient with respect to the application of accountingpolicies for complex transactions as we ultimately need to be. As with thefirst reportable condition discussed above, the existence of this condition at March 8,2005 principally related to the limited periods of time that several of ourManager’s accounting and financial reporting staff had been employed by ourManager, and the need at such time for these individuals to establish morerobust procedures for the ongoing selection and application of accountingpolicies for many of our transactions.

We are actively remediatingthe reportable conditions identified but no assurance can be given that allsuch conditions will be fully remedied in a timely fashion. If we fail toremedy these weaknesses or otherwise fail to achieve and maintain effectiveinternal controls on a timely basis, our internal controls would be consideredineffective for purposes of Section 404 of the Sarbanes-Oxley Act.

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***We may change ourinvestment strategy and operational policies without stockholder consent, whichmay result in riskier investments and adversely affect the market price of ourcommon stock and our ability to make distributions to our stockholders.***

We may change ourinvestment strategy at any time without the consent of our stockholders, whichcould result in our making investments that are different from, and possiblyriskier than, the investments described in this Annual Report on Form 10-K. Achange in our investment strategy may increase our exposure to credit risk andmarket risk. Furthermore, our board of directors determines our operationalpolicies and may amend or revise our policies, including our policies withrespect to our REIT status, acquisitions, growth, operations, indebtedness,capitalization and distributions or approve transactions that deviate fromthese policies, without a vote of, or notice to, our stockholders. Operationalpolicy changes could adversely affect the market price of our common stock andour ability to make distributions to our stockholders.

***Our Manager’sfailure to identify and invest in securities and loans that meet our investmentcriteria or perform its responsibilities under the management agreement mayadversely affect our ability for future growth.***

Our ability to achieve ourinvestment objective will depend on our ability to grow, which in turn willdepend on our Manager’s ability to identify and invest in securities that meetour investment criteria. Accomplishing this result on a cost-effective basis willbe largely a function of our Manager’s structuring of the investment process,its ability to provide competent, attentive and efficient services to us, andour access to financing on acceptable terms. The senior management team of ourManager has substantial responsibilities under the management agreement. Inorder to grow, our Manager will need to hire, train, supervise and manage newemployees successfully. Any failure to manage our future growth effectivelycould have a material adverse effect on our business, financial condition andresults of operations.

***We operate in ahighly competitive market for investment opportunities.***

A number of entitiescompete with us to make the types of investments that we plan to make. Wecompete with other REITs, financial companies, public and private funds,commercial and investment banks and commercial finance companies. Many of ourcompetitors are substantially larger and have considerably greater financial,technical and marketing resources than we do. Several other REITs have recentlyraised, or are expected to raise, significant amounts of capital, and may haveinvestment objectives that overlap with ours, which may create competition forinvestment opportunities. Some competitors may have a lower cost of funds andaccess to funding sources that are not available to us. In addition, some ofour competitors may have higher risk tolerances or different risk assessments,which could allow them to consider a wider variety of investments and establishmore relationships than us. We cannot assure you that the competitive pressureswe face will not have a material adverse effect on our business, financialcondition and results of operations. Also, as a result of this competition, wemay not be able to take advantage of attractive investment opportunities fromtime to time, and we can offer no assurance that we will be able to identifyand make investments that are consistent with our investment objectives.

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***Failure to procure adequate capital and funding wouldadversely affect our results and may, in turn, negatively affect the marketprice of shares of our common stock and our ability to make distributions toour stockholders.***

We depend upon theavailability of adequate funding and capital for our operations. As a REIT, weare required to distribute annually at least 90% of our REIT taxable income,determined without regard to the deduction for dividends paid and excluding netcapital gain, to our stockholders and are therefore not able to retain ourearnings for new investments (excluding earnings generated by KKR TRSHoldings, Inc., and any other domestic taxable REIT subsidiary, subject tothe REIT requirements). We cannot assure you that any, or sufficient, fundingor capital will be available to us in the future on terms that are acceptableto us. In the event that we cannot obtain sufficient funding on acceptableterms, there may be a negative impact on the market price of our common stockand our ability to make distributions to our stockholders.

***We leverage our portfolio investments, which mayadversely affect our return on our investments and may reduce cash availablefor distribution.***

We expect to leverage ourportfolio investments through borrowings, generally through the use ofwarehouse facilities, bank credit facilities, repurchase agreements, asset-backedsecured liquidity notes, mortgage loans on real estate, securitizations,including the issuance of CDOs, loans to entities in which we hold, directly orindirectly, interests in pools of properties or loans, and other borrowings.The percentage of leverage varies depending on our ability to obtain creditfacilities and the lender’s and rating agencies’ estimate of the stability ofthe portfolio investments’ cash flow. Our return on our investments and cashavailable for distribution to our stockholders may be reduced to the extentthat changes in market conditions cause the cost of our financing to increaserelative to the income that can be derived from the assets acquired. Our debtservice payments reduce cash flow available for distributions to stockholders.We may not be able to meet our debt service obligations and, to the extent thatwe cannot, we risk the loss of some or all of our assets to foreclosure or saleto satisfy our debt obligations. We leverage certain of our investments throughrepurchase agreements and asset-backed secured liquidity notes. A decrease inthe value of the assets may lead to margin calls that we will have to satisfy.We may not have the funds available to satisfy any such margin calls.

***If credit spreads widen before we obtain long-termfinancing for our net assets we may experience a material reduction in theeconomic value of the assets that we have acquired.***

We price our net assetsbased on our assumptions about future levels of credit spreads (the riskpremium for taking credit risk which is the difference between the risk freerate and the interest rate paid on the investment) for term financing of thoseassets. We expect to obtain longer term financing for these assets at a spreadover a certain benchmark, such as the yield on United States Treasury bonds,swaps, or LIBOR. If the spread that investors will pay over the benchmark widensand the rates we charge on our loans or the income we generate from our otherassets are not increased accordingly, we may experience a material adversereduction in the economic value of the assets that we have acquired.

***If we are unable to continue to securitize ourportfolio successfully, we may be unable to grow or fully execute our businessstrategy and our earnings may decrease.***

We intend to continue to structureour securitization transactions so that we must account for them as securedborrowings in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*,and as a result we are precluded from using sale accounting to recognize any gainor loss. To securitize our portfolio investments, we may create a wholly-ownedsubsidiary and contribute a pool of portfolio investments to the subsidiary. Aninability to securitize our portfolio successfully could limit our ability togrow our business or fully execute our business strategy and could decrease ourearnings, if any. Moreover, the successful 

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securitizationof our portfolio investments might expose us to losses as the residualportfolio investments in which we do not sell interests will tend to be thosethat are riskier and more likely to generate losses.

***We may not be able to acquire eligible securities fora CDO or CLO issuance, or may not be able to issue CDO or CLO securities onattractive terms that closely match-fund the duration of our assets andliabilities, which may require us to seek more costly financing for ourinvestments or to liquidate assets.***

We intend to continue to financecertain of our portfolio investments on a long-term basis, such as through theissuance of CDOs and CLOs. We use these short term facilities to finance theacquisition of securities until a sufficient quantity of securities isaccumulated, at which time we intend to refinance these facilities through asecuritization, such as a CDO or CLO issuance, or other long-term financing. Asa result, we are subject to the risk that we will not be able to acquire,during the period that our short-term facilities are available, a sufficientamount of eligible securities to maximize the efficiency of a CDO or CLOissuance. We also bear the risk that we will not be able to obtain short-termcredit facilities or may not be able to renew any short-term credit facilitiesafter they expire should we find it necessary to extend our short-term creditfacilities to allow more time to seek and acquire the necessary eligiblesecurities for a long-term financing. Inability to renew our short-term creditfacilities may require us to seek more costly financing for our investments orto liquidate assets. In addition, conditions in the capital markets may makethe issuance of a CDO or CLO less attractive to us when we do have a sufficientpool of collateral. If we are unable to issue a CDO or CLO to finance theseassets, we may be required to seek other forms of potentially less attractivefinancing or otherwise to liquidate the assets.

***The use of CDO or CLO financings withover-collateralization requirements may have a negative impact on our cash flow.***

The terms of the CDOs andCLOs we issue generally provide that the principal amount of assets must exceedthe principal balance of the related bonds by a certain amount. This excesscollateral requirement is commonly referred to as “over-collateralization.” TheCDO and CLO terms provide that, if losses exceed the specified levels based onrating agencies’ (or the financial guaranty insurer’s, if applicable) analysesof the characteristics of the assets pledged to collateralize the bonds, the requiredlevel of over-collateralization may be insufficient and as a result we may besubject to restrictions that limit our ability to receive cash flows fromassets pledged to secure CDOs or CLOs. We cannot assure you that theperformance tests will be satisfied, nor can we assure you, in advance ofcompleting negotiations with the rating agencies or other key transactionparties on our future CDO and CLO financings, of the effects of the actualterms of the delinquency tests, over-collateralization terms, cash flow releasemechanisms or other significant factors regarding the release of cash flow tous. Failure to obtain favorable terms with regard to these matters maymaterially and adversely affect our liquidity. If our assets fail to perform asanticipated, our over-collateralization or other forms of credit enhancementassociated with our CDO and CLO financings will likely increase on futuretransactions, thereby resulting in increased borrowing costs.

***We may be required to repurchase loans or securitiesthat we have sold in connection with CDOs and CLOs.***

If any of the loans orsecurities that we originate or acquire and sell or securitize does not complywith representations and warranties that we make about certain characteristicsof the loans, the borrowers and the underlying properties, we may be requiredto repurchase such loans or securities (including from a trust vehicle used tofacilitate a structured financing of the assets through CDOs and CLOs) orreplace them with substitute loans or securities. In addition, in the case ofloans or securities that we have sold instead of retained, we may be requiredto indemnify purchasers for losses or expenses incurred as a result of a breachof a representation or warranty. Any significant repurchases or indemnificationpayments could materially and adversely affect our liquidity, financialcondition and operating results.

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***The B Notes in which we invest may be subject toadditional risks relating to the privately negotiated structure and terms ofthe transaction, which may result in losses to us.***

A B Note is a mortgageloan typically (i) secured by a first mortgage on a single largecommercial property or group of related properties and (ii) subordinatedto an A Note secured by the same first mortgage on the same collateral. As aresult, if a borrower defaults, there may not be sufficient funds remaining forB Note holders after payment to the A Note holders. B Notes reflect similarcredit risks to comparably rated commercial mortgage-backed securities. Sinceeach transaction is privately negotiated, however, B Notes can vary in theirstructural characteristics and risks. For example, the rights of holders of BNotes to control the process following a borrower default may be limited incertain investments. We cannot predict the terms of each B Note investment. BNotes also are less liquid than commercial mortgage-backed securities, thus wemay be unable to dispose of performing, underperforming or non-performing BNote investments. The higher risks associated with our subordinate position inour B Note investments could subject us to increased risk of losses.

***An increase in our borrowing costs relative to theinterest we receive on our portfolio investments may adversely affect ourprofitability, which may negatively affect cash available for distribution toour stockholders.***

As our repurchaseagreements and other short-term borrowing instruments mature, we will berequired either to enter into new repurchase agreements and other short-termborrowings or to sell certain of our portfolio investments. An increase inshort-term interest rates at the time that we seek to enter into new repurchaseagreements may reduce the spread between our returns on our portfolioinvestments and the cost of our borrowings. This change in interest rates wouldadversely affect our returns on our portfolio investments that are fixed rateand/or subject to prepayment or extension risk, including our mortgage loansand mortgage-backed securities investments, which might reduce earnings and, inturn, cash available for distribution to our stockholders.

***We may enter into derivative contracts that couldexpose us to contingent liabilities in the future.***

Part of ourinvestment strategy involves entering into derivative contracts that will requireus to fund cash payments in certain circumstances. These payments will becontingent liabilities and therefore may not appear on our balance sheet. Ourability to fund these contingent liabilities will depend on the liquidity ofour assets and access to capital at the time, and the need to fund thesecontingent liabilities could adversely impact our financial condition.

***Hedging against interest rate exposure may adverselyaffect our earnings, which could adversely affect cash available fordistribution to our stockholders.***

We enter into interestrate swap agreements and other interest rate hedging strategies. Our hedgingactivity will vary in scope based on the level of interest rates, the type ofportfolio investments held, and other changing market conditions. Interest ratehedging may fail to protect or could adversely affect us because, among otherthings:

·       interestrate hedging can be expensive, particularly during periods of rising andvolatile interest rates;

·       availableinterest rate hedging may not correspond directly with the interest rate riskfor which protection is sought;

·       theduration of the hedge may not match the duration of the related liability orasset;

·       theamount of income that a REIT may earn from hedging transactions to offsetinterest rate losses is limited by federal tax provisions governing REITs;

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·       thecredit quality of the party owing money on the hedge may be downgraded to suchan extent that it impairs our ability to sell or assign our side of the hedgingtransaction; and

·       theparty owing money in the hedging transaction may default on its obligation topay.

Any hedging activity weengage in may adversely affect our earnings, which could adversely affect cashavailable for distribution to our stockholders. Therefore, while we may enterinto such transactions to seek to reduce interest rate risks, unanticipatedchanges in interest rates may result in poorer overall investment performancethan if we had not engaged in any such hedging transactions. In addition, thedegree of correlation between price movements of the instruments used in ahedging strategy and price movements in the portfolio positions being hedged orliabilities being hedged may vary materially. Moreover, for a variety ofreasons, we may not seek to establish a perfect correlation between suchhedging instruments and the portfolio holdings being hedged. Any such imperfectcorrelation may prevent us from achieving the intended hedge and expose us torisk of loss.

***Hedging instruments often are not traded on regulatedexchanges, guaranteed by an exchange or its clearing house, or regulated by anyU.S. or foreign governmental authorities and involve risks and costs.***

The cost of using hedginginstruments increases as the period covered by the instrument increases andduring periods of rising and volatile interest rates. We may increase ourhedging activity and thus increase our hedging costs during periods wheninterest rates are volatile or rising and hedging costs have increased. Inaddition, hedging instruments involve risk since they often are not traded onregulated exchanges, guaranteed by an exchange or its clearing house, orregulated by any U.S. or foreign governmental authorities. Consequently, thereare no requirements with respect to record keeping, financial responsibility orsegregation of customer funds and positions. Furthermore, the enforceability ofagreements underlying derivative transactions may depend on compliance withapplicable statutory, commodity and other regulatory requirements and,depending on the identity of the counterparty, applicable internationalrequirements. The business failure of a hedging counterparty with whom we enterinto a hedging transaction will most likely result in a default. Default by aparty with whom we enter into a hedging transaction may result in the loss ofunrealized profits and force us to cover our resale commitments, if any, at thethen current market price. Although generally we will seek to reserve the rightto terminate our hedging positions, it may not always be possible to dispose ofor close out a hedging position without the consent of the hedgingcounterparty, and we may not be able to enter into an offsetting contract inorder to cover our risk. We cannot assure you that a liquid secondary marketwill exist for hedging instruments purchased or sold, and we may be required tomaintain a position until exercise or expiration, which could result in losses.

***We make investments in non-U.S. dollar denominated investments,which subject us to currency rate exposure and the uncertainty of foreign lawsand markets.***

We purchase investments denominatedin foreign currencies. A change in foreign currency exchange rates may have anadverse impact on returns on any of these non-dollar denominated investments.Although we may hedge our foreign currency risk subject to the REIT incomequalification tests, we may not be able to do so successfully and may incurlosses on these investments as a result of exchange rate fluctuations.Investments in foreign countries also subject us to risks of multiple andconflicting tax laws and regulations and political and economic instabilityabroad, which could adversely affect our receipt of interest income on theseinvestments.

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**RisksRelated To Our Investments**

***We may not realize gains or income from ourinvestments.***

We seek to generate bothcurrent income and capital appreciation. The securities in which we invest maynot appreciate in value, however, and, in fact, may decline in value, and thedebt securities in which we invest may default on interest and/or principalpayments. Accordingly, we may not be able to realize gains or income from ourinvestments. Any gains that we do realize may not be sufficient to offset anyother losses we experience. Any income that we realize may not be sufficient tooffset our expenses.

***Declines in the market values of our investments mayadversely affect periodic reported results and credit availability, which mayreduce earnings and, in turn, cash available for distribution to ourstockholders.***

A substantial portion of our assets are, and webelieve are likely to continue to be, classified for accounting purposes as“available-for-sale.” Changes in the market values of those assets will bedirectly charged or credited to stockholders’ equity. As a result, a decline invalues may reduce the book value of our assets. Moreover, if the decline invalue of an available-for-sale security is considered by our Manager to be otherthan temporary, such decline will reduce earnings.

A decline in the market value of our assets mayadversely affect us particularly in instances where we have borrowed moneybased on the market value of those assets. If the market value of those assetsdeclines, the lender may require us to post additional collateral to supportthe loan. If we were unable to post the additional collateral, we would have tosell the assets at a time when we might not otherwise choose to do so. Areduction in credit available may reduce our earnings and, in turn, cashavailable for distribution to stockholders.

Further, credit facility providers may require us tomaintain a certain amount of cash invested or to set aside unlevered assetssufficient to maintain a specified liquidity position which would allow us tosatisfy our collateral obligations. As a result, we may not be able to leverageour assets as fully as we would choose, which could reduce our return onequity. In the event that we are unable to meet these contractual obligations,our financial condition could deteriorate rapidly.

Market values of ourinvestments may decline for a number of reasons, such as causes related tochanges in prevailing market rates, increases in defaults, increases involuntary prepayments for those investments that we have that are subject toprepayment risk, and widening of credit spreads.

***Some of our portfolio investments are recorded at fairvalue as determined by our Manager and, as a result, there is uncertainty as tothe value of these investments.***

Some of our portfolioinvestments are, and we believe are likely to continue to be, in the form ofsecurities that have limited liquidity or are not publicly traded. The fairvalue of securities and other investments that have limited liquidity or arenot publicly traded may not be readily determinable. We value these investmentsquarterly at fair value as determined by our Manager. Because such valuationsare inherently uncertain, may fluctuate over short periods of time and may bebased on estimates, our determinations of fair value may differ materially fromthe values that would have been used if a ready market for these securitiesexisted. The value of our common stock could be adversely affected if ourdeterminations regarding the fair value of these investments are materiallyhigher than the values that we ultimately realize upon their disposal.

***Changes in interest rates could negatively affect thevalue of our investments, which could result in reduced earnings or losses andnegatively affect the cash available for distribution to our stockholders.***

We invest in mortgage loans and mortgage-backedsecurities and other fixed-rate debt investments. Under a normal yield curve,an investment in these instruments will decline in value if interest ratesincrease. We also invest in floating rate debt investments, for which decreasesin interest rates may have a 

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negative effect on value.Declines in market value may ultimately reduce earnings or result in losses tous, which may negatively affect cash available for distribution to ourstockholders.

In particular, asignificant risk associated with our investment in mortgage loans and mortgage-backedsecurities and other fixed-rate debt investments is the risk that bothlong-term and short-term interest rates will increase significantly. If rateswere to increase significantly, the market value of these securities woulddecline and, with respect to mortgage-backed securities, the duration andweighted average life of the investments would increase. We could realize aloss if the securities were sold. At the same time, an increase in short-terminterest rates would increase the amount of interest owed on short termborrowings we may enter into in order to finance the purchase of theseinvestments.

***Our assets include leveraged loans, high yieldsecurities and common and preferred equity securities, each of which hasgreater risks of loss than secured senior loans and, if those losses arerealized, it could adversely affect our earnings, which could adversely affectour cash available for distribution to our stockholders.***

Our assets include leveraged loans, high yieldsecurities and marketable and non-marketable common and preferred equitysecurities, each of which involves a higher degree of risk than senior securedloans. First, the leveraged loans and high yield securities may not be securedby mortgages or liens on assets. Even if secured, these leveraged loans andhigh yield securities may have higher loan-to-value ratios than a seniorsecured loan. Furthermore, our right to payment and the security interest maybe subordinated to the payment rights and security interests of the seniorlender. Therefore, we may be limited in our ability to enforce our rights tocollect these loans and to recover any of the loan balance through aforeclosure of collateral.

Certain of these leveraged loans and high yieldsecurities may have an interest-only payment schedule, with the principalamount remaining outstanding and at risk until the maturity of the loan. Inthis case, a borrower’s ability to repay its loan may be dependent upon aliquidity event that will enable the repayment of the loan.

In addition to the above, numerous other factors mayaffect a company’s ability to repay its loan, including the failure to meet itsbusiness plan, a downturn in its industry or negative economic conditions. Adeterioration in a company’s financial condition and prospects may beaccompanied by deterioration in the collateral for the high yield securities andleveraged loans. Losses on our high yield securities and leveraged loans couldadversely affect our earnings, which could adversely affect cash available fordistribution to our stockholders.

In addition, marketableand non-marketable common and preferred equity securities may also have agreater risk of loss than senior secured loans since such investments aresubordinate to debt of the issuer and are not secured by property underlyingthe investment.

***Prepayments can adversely affect the yields on our investments.***

In the case of residential mortgage loans, there areseldom 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 theprepayments at the lower prevailing interest rates. Conversely, homeowners tendnot to prepay mortgage loans when interest rates increase. Consequently, ownersof the loans are unable to reinvest money that would have otherwise beenreceived from prepayments at the higher prevailing interest rates. Thisvolatility in prepayment rates may affect our ability to maintain targetedamounts of leverage on our mortgage-backed securities portfolio and may resultin reduced earnings or losses for us and negatively affect the cash availablefor distribution to our stockholders.

The yield of our otherassets may be affected by the rate of prepayments differing from ourprojections. Prepayments on debt instruments, where permitted under the debtdocuments, are influenced 

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bychanges in current interest rates and a variety of economic, geographic andother factors beyond our control, and consequently, such prepayment ratescannot be predicted with certainty. If we are unable to invest the proceeds ofsuch prepayments received, the yield on our portfolio will decline. Inaddition, we may acquire assets at a discount or premium and if the asset doesnot repay when expected, our anticipated yield may be impacted. Under certaininterest rate and prepayment scenarios we may fail to recoup fully our cost ofacquisition of certain investments.

***The mortgage loans we invest in and the mortgage loansunderlying the mortgage and asset-backed securities we invest in are subject todelinquency, foreclosure and loss, which could result in losses to us.***

Commercial real estate loans are secured bymultifamily or commercial property and are subject to risks of delinquency andforeclosure, and risks of loss that are greater than similar risks associatedwith loans made on the security of single-family residential property. Theability of a borrower to repay a loan secured by an income-producing propertytypically is dependent primarily upon the successful operation of such propertyrather than upon the existence of independent income or assets of the borrower.If the net operating income of the property is reduced, the borrower’s abilityto repay the loan may be impaired. Net operating income of an income-producingproperty can be affected by, among other things: tenant mix, success of tenantbusinesses, property management decisions, property location and condition,competition from comparable types of properties, changes in laws that increaseoperating expense or limit rents that may be charged, any need to addressenvironmental contamination at the property, the occurrence of any uninsuredcasualty at the property, changes in national, regional or local economicconditions and/or specific industry segments, declines in regional or localreal estate values, declines in regional or local rental or occupancy rates,increases in interest rates, real estate tax rates and other operatingexpenses, changes in governmental rules, regulations and fiscal policies,including environmental legislation, acts of God, terrorism, social unrest andcivil disturbances.

Residential mortgage loans are secured bysingle-family residential property and are subject to risks of delinquency,foreclosure and risks of loss. The ability of a borrower to repay a loansecured by a residential property is dependent upon the income or assets of theborrower. A number of factors, including a general economic downturn, acts ofGod, terrorism, social unrest and civil disturbances, may impair borrowers’abilities to repay their loans. Asset-backed securities are bonds or notesbacked by loans and/or other financial assets. The ability of borrowers torepay these loans or other financial assets is dependent upon the income orassets of these borrowers.

In the event of any default under a mortgage loan helddirectly by us, we will bear a risk of loss of principal to the extent of anydeficiency between the value of the collateral and the principal and accruedinterest of the mortgage loan, which could have a material adverse effect onour cash flow from operations. In the event of the bankruptcy of a mortgageloan borrower, the mortgage loan to such borrower will be deemed to be securedonly to the extent of the value of the underlying collateral at the time ofbankruptcy (as determined by the bankruptcy court), and the lien securing themortgage loan will be subject to the avoidance powers of the bankruptcy trusteeor debtor-in-possession to the extent the lien is unenforceable under statelaw.

Foreclosure of a mortgageloan can be an expensive and lengthy process that could have a substantialnegative effect on our anticipated return on the foreclosed mortgage loan. RMBSevidence interests in or are secured by pools of residential mortgage loans andCMBS evidence interests in or are secured by a single commercial mortgage loanor a pool of commercial real estate loans. Accordingly, the mortgage-backedsecurities we invest in are subject to all of the risks of the underlyingmortgage loans.

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***In the future we may invest in RMBS backed bynon-prime or sub-prime residential mortgage loans which are subject to higherdelinquency, foreclosure and loss rates than prime residential mortgage loanswhich could result in losses to us.***

Non-prime and sub-primeresidential mortgage loans are made to borrowers who have poor or limitedcredit histories and as a result they do not qualify for traditional mortgageproducts. Because of the poor, or lack of, credit history, non-prime andsub-prime borrowers have a materially higher rate of delinquencies andforeclosure and loss rates compared to prime credit quality borrowers. There islimited history with respect to the performance of RMBS backed by residentialmortgage loans over various economic cycles. Investments in non-prime andsub-prime RMBS backed by sub-prime or non-prime residential mortgage loans havehigher risk than investments in RMBS backed by prime residential mortgageloans. We may realize credit losses if we invest in RMBS backed by sub-primeand non-prime residential mortgage loans because such RMBS are subject to allof the risks of the underlying sub-prime and non-prime residential mortgageloans.

***All, or a significant portion, of our investmentportfolio is invested in non-agency RMBS and non-conforming residentialmortgage loans.***

A significant portion of our investment portfolio consistsof non-agency RMBS and non-conforming residential mortgage loans. Agency backedsecurities include RMBS which represent the entire ownership interest in poolsof residential mortgage loans secured by residential real property and areguaranteed as to principal and interest by federally chartered entities such asFannie Mae and Freddie Mac and, in the case of Ginnie Mae, by the U.S.government. Non-agency RMBS are not guaranteed by Fannie Mae, Freddie Mac,Ginnie Mae, or the U.S. government; rather their ratings are assigned bynationally recognized rating agencies such as Moody’s and Standard &Poor’s. Non-agency RMBS have a higher risk of loss than do agency RMBS. We mayrealize credit losses on our investment in non-agency RMBS.

We expect that a materialportion of our investment portfolio of residential mortgage loans and RMBS willconsist of, or in the case of RMBS be backed by, non-conforming residentialmortgage loans. We expect that the residential mortgage loans will benon-conforming due to non-credit factors including, but not limited to, thefact that the (i) mortgage loan amounts exceed the maximum amount for suchmortgage loan to qualify as a conforming mortgage loan, and (ii) underwritingdocumentation for the mortgage loan does not meet the criteria forqualification as a conforming mortgage loan. Non-conforming residentialmortgage loans may have higher risk of delinquency and foreclosure and lossesthan conforming mortgage loans. We may realize credit losses on our investmentin non-conforming residential mortgage loans and RMBS backed by non-conformingresidential mortgage loans.

***Our investment portfolio of residential mortgageloans, residential mortgage-backed securities, commercial real estate loans,and commercial real estate mortgage-backed securities may have materialgeographic concentrations.***

We have materialgeographic concentrations related to investments in residential mortgage loansand RMBS. We expect that over 60% of our investment portfolio of residentialmortgage loans and RMBS will consist of properties located in California, NewYork, New Jersey, Florida, Virginia and Texas. We have material geographicconcentrations related to investments in commercial real estate loans and CMBS.We expect that over 60% of our investment portfolio of commercial real estateloans and CMBS will consist of properties located in New York, California,Arizona, Florida and Hawaii. The risk of foreclosure and losses are likely tobe correlated between our residential and our commercial real estateinvestments and the correlation may be exacerbated by our geographicconcentrations. We may realize credit losses on our residential and commercialreal estate mortgage loan and mortgage-backed securities because of ourgeographic concentrations and the correlation of foreclosure and losses betweenour residential and commercial real estate investments.

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***Our investments in subordinated commercialmortgage-backed securities are generally in the “second loss” position andtherefore subject to losses.***

In general, losses on anasset securing a mortgage loan included in a securitization will be borne firstby the equity holder of the property, then by a cash reserve fund or letter ofcredit, if any, and then by the “first loss” subordinated security holder andthen by the “second loss” subordinated security holder. In the event of defaultand the exhaustion of any equity support, reserve fund, letter of credit andany classes of securities junior to those in which we invest, we will not beable to recover all of our investment in the securities we purchase. Inaddition, if the underlying mortgage portfolio has been overvalued by theoriginator, or if the values subsequently decline and, as a result, lesscollateral is available to satisfy interest and principal payments due on therelated mortgage-backed securities, the securities in which we invest mayeffectively become the “first loss” position behind the more senior securities,which may result in significant losses to us. The prices of lower creditquality securities are generally less sensitive to interest rate changes thanmore highly rated investments, but more sensitive to economic downturns orindividual issuer developments. A projection of an economic downturn, forexample, could cause a decline in the price of lower credit quality securitiesbecause the ability of obligors of mortgages underlying mortgage-backed securitiesto make principal and interest payments may be impaired. In such event,existing credit support in the securitization structure may be insufficient toprotect us against loss of our principal on these securities.

***Our investments in senior unsecured REIT securitiesare subject to specific risks relating to the particular REIT issuer of thesecurities and to the general risks of investing in subordinated real estaterelated securities, which may result in losses to us.***

Our investments in REITsecurities involve special risks relating to the particular REIT issuer of thesecurities, including the financial condition and business outlook of theissuer. REITs generally are required to invest substantially in operating realestate or real estate-related assets and are subject to the inherent risksassociated with real estate-related investments discussed in this Annual Reporton Form 10-K. Our investments in REIT securities are also subject tothe risks described above with respect to mortgage loans and mortgage-backedsecurities and similar risks, including (i) risks of delinquency andforeclosure, and risks of loss in the event thereof, (ii) the dependenceupon the successful operation of and net income from real property, (iii) risksgenerally incident to interests in real property, and (iv) risks that maybe presented by the type and use of a particular commercial property. REITsecurities are generally unsecured and may also be subordinated to otherobligations of the issuer.

We may also invest in REITsecurities that are rated below investment grade. As a result, investments inREIT securities are also subject to risks of: (i) limited liquidity in thesecondary trading market, (ii) substantial market price volatilityresulting from changes in prevailing interest rates, (iii) subordinationto the prior claims of banks and other senior lenders to the issuer, (iv) theoperation of mandatory sinking fund or call/redemption provisions duringperiods of declining interest rates that could cause the issuer to reinvestpremature redemption proceeds in lower yielding assets, (v) thepossibility that earnings of the REIT issuer may be insufficient to meet itsdebt service and dividend obligations and (vi) the decliningcreditworthiness and potential for insolvency of the issuer of such REITsecurities during periods of rising interest rates and economic downturn. Theserisks may adversely affect the value of outstanding REIT securities and theability of the issuers thereof to repay principal and interest or makedistributions to our stockholders.

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***Our dependence on the management of other entities mayadversely affect our business.***

We do not control themanagement, investment decisions or operations of the enterprises in which wehave invested. Management of those enterprises may decide to change the natureof their assets, or management may otherwise change in a manner that is notsatisfactory to us. We have no ability to affect these management decisions andwe may have only limited ability to dispose of our investments.

***Our due diligence may not reveal all of an entity’sliabilities and may not reveal other weaknesses in its business.***

Before making aninvestment in a business entity, we assess the strength and skills of theentity’s management and other factors that we believe will determine the successof the investment. In making the assessment and otherwise conducting duediligence, we rely on the resources available to us and, in some cases, aninvestigation by third parties. This process is particularly important andsubjective with respect to newly organized entities because there may be littleor no information publicly available about the entities. Against thisbackground, there can be no assurance that our due diligence processes willuncover all relevant facts or that any investment will be successful.

***A prolonged economic slowdown, a recession ordeclining real estate values could impair our investments and harm ouroperating results.***

Many of our investmentsmay be susceptible to economic slowdowns or recessions, which could lead tofinancial losses in our investments and a decrease in revenues, net income andassets. An economic slowdown or recession, in addition to other non-economicfactors such as an excess supply of properties, could have a material negativeimpact on the values of both commercial real estate and residential real estateproperties. If residential and/or commercial real estate property valuesdecrease materially it may cause borrowers to default on their mortgages ornegotiate more favorable terms and conditions on their mortgages. As a result,we may realize losses related to foreclosures or to the restructuring of ourmortgage loans, and the mortgage loans we own that back the mortgage-backedsecurities, in our investment portfolio. Unfavorable economic conditions alsocould increase our funding costs, limit our access to the capital markets orresult in a decision by lenders not to extend credit to us. These events couldprevent us from increasing investments and harm our operating results.

***Many of our investments are illiquid and we may not beable to vary our portfolio in response to changes in economic and otherconditions.***

The securities that wepurchase in connection with privately negotiated transactions are notregistered under the relevant securities laws, resulting in a prohibitionagainst their transfer, sale, pledge or other disposition except in atransaction that is exempt from the registration requirements of, or isotherwise in accordance with, those laws. A majority of the mortgage-backedsecurities that we purchase are traded in private, unregistered transactionsand are therefore subject to restrictions on resale or otherwise have noestablished trading market. As a result, our ability to vary our portfolio inresponse to changes in economic and other conditions may be relatively limited.In addition, if we are required to liquidate all or a portion of our portfolioquickly, we may realize significantly less than the value at which we havepreviously recorded our investments. Furthermore, we may face otherrestrictions on our ability to liquidate an investment in a business entity tothe extent that we or our Manager has or could be attributed with materialnon-public information regarding such business entity.

***We are exposed to environmental liabilities withrespect to properties to which we take title.***

In the course ofour business, we may take title to real estate, and, if we do take title, wecould be subject to environmental liabilities with respect to these properties.In such a circumstance, we may be held liable to a governmental entity or tothird parties for property damage, personal injury, and investigation 

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and clean-up costsincurred by these parties in connection with environmental contamination, ormay be required to investigate or clean up hazardous or toxic substances, orchemical releases, at a property. The costs associated with investigation orremediation activities could be substantial. If we ever become subject tosignificant environmental liabilities, our business, financial condition,liquidity and results of operations could be materially and adversely affected.

**Risks Related to our Organization and Structure**

***Our ability to make future distributions may beaffected by, and the amount of such distributions may be reduced by, amongother factors, a change in the return on our investments, our operating expenselevels and certain restrictions imposed by Maryland law.***

As a REIT, we mustdistribute annually at least 90% of our REIT taxable income to our stockholders,determined without regard to the deduction for dividends paid and excluding netcapital gain. Our ability to make and sustain cash distributions is based onmany factors, including the return on our investments, operating expense levelsand certain restrictions imposed by Maryland law. Some of the factors arebeyond our control and a change in any such factor could affect our ability tomake future distributions to our stockholders or reduce the amount of suchdistributions. No assurance can be given as to our ability to makedistributions to our stockholders.

***The terms of our indebtedness may restrict our abilityto make future distributions and impose limitations on our current and futureoperations.***

In June 2005,we entered into a $275 million secured credit facility that expires onJune 15, 2006 with affiliates of J.P. Morgan Securities Inc. and CitigroupGlobal Markets Inc. as agents, joint bookrunners, arrangers and lenders underthat facility. The credit facility contains, and any future indebtedness mayalso contain, a number of restrictive covenants that impose operatingrestrictions on us, including restrictions on our ability to make distributionsto stockholders. The credit facility includes covenants restricting our abilityto:

·       incuror guarantee additional debt, other than secured debt incurred in the course ofour business consistent with current operations;

·       createor incur liens, other than liens relating to secured debt permitted to beincurred;

·       engagein mergers, acquisitions and sales of substantially all of our assets;

·       makeloans, acquisitions or investments, other than investments made in the courseof our business consistent with current operations;

·       paydividends, or make certain redemptions and repurchases, with respect to capitalstock;

·       createlimitations on the ability of our subsidiaries to make dividends ordistributions to us; and

·       engagein transactions with affiliates.

In addition, the facilityalso includes financial covenants, including requirements that we:

·       maintaina consolidated net worth of at least $675 million plus an amount equal to 75%of the proceeds of subsequent equity issuances; and

·       notexceed a leverage ratio of 12.5 to 1.

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With respect to our ability to make distributions toour stockholders, the credit facility limits the amount of distributions we maymake to 100% of our taxable income (which, as defined, is expected at all timesto exceed our calculation of taxable income for REIT compliance purposes, as itis computed without giving effect to net operating loss carryforwards andnonrecurring items, including, but not limited to, stock-based compensationexpense and bad debt write-offs). The facility also prohibits distributions inthe event of certain defaults under that agreement, including: failure to payprincipal or interest under the facility and other material indebtedness as andwhen due; breaches of representations, warranties and covenants; defaults underother material indebtedness; events of insolvency; unpaid judgments in excessof $25 million; certain events relating to benefit plans subject to ERISA; thefailure of our Manager to continue as our Manager and remain affiliated withKKR; our failure to maintain our status as a REIT; and any change in control(such defaults subject in certain cases to grace periods). As a result, theselimitations, and limitations imposed by any future financing agreements, mayadversely affect our ability to make future distributions to our stockholdersor may reduce the amount of such distributions. No assurance can be given as toour ability to make distributions to our stockholders.

In addition, the operatingand financial restrictions in our credit facility and any future financingagreements may adversely affect our ability to engage in our current and futureoperations. Specifically, these restrictions may limit our ability to incuradditional indebtedness, including indebtedness that may be required to meetour short-term liquidity needs such as for the payment of distributions. Abreach of any of the restrictive covenants in our credit facility could resultin a default under the facility. If any such default occurs, in addition to thelimitations on distributions described above, the lenders under the facilitymay elect to declare all outstanding borrowings, together with accrued interestand other fees, to be immediately due and payable, enforce their securityinterest or require us to apply all of our available cash to repay theseborrowings. Those lenders will also have the right in these circumstances toterminate any commitments they have to provide further borrowings.

***Our Investment Company Act exemption limits ourinvestment discretion and loss of the exemption would adversely affect us andnegatively affect the market price of shares of our common stock and theability to make distributions to our stockholders.***

We believe that we currently are not, and we intend tooperate our company so that we will not be regulated as, an investment companyunder the Investment Company Act because we are “primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate.” Specifically, we are required to invest at least 55%of our assets in “qualifying real estate assets”; (that is, mortgage loans,RMBS and CMBS that represent the entire ownership in a pool of mortgage loansand other qualifying interests in real estate), and at least an additional 25% ofour assets in RMBS, CMBS and other “real estate-related assets” or additionalqualifying real estate assets.

We will need to monitor our assets to ensure that wecontinue to satisfy the percentage tests. Although we believe that it shouldnot be difficult to maintain at least 80% of our assets in real estate-relatedassets, the requirement that at least 55% of our assets constitute qualifying realestate assets is more limiting. For example, our ability to invest in privatelyissued mortgage-backed securities for which we do not own all of the securitiesissued and with respect to which we do not obtain the right to foreclose on therelated mortgage loans is limited because these securities do not constitutequalifying investments for the 55% test, even if they are treated morefavorably under the REIT tax rules. Maintaining our exemption from regulation asan investment company under the Investment Company Act limits our ability toinvest in assets that otherwise would meet our investment strategies.

If we fail to qualify forthis exemption, we could not operate our business efficiently under theregulatory scheme imposed on investment companies under the Investment CompanyAct. Accordingly, we could be required to restructure our activities. Forexample, if the market value of our investments in equity securities were toincrease by an amount that resulted in less than 55% of our assets beinginvested 

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inmortgage loans or other qualifying real estate assets, we might have to sellequity securities in order to qualify for exemption under the InvestmentCompany Act. The sale could occur under adverse market conditions. In addition,our Manager may terminate its management agreement with us if we fail toqualify for this exemption.

***Rapid changes in the values of our mortgage-backedsecurities and other real estate related investments may make it more difficultfor us to maintain our REIT status or exemption from the Investment CompanyAct.***

If the market value orincome potential of our mortgage-backed securities and other real estaterelated investments declines as a result of increased interest rates,prepayment rates or other factors, we may need to increase our real estateinvestments and income and/or liquidate our non-qualifying assets in order tomaintain our REIT status or exemption from the Investment Company Act. If thedecline in real estate asset values and /or income occurs quickly, this may beespecially difficult to accomplish. This difficulty may be exacerbated by theilliquid nature of many of our non-real estate assets. We may have to makeinvestment decisions that we otherwise would not make absent the REIT andInvestment Company Act considerations.

***Maryland takeover statutes may prevent or makedifficult a change of control of our company that could be in the interests ofour stockholders.***

Certain provisions of theMaryland General Corporation Law, or MGCL, may have the effect of inhibiting athird party from making a proposal to acquire us or of impeding a change incontrol under circumstances that otherwise could provide the holders of sharesof our common stock with the opportunity to realize a premium over thethen-prevailing market price of such shares. We are subject to the “businesscombination” provisions of the MGCL that, subject to limitations, prohibitcertain business combinations between us and an “interested stockholder”(defined generally as any person who beneficially owns 10% or more of thevoting power of our shares or an affiliate or associate of ours who, at anytime within the two-year period prior to the date in question, was thebeneficial owner of 10% or more of our then outstanding voting shares, or anaffiliate thereof) for five years after the most recent date on which thestockholder becomes an interested stockholder, and thereafter imposes specialappraisal rights and special stockholder voting requirements on thesecombinations. We have, by resolution, however, exempted business combinationsbetween us and any person, provided that such business combination is firstapproved by our board of directors, from the provisions of the MarylandBusiness Combination Act. Consequently, the five-year prohibition and thesupermajority vote requirements will not apply to business combinations betweenus and any person described above if approved by our board of directors. Wehave determined to opt out of the so-called “control share” provisions of theMGCL that provide that “control shares” of a Maryland corporation (defined asshares which, when aggregated with other shares controlled by the stockholder,entitle the stockholder to exercise one of three increasing ranges of votingpower in electing directors) acquired in a “control share acquisition” (definedas the direct or indirect acquisition of ownership or control of “controlshares”) have no voting rights except to the extent approved by ourstockholders by the affirmative vote of at least two-thirds of all the votesentitled to be cast on the matter, excluding all interested shares. We may inthe future, however, elect to become subject to the control share provisions ofthe MGCL. The “unsolicited takeover” provisions of the MGCL permit our board ofdirectors, without stockholder approval and regardless of what is currentlyprovided in our charter or bylaws, to implement takeover defenses, some ofwhich (for example, a classified board) we do not yet have. These provisionsmay have the effect of inhibiting a third party from making an acquisitionproposal for us or of delaying, deferring or preventing a change in control ofour company under the circumstances that otherwise could provide the holders ofour common stock with the opportunity to realize a premium over thethen-current market price. We have no present plans to classify our board.

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***Our charter and bylaws contain provisions that mayinhibit potential acquisition bids that our stockholders may considerfavorable, and the market price of our common stock may be lower as a result.***

Our charter andbylaws contain provisions that may have an anti-takeover effect and inhibit achange in our board of directors. These provisions include the following:

·       Thereare ownership limits and restrictions on transferability and ownership in ourcharter. In order to qualify as a REIT for each taxable year after 2004, notmore than 50% of the value of our outstanding stock may be owned, directly orconstructively, by five or fewer individuals during the second half of anycalendar year and our shares must be beneficially owned by 100 or more personsduring at least 335 days of a taxable year of 12 months or during aproportionate part of a shorter taxable year. To assist us in satisfying thesetests, subject to some exceptions, our charter generally prohibits anystockholder from beneficially or constructively owning more than 9.8% in valueor number of shares, whichever is more restrictive, of any class or series ofour outstanding capital stock. This restriction may:

·        discouragea tender offer or other transactions or a change in the composition of ourboard of directors or control that might involve a premium price for our sharesor otherwise be in the best interests of our stockholders; and

·        resultin shares issued or transferred in violation of such restrictions beingautomatically transferred to a trust for a charitable beneficiary and therebyresulting in a forfeiture of owning the additional shares.

·       Ourcharter permits our board of directors to issue preferred stock with terms thatmay discourage a third party from acquiring us. Our charter permits our boardof directors to amend the charter to increase the total number of authorizedshares of stock or the number of shares of any class or series and to issuepreferred stock, and to classify or reclassify authorized but unissued sharesof our stock having preferences, conversion or other rights, voting powers,restrictions, limitations as to distributions, qualifications, or terms orconditions of redemption as determined by our board. Thus, our board couldauthorize the issuance of preferred stock with terms and conditions that couldhave the effect of discouraging a takeover or other transaction in whichholders of some or a majority of our shares might receive a premium for theirshares over the then-prevailing market price of our shares.

·       Our charter and bylawscontain other possible anti-takeover provisions that may have the effect ofdelaying, deferring or preventing a change in control of us or the removal ofexisting directors and, as a result, could prevent our stockholders from beingpaid a premium for their common stock over the then-prevailing market price.

***Our rights and the rights of our stockholders to takeaction against our directors and officers are limited, which could limit their recoursein the event of actions not in their best interests.***

Our charter limitsthe liability of our directors and officers to us and our stockholders formoney damages, except for liability resulting from:

·       actualreceipt of an improper benefit or profit in money, property or services; or

·       afinal judgment based upon a finding of active and deliberate dishonesty by thedirector or officer that was material to the cause of action adjudicated.

In addition, our charterauthorizes us to obligate our company to indemnify our present and formerdirectors and officers for actions taken by them in those capacities to themaximum extent permitted by Maryland law. Our bylaws require us to indemnifyeach present or former director or officer, to the maximum extent permitted byMaryland law, in the defense of any proceeding to which he or she is made, 

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orthreatened to be made, a party by reason of his or her service to us. Inaddition, we may be obligated to fund the defense costs incurred by ourdirectors and officers.

**TaxRisks**

***Complying with REIT requirements may cause us to forgootherwise attractive opportunities or engage in marginal investmentopportunities.***

To qualify as a REIT forfederal income tax purposes, we must continually satisfy tests concerning,among other things, the sources of our income, the nature and diversificationof our assets, the amounts we distribute to our stockholders and the ownershipof our stock. In order to meet these tests, we may be required to forgoattractive business or investment opportunities or engage in marginal investmentopportunities. Thus, compliance with the REIT requirements may hinder ourability to operate solely on the basis of maximizing profits.

***The prohibited transactions tax will limit our abilityto engage in transactions, including certain methods of securitizing mortgageloans, that would be treated as sales for federal income tax purposes.***

A REIT’s net income from prohibited transactions issubject to a 100% tax. In general, prohibited transactions are sales or otherdispositions of property, other than foreclosure property, but including loans,held primarily for sale to customers in the ordinary course of business. Wemight be subject to this tax if we were able to sell or securitize loans in amanner that was treated as a sale of the loans for federal income tax purposes.Therefore, in order to avoid the prohibited transactions tax, we may choose notto engage in certain sales of loans and may limit the structures we utilize forour securitization transactions even though such sales or structures might otherwisebe beneficial to us.

It may be possible toreduce the impact of the prohibited transaction tax and the holding of assetsnot qualifying as real estate assets for purposes of the REIT asset tests byconducting certain activities, holding non-qualifying REIT assets or engagingin CDO or CLO transactions through our subsidiaries that are taxable REITsubsidiaries, subject to certain limitations as described below. To the extentthat we engage in such activities through taxable REIT subsidiaries, the incomeassociated with such activities may be subject to full corporate income tax.

***We may be subject to the prohibited transactions taxon the loans we sold or will sell to our CLO issuers if the Internal RevenueService challenges our characterization of those transactions.***

We have sold certain loansto our CLO issuers, including KKR Financial CLO 2005-1, Ltd. and KKRFinancial CLO 2005-2, Ltd. We believe that such loans have not been heldby us primarily for sale to customers in the ordinary course of our trade orbusiness, and we do not believe that the prohibited transactions tax applies tothe sales of such loans. There can be no complete assurance, however, that theInternal Revenue Service, or IRS, will not successfully assert a contraryposition, in which case we would be subject to the prohibited transactions taxon the gain from the sale of such loans, which would reduce our distributionsto you.

***Certain of our financing activities may subject us toU.S. federal income tax.***

It is possible thatcertain of our financing activities, such as securitizations, may result intreatment of us or a portion of our assets as a “taxable mortgage pool” forU.S. federal income tax purposes. As a result, although the law on the matteris unclear, we might be taxable at the highest corporate income tax rate on aportion of the income arising from a taxable mortgage pool that is allocable tothe percentage of our stock held by “disqualified organizations,” which aregenerally certain cooperatives, governmental entities and tax-exemptorganizations that are exempt from unrelated business taxable income. We expectthat disqualified organizations will own our stock. Because this tax would beimposed on us, all of our investors, 

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includinginvestors that are not disqualified organizations, would bear a portion of thetax cost associated with the classification of us or a portion of our assets asa taxable mortgage pool. We may, in our discretion, elect to conduct financingactivities that otherwise would result in our treatment as a taxable mortgagepool through KKR TRS Holdings, Inc., our domestic taxable REIT subsidiary.In such case, we would not be subject to the special REIT rules regardingtaxable mortgage pools but taxable income associated with such financingactivities would be subject to federal, state and local income tax.

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

We operate, and intend to continue to operate, in amanner that is intended to cause us to qualify as a REIT for U.S. federalincome tax purposes commencing with our short taxable year ended on December 31,2004. The U.S. federal income tax laws governing REITs are extremely complex,however, and interpretations of the U.S. federal income tax laws governingqualification as a REIT are limited. Qualifying as a REIT requires us to meetvarious tests regarding the nature of our assets and our income, the ownershipof our outstanding stock, and the amount of our distributions on an ongoingbasis. While we have operated and intend to continue to operate so that we willqualify as a REIT, given the highly complex nature of the rules governingREITs, the ongoing importance of factual determinations and the possibility offuture changes in our circumstances, no assurance can be given that we will soqualify for any particular year.

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

***Failure to make required distributions would subjectus to tax, which would reduce the cash available for distribution to ourstockholders.***

In order to qualifyas a REIT, an entity must distribute annually to its stockholders, eachcalendar year, at least 90% of its REIT taxable income, determined withoutregard to the deduction for dividends paid and excluding net capital gain. Tothe extent that a REIT satisfies the 90% distribution requirement, butdistributes less than 100% of its taxable income, it will be subject to federalcorporate income tax on its undistributed income. In addition, a REIT willincur a 4% nondeductible excise tax on the amount, if any, by which itsdistributions in any calendar year are less than the sum of:

·       85%of its REIT ordinary income for that year;

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

·       100%of its undistributed taxable income from prior years.

We intend to pay out our REIT taxable income to ourstockholders in a manner intended to satisfy the 90% distribution requirementand to avoid both corporate income tax and the 4% nondeductible excise tax.There is, however, no requirement that domestic taxable REIT subsidiariesdistribute their after-tax net income to their parent REIT or theirstockholders, and our domestic taxable REIT subsidiary may determine not tomake any distributions to us.

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Our taxable income maysubstantially exceed our net income as determined based on GAAP because, forexample, realized capital losses will be deducted in determining our GAAP netincome, but may not be deductible in computing our taxable income. In addition,we may invest in assets that generate taxable income in excess of economicincome or in advance of the corresponding cash flow from the assets, referredto as phantom income. Although some types of phantom income are excluded indetermining the 90% distribution requirement, we will incur corporate incometax and the 4% nondeductible excise tax with respect to any phantom incomeitems if we do not distribute those items on an annual basis. As a result ofthe foregoing, we may generate less cash flow than taxable income in aparticular year. In that event, we may be required to use cash reserves, incurdebt or liquidate non-cash assets at rates or times that we regard asunfavorable in order to satisfy the distribution requirement and to avoidcorporate income tax and the 4% nondeductible excise tax in that year.

***Ownershiplimitations and certain provisions of our charter may restrict a change ofcontrol in which our stockholders might receive a premium for their shares.***

In order for us to qualifyas a REIT, no more than 50% in value of our outstanding capital stock may beowned, directly or indirectly, by five or fewer individuals during the lasthalf of any calendar year (other than our first REIT taxable year).“Individuals” for this purpose include natural persons, private foundations,some employee benefit plans and trusts, and some charitable trusts. In order topreserve our REIT status, our charter generally prohibits any person fromdirectly or indirectly owning more than 9.8% in value or in number of shares,whichever is more restrictive, of any class or series of the outstanding sharesof our capital stock.

The ownership limitationcould have the effect of discouraging a takeover or other transaction in whichholders of our common stock might receive a premium for their shares over thethen prevailing market price or which holders might believe to be otherwise intheir best interests. Our charter and bylaws and Maryland law contain a numberof additional provisions that also could deter such a transaction.

***Our ownership ofand relationship with our taxable REIT subsidiaries will be limited and afailure to comply with the limits would jeopardize our REIT status and mayresult 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 REITsubsidiary may earn income that would not be qualifying income if earneddirectly by the parent REIT. Both the subsidiary and the REIT must jointlyelect to treat the subsidiary as a taxable REIT subsidiary. A corporation ofwhich a taxable REIT subsidiary directly or indirectly owns more than 35% ofthe voting power or value of the stock will automatically be treated as ataxable REIT subsidiary. Overall, no more than 20% of the value of a REIT’sassets may consist of stock or securities of one or more taxable REITsubsidiaries. A domestic taxable REIT subsidiary will pay federal, state andlocal income tax at regular corporate rates on any income that it earns. Inaddition, the taxable REIT subsidiary rules limit the deductibility ofinterest paid or accrued by a taxable REIT subsidiary to its parent REIT toassure that the taxable REIT subsidiary is subject to an appropriate level ofcorporate taxation. The rules also impose a 100% excise tax on certaintransactions between a taxable REIT subsidiary and its parent REIT that are notconducted on an arm’s-length basis. We can not assure you that we will be ableto comply with the 20% value limitation on ownership of taxable REIT subsidiarystock and securities on an ongoing basis so as to maintain REIT status or toavoid application of the 100% excise tax imposed on certain non-arm’s lengthtransactions. KKR TRS Holdings, Inc., as a domestic taxable REITsubsidiary, pays federal, state and local income tax on its taxable income, andits after-tax net income is available for distribution to us, but is notrequired to be distributed to us.

***Our stockholders mayreceive lower distributions because KKR TRS Holdings, Inc. will likelyretain its earnings.***

As a REIT, we mustdistribute annually at least 90% of our REIT taxable income to ourstockholders, determined without regard to the deduction for dividends paid andexcluding net capital gain. The 

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earningsof a taxable REIT subsidiary are subject to the distribution requirement onlyto the extent they are included in the parent REIT’s income. The earnings ofKKR TRS Holdings, Inc. and any other domestic taxable REIT subsidiary,will be included in our income only to the extent they make distributions tous. There is no requirement that KKR TRS Holdings, Inc. distribute itsearnings to us. In addition, we anticipate that KKR TRS Holdings, Inc.will likely, but is not required to, retain its after-tax earnings, subject toour complying with the rule that no more than 20% of the value of ourassets may consist of stock or securities of one or more taxable REITsubsidiaries. We are, however, required to include in income, on a currentbasis, the earnings of our CDO and CLO issuers that have elected to be taxableREIT subsidiaries, such as KKR Financial CLO 2005-1, Ltd., KKR FinancialCLO 2005-2, Ltd., KKR Financial CDO 2005-1, Ltd. and KKR FinancialCLO 2006-1, Ltd. Because we anticipate that KKR TRS Holdings, Inc.will retain its after-tax earnings, our stockholders may receive lowerdistributions from us.

***We may lose ourREIT status if the IRS successfully challenges our characterization of ourincome from our CLO and CDO issuers.***

We intend to treat certainincome inclusions received with respect to our equity investments in CDOs andCLOs, including equity investments in CLO issuers, such as KKR Financial CLO2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKR Financial CDO2005-1, Ltd. and KKR Financial CLO 2006-1, Ltd., as qualifyingincome for purposes of the 95% gross income test but not the 75% gross incometest. Because there is no clear precedent with respect to the qualification ofsuch income for purposes of the REIT gross income tests, no assurance can begiven that the IRS will not assert a contrary position. In the event that suchincome was determined not to qualify for the 95% gross income test, we could besubject to a penalty tax with respect to such income to the extent it exceeds5% of our gross income or we could fail to qualify as a REIT.

***If our CLO and CDOissuers that are taxable REIT subsidiaries are subject to federal income tax atthe entity level, it would greatly reduce the amounts those entities would haveavailable to distribute to us and that we would have available to pay theircreditors.***

Our CLO and CDO issuersKKR Financial CLO 2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKRFinancial CDO 2005-1, Ltd. and KKR Financial CLO 2006-1, Ltd.,which have elected to be taxable REIT subsidiaries, are organized as CaymanIslands companies. There is a specific exemption from federal income tax fornon-U.S. corporations that restrict their activities in the United States totrading stock and securities (or any activity closely related thereto) fortheir own account whether such trading (or such other activity) is conducted bythe corporation or its employees through a resident broker, commission agent,custodian or other agent. We intend that KKR Financial CLO 2005-1, Ltd.,KKR Financial CLO 2005-2, Ltd., KKR Financial CDO 2005-1, Ltd., KKRFinancial CLO 2006-1, Ltd. and any other of our CLO and CDO issuers thatare taxable REIT subsidiaries will rely on that exemption or otherwise operatein a manner so that they will not be subject to federal income tax on their netincome at the entity level. If the IRS were to succeed in challenging that taxtreatment, it could greatly reduce the amount that those CLO and CDO issuerswould have available to distribute to us and to pay to their creditors.

***The taxation ofcorporate dividends may adversely affect the value of our common stock.***

The Jobs and Growth TaxRelief Reconciliation Act of 2003, among other things, generally reduced to 15%the maximum marginal rate of tax payable by domestic noncorporate taxpayers ondividends received from a regular C corporation for tax years 2003 through2008. This reduced tax rate does not apply, however, to dividends paid todomestic noncorporate taxpayers by a REIT on its stock, except for certainlimited amounts. Although the earnings of a REIT that are distributed to itsstockholders are generally subject to less federal income taxation thanearnings of a non-REIT C corporation that are distributed to its stockholdersnet of corporate level income tax, this legislation could cause domesticnoncorporate 

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investorsto view the stock of regular C corporations as more attractive relative to thestock of a REIT than was the case prior to the enactment of the legislation,because the dividends from regular C corporations are now generally taxed at alower rate while dividends from REITs are generally taxed at the same rate asthe domestic noncorporate taxpayer’s ordinary income. The more favorable taxrates applicable to regular corporate dividends could cause domesticnoncorporate investors to perceive investments in REITs to be relatively lessattractive than investments in the stocks of non-REIT corporations that paydividends, which could adversely affect the value of the stock of REITs,including our common stock.

***Complying with REITrequirements may limit our ability to hedge effectively.***

The existing REITprovisions of the Internal Revenue Code substantially limit our ability tohedge mortgage loans and mortgage-backed securities and related borrowings.Under these provisions, our annual gross income from qualifying hedges of ourborrowings, together with any other income not generated from qualifying realestate assets, is limited to 25% or less of our gross income. In addition, wemust limit our aggregate gross income from non-qualifying hedges, fees andcertain other non-qualifying sources to 5% or less of our annual gross income.As a result, we might in the future have to limit our use of advantageoushedging techniques or implement those hedges through KKR TRS Holdings, Inc.This could increase the cost of our hedging activities or leave us exposed togreater risks associated with changes in interest rates than we would otherwisewant to bear.

***We may be subjectto adverse legislative or regulatory tax changes that could reduce the marketprice of our common stock.***

At any time, the federalincome tax laws or regulations governing REITs or the administrativeinterpretations of those laws or regulations may be amended. We cannot predictwhen or if any new federal income tax law, regulation or administrativeinterpretation, or any amendment to any existing federal income tax law,regulation or administrative interpretation, will be adopted, promulgated orbecome effective and any such law, regulation or interpretation may take effectretroactively. We and our stockholders could be adversely affected by any suchchange in, or any new, federal income tax law, regulation or administrativeinterpretation.

**Item1B.**               UNRESOLVED STAFFCOMMENTS

None.

**Item 2.**                     PROPERTIES

Our principal executiveoffices are located in San Francisco, California and are provided by ourManager in accordance with the Management Agreement.

**Item 3.**                     LEGALPROCEEDINGS

At December 31, 2005,there were no material pending legal proceedings to which we were a party or towhich any of our property was subject.

**Item 4.        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

No matters were submitted to a vote of our stockholdersduring the fourth quarter of 2005.

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**PART II**

**Item 5.**                        MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Market Information**

Ourcommon stock is traded on the NYSE under the symbol “KFN.”  On March 24, 2006, the closing price ofour common stock, as reported on the NYSE, was $22.50. The following table setsforth the high and low sale prices for our common stock for the periodindicated as reported on the NYSE:

| ** **                          | ** ** | **Sales Price** | ** ** |
|-------------------------------------|------------|----------------------|------------|
| **Quarter Ended**              | ** ** | ** **           | ** ** | **High** | ** ** | **Low** | ** ** |
| June 30, 2005 (from  June 24, 2005) |       | 25.07                |       | 24.00 |   |
| September 30,  2005                 |       | 25.01                |       | 21.55 |   |
| December 31, 2005                   |       | 24.18                |       | 20.71 |   |
|                                     |            |                      |            |  |  |  |  |

 

As of March 24, 2006,we had 80,374,061 issued and outstanding shares of common stock that were heldby 19 holders of record. The 19 holders of record include Cede & Co.,which holds shares as nominee for The Depository Trust Company, which itselfholds shares on behalf of the beneficial owners of our common stock.

**Distributions**

We generally need to distribute at least 90% of ournet taxable income each year (subject to certain adjustments) so that we canqualify as a REIT under the Internal Revenue Code. Up to 20% of the value of aREIT’s assets may consist of investments in the securities of one or moretaxable REIT subsidiaries. A domestic taxable REIT subsidiary, such as KKR TRSHoldings, Inc., may retain its taxable income, and its earnings are subject tothe 90% distribution requirement only to the extent the domestic taxable REITsubsidiary actually distributes its earnings to the REIT. However, a foreigntaxable REIT subsidiary, such as KKR Financial CLO 2005-1, Ltd., KKR FinancialCLO 2005-2, Ltd., KKR Financial CDO 2005-1, Ltd., and KKR Financial CLO 2006-1,Ltd., generally is deemed to distribute its earnings to the REIT on an annualbasis for federal income tax purposes, and its earnings are subject to the 90%distribution requirement, regardless of whether it actually distributes itsearnings. 

Subject to the distribution requirements referred toabove, we intend, to the extent practicable, to invest substantially all of theproceeds from repayments, sales and refinancings of our assets in realestate-related assets and other assets. We may, however, under certaincircumstances, make a distribution of capital or of assets.  Such distributions, if any, will be made atthe discretion of our board of directors. Distributions will be made in cash tothe extent that cash is available for distribution.

The actual amount and timing of distributions will beat the discretion of our board of directors and may not be in even amountsthroughout our fiscal year.

Thefollowing table shows the distributions relating to our 2005 fiscal year:

| ** **        | **Record Date** | ** **         | ** ** | ** ** | **Payment  Date** | ** ** | ** ** | ** ** | **Cash Distribution  Declared per Share** | ** ** |
|-------------------|----------------------|--------------------|------------|------------|------------------------|------------|------------|------------|----------------------------------------------------------|------------|
| April 5, 2005     |                 | April  18, 2005    |       | $0.25      |
| June 21, 2005     |                 | August  2, 2005    |       | $0.40      |
| November 16, 2005 |                 | November  30, 2005 |       | $0.32      |
| February 15, 2006 |                 | February 28, 2006  |       | $0.40      |

 

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** **

**Item 6.**                        SELECTEDCONSOLIDATED FINANCIAL DATA

Thefollowing selected financial data is derived from our audited consolidatedfinancial statements for the year ended December 31, 2005 and for the periodended December 31, 2004.  You shouldread the selected financial data together with the more detailed informationcontained in the consolidated financial statements and associated notes and“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” included elsewhere in this Annual Report on Form 10-K.

| ** **                                             | ** ** | **Year Ended  December 31, 2005**                   | ** **                                      | **Period from  August 12, 2004 (inception)  through December 31, 2004** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------------------------|-------------------------------------------------|------------------------------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **(in thousands, except per share data)** | ** **                                      |
| **Consolidated Statement of  Operations Data:**        |       |                                                               |                                            |                                                                                                       |       |   |   |   |   |
| **Net Investment Income:**                             |       |                                                               |                                            |                                                                                                       |       |   |   |   |   |
| Total investment  income                               |       |                                                               | $                                               | 399,929                                                                                                    |       |   |   | $ | 8,122 |   |   |
| Interest expense                                       |       |                                                               | (279,718                                        | )                                                                                                          |       |   | (975 | ) |   |
| Provision for  loan losses                             |       |                                                               | (1,500                                          | )                                                                                                          |       |   | — |   |   |
| Net investment income                                  |       |                                                               | 118,711                                         |                                                                                                       |       |   | 7,147 |   |   |
| **Other income (loss):**                               |       |                                                               |                                            |                                                                                                       |       |   |   |   |   |
| Total other income (loss)                              |       |                                                               | 7,560                                           |                                                                                                       |       |   | (488 | ) |   |
| **Non-investment expenses:**                           |       |                                                               |                                            |                                                                                                       |       |   |   |   |   |
| Related party  management compensation                 |       |                                                               | 50,791                                          |                                                                                                       |       |   | 11,222 |   |   |
| Professional  services                                 |       |                                                               | 4,121                                           |                                                                                                       |       |   | 901 |   |   |
| Loan servicing  expense                                |       |                                                               | 5,143                                           |                                                                                                       |       |   | — |   |   |
| Insurance  expenses                                    |       |                                                               | 975                                             |                                                                                                       |       |   | 335 |   |   |
| Directors  expenses                                    |       |                                                               | 1,071                                           |                                                                                                       |       |   | 341 |   |   |
| Other general and  administrative expenses             |       |                                                               | 5,945                                           |                                                                                                       |       |   | 797 |   |   |
| Total non-investment expenses                          |       |                                                               | 68,046                                          |                                                                                                       |       |   | 13,596 |   |   |
| Net income (loss)  before income tax expense (benefit) |       |                                                               | 58,225                                          |                                                                                                       |       |   | (6,937 | ) |   |
| Income tax  expense (benefit)                          |       |                                                               | 3,144                                           |                                                                                                       |       |   | (228 | ) |   |
| Net income (loss)                                      |       |                                                               | $  55,081                             |                                                                                                       |       |   | $ (6,709 | ) |   |
| **Net income (loss) per common  share:**               |       |                                                               |                                            |                                                                                                       |       |   |   |   |   |
| Basic                                                  |       |                                                               | $       0.93 |                                                                                                       |       |   | $ (0.17 | ) |   |
| Diluted                                                |       |                                                               | $       0.92 |                                                                                                       |       |   | $ (0.17 | ) |   |
| Weighted-average number  of common shares outstanding: |       |                                                               |                                            |                                                                                                       |       |   |   |   |   |
| Basic                                                  |       |                                                               | 58,998                                          |                                                                                                       |       |   | 39,796 |   |   |
| Diluted                                                |       |                                                               | 60,087                                          |                                                                                                       |       |   | 39,796 |   |   |
| Distributions declared  per common share               |       |                                                               | $       0.97 |                                                                                                       |       |   | — |   |   |
|                                                        |            |                                                                    |                                                 |                                                                                                            |            |  |  |  |  |  |  |

 

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| ** **                                                                                                                           | ** ** | **As of December 31, 2005**                    | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated  Balance Sheet Data:**                                                                                                |       |                                                               |       |                                            |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                           |       |                                                               | $          | 16,110                                          |       |   |   | $ | 7,219 |   |   |
| Restricted cash  and cash equivalents                                                                                                |       |                                                               | 80,223     |                                            |       |   | 1,321 |   |   |
| Securities  available-for-sale, $5,910,399 and $1,484,222 pledged as collateral as of  December 31, 2005 and 2004, respectively |       |                                                               | 6,149,506  |                                            |       |   | 1,651,280 |   |   |
| Loans, net of  allowance for loan losses of $1,500 and 0 as of December 31, 2005 and  2004, respectively                        |       |                                                               | 8,846,341  |                                            |       |   | 682,757 |   |   |
| Total assets                                                                                                                         |       |                                                               | 15,290,540 |                                            |       |   | 2,347,340 |   |   |
| Total borrowings                                                                                                                     |       |                                                               | 13,363,838 |                                            |       |   | 1,586,149 |   |   |
| Total liabilities                                                                                                                    |       |                                                               | 13,635,394 |                                            |       |   | 1,590,592 |   |   |
| Total  stockholders’ equity                                                                                                     |       |                                                               | 1,655,146  |                                            |       |   | 756,748 |   |   |
| Book value per share                                                                                                                 |       |                                                               | $          | 20.59                                           |       |   |   | $ | 18.46 |   |   |

 

 

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**Item 7.**                       Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*Except where the context suggests otherwise, the terms“we,” “us” and “our” refer to KKR Financial Corp. and its subsidiaries.*

**Executive Overview**

We are a specialty finance company that invests inmultiple asset classes and uses leverage to generate competitive leveragedrisk-adjusted returns subject to maintaining our status as a REIT, and ourexemption from regulation under the Investment Company Act of 1940, as amended(the “Investment Company Act”). Our objective is to provide competitive returnsto our investors through a combination of dividends and capital appreciation.As part of our multi-asset class strategy, we seek to investopportunistically in those asset classes that can generate competitiveleveraged risk-adjusted returns. Investing in multiple asset classes does not,however, reduce or eliminate many of the risks associated with our investmentportfolio such as geographic concentration risk, asset class concentrationrisk, market risk and credit risk. We currently make investments in thefollowing asset classes: (i) residential mortgage loans and mortgage-backedsecurities; (ii) corporate loans and debt securities; (iii) commercialreal estate loans and debt securities; (iv) asset-backed securities;and (v) marketable and non-marketable equity securities. We also makeopportunistic investments in other asset classes from time to time. Ourinvestment guidelines do not impose any limitations on the amount of ourinvestments in any specific asset class, industry, or investment. Our income isgenerated primarily from the difference between the interest and dividendincome earned on our investments and the cost of our borrowings, plus (i) realizedand unrealized gains and losses our free-standing derivatives, (ii) realizedgains and losses from the sales of investments, and (iii) fee income.

We were organized as a Maryland corporation on July 7,2004 and commenced operations on August 12, 2004 (“Inception”). We aremanaged by KKR Financial Advisors LLC (the “Manager”) pursuant to a managementagreement (the “Management Agreement”). The Manager is an affiliate of KohlbergKravis Roberts & Co. L.P. The Company is taxed as a real estateinvestment trust (“REIT”) and is required to comply with the provisions of theInternal Revenue Code of 1986, as amended (the “Code”) with respect thereto.

We completed our initial private placement of sharesof our common stock on August 12, 2004, which generated net proceeds ofapproximately $755.5 million. We completed our initial public offering (“IPO”)of our common stock on June 29, 2005, which generated net proceeds ofapproximately $848.8 million. In the IPO we sold 37,500,000 shares ofcommon stock at $24.00 per share. The IPO included 28,750 shares of commonstock that were sold by existing stockholders. Our stock is listed on the NewYork Stock Exchange under the symbol “KFN” and began trading on June 24,2005. On June 23, 2005 we effected a reverse stock split of our commonstock at a ratio of one share of common stock for every two shares of commonstock then outstanding. The accompanying consolidated financial statements havebeen adjusted to give effect to the reverse stock split for all periodspresented.

We commenced ourinvestment activities by funding our first investment on September 30,2004. Assuming no material changes in market conditions or our businessstrategy, our objective is to have fully deployed our capital on a fullyleveraged basis by the end of the second quarter of 2006. We used the proceedsfrom our IPO to reduce short-term borrowings and intend to fund futureinvestments principally through borrowings until such time that we fully deployour capital on a fully leveraged basis. Provided that market conditions andmarket opportunities are favorable, we may undertake to raise additional equitycapital subsequent to the deployment of our existing capital and leverage.

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***Cash Distributions to Stockholders***

Our total distributionsfor 2005, including a distribution for the fourth quarter that was declared on February 1,2006, totaled $84.5 million.

***Investment Portfolio***

As of December 31,2005, our investment portfolio totaled $15.0 billion, representing an increaseof 552.2% from $2.3 billion as of December 31, 2004. As of December 31,2005, our investment portfolio primarily consisted of residential mortgageloans and securities totaling $12.0 billion, corporate loans and securitiestotaling $2.4 billion, commercial real estate loans and securities totaling$604.0 million, and marketable equity securities consisting of preferred andcommon stock totaling $47.0 million. In addition, our investment portfolioincludes investments in non-marketable equity securities totaling $52.5 millionas of December 31, 2005.

***Funding Activities***

We have expanded oursources of funding during 2005. During 2005 we completed our IPO whichgenerated net proceeds of $848.8 million. Consistent with 2004, our primarysource of borrowed funding continues to be from repurchase agreements whichtotaled $9.8 billion, or 73% of our totaling borrowings as of December 31,2005. Additionally, we closed two separate $1 billion collateralized loantransactions during 2005 from which $1.5 billion of senior secured notes wereissued. We also closed our first asset-backed commercial paper conduit during2005, from which we had $2.0 billion of secured liquidity notes outstanding asof December 31, 2005. We also entered into a $275 million 364-day securedrevolving credit facility from which we had borrowed $54.0 million as of December 31,2005.

**Critical Accounting Policies**

Our consolidated financialstatements are prepared by management in conformity with accounting principlesgenerally accepted in the United States of America (“GAAP”). Our significantaccounting policies are fundamental to understanding our financial conditionand results of operations because some of these policies require that we makesignificant estimates and assumptions that may affect the value of our assetsor liabilities and financial results. We believe that certain of our policiesare critical because they require us to make difficult, subjective, and complexjudgments about matters that are inherently uncertain. We have reviewed thesecritical accounting policies with our board of directors and our audit committee.

***Revenue Recognition***

We account for interest income on our investmentsusing the effective yield method. For investments purchased at par, theeffective yield is the contractual coupon rate on the investment. Unamortizedpremiums and discounts on non-residential mortgage-backed securities arerecognized in interest income over the contractual life, adjusted for actualprepayments, of the securities using the effective interest method. Forsecurities representing beneficial interests in securitizations (i.e.,residential mortgage-backed securities), unamortized premiums and discounts arerecognized over the contractual life, adjusted for estimated prepayments andestimated credit losses of the securities using the effective interest method.Actual prepayment and credit loss experience is reviewed quarterly andeffective yields are recalculated when differences arise between prepaymentsand credit losses originally anticipated compared to amounts actually receivedplus anticipated future prepayments.

Interest income on loans includes interest at statedcoupon rates adjusted for accretion of purchase discounts and the amortizationof purchase premiums. For corporate and commercial real estate loans,unamortized premiums and discounts are recognized in interest income over thecontractual life, adjusted 

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for actual prepayments, ofthe loans using the effective interest method. For residential mortgage loans,unamortized premiums and discounts are recognized over the contractual life,adjusted for estimated prepayments using the effective interest method.

As of December 31,2005, unamortized purchase premiums and unaccreted purchase discounts on ourinvestment portfolio totaled $42.8 million and $49.5 million,respectively.

***Share-Based Payment***

We account for share-based compensation issuedto members of our board of directors and our Manager using the fair value basedmethodology in accordance with SFAS No. 123(R). We do not have anyemployees, although we believe that members of our board of directors aredeemed to be employees for purposes of interpreting and applying accountingprinciples relating to share-based compensation. We record ascompensation costs the restricted common stock that we issued to members of ourboard of directors at estimated fair value as of the grant date and we amortizethe cost into expense over the three-year vesting period using thestraight-line method. We recorded compensation costs for restricted commonstock and common stock options that we issued to our Manager at estimated fairvalue as of the grant date and we remeasure the amount on subsequent reportingdates to the extent that the restricted common stock and/or common stockoptions have not vested. Unvested restricted common stock is valued usingobservable secondary market prices. Unvested common stock options are valuedusing the Black-Scholes model and assumptions based on observable marketdata for comparable companies. We amortize compensation expense related to therestricted common stock and common stock options that we granted to our Managerusing the graded vesting attribution method in accordance with SFAS No. 123(R).

Because we remeasure theamount of compensation costs associated with the unvested restricted commonstock and unvested common stock options that we issued to our Manager as ofeach reporting period, our share-based compensation expense reported inour consolidated financial statements will change based on the estimated fairvalue of our common stock and this may result in earnings volatility. For theyear ended December 31, 2005, share-based compensation totaled $30.2million. As of December 31, 2005, substantially all of the non-vestedcommon stock options and restricted common stock issued that is subject to SFASNo. 123(R) is subject to remeasurement. As of December 31, 2005,a $1 increase in the price of our common stock increases our future share-basedcompensation expense by approximately $3.0 million and this future share-basedcompensation expense would be recognized over the remaining vesting periods ofour outstanding restricted common stock and common stock options. As of December 31,2005, future unamortized share-based compensation totaled $41.7 million, ofwhich $27.8 million, $11.2 million, and $2.7 million will be recognized in2006, 2007, and 2008.

***Classifications of Investment Securities***

Our investments insecurities are classified as “available-for-sale” and are recorded and reportedon our consolidated balance sheet at estimated fair value with unrealized gainsand losses reported in accumulated other comprehensive income (loss) on ourconsolidated balance sheet. We designate and classify our investments insecurities as available-for-sale because we may sell them prior to theirmaturity date. We do not designate and classify our investments in securitiesas trading securities because we do not intend to trade them or sell them inthe near term. We determine the estimated fair value of our investments insecurities using quoted market prices, dealers who make markets in thesecurities, and third-party pricing services. When we sell an investmentsecurity, the realized net gain or loss on the sale of the security is includedin our consolidated statements of operations and we specifically identify thesecurity that was sold and its specific cost basis when we compute the netrealized gain or loss.

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***Accounting for Derivative Instruments and HedgingActivities***

Our policies permit us to enter into derivativecontracts, including interest rate swaps, interest rate corridors, interestrate swaptions, interest rate straddles, and credit and currency derivatives.We use interest rate derivatives to manage interest rate risk. We formallydocument relationships between our hedging instruments and our hedgedtransactions as of the inception date of the hedge, including (i) our riskmanagement objective and hedge strategy, (ii) the risk that we arehedging, (iii) the hedging instruments, consisting of the derivativeinstruments that comprise the hedge, (iv) the hedged transaction,consisting of the recognized or forecasted transaction that we are hedging, (v) themethod that we used to assess the hedge’s effectiveness on a retrospective andprospective basis, and (vi) the methodology that we will use to measurehedge ineffectiveness. On the date that we enter into an interest ratederivative transaction we designate the interest rate derivative as (i) ahedge of a forecasted transaction or of the variability of cash flows relatedto a recognized liability (“cash flow hedge”) or (ii) held for trading (“tradinginstrument”). Our interest rate swaptions are undesignated derivative contractsand accounted for as trading instruments, and our interest rate swap andinterest rate corridor contracts are designated and accounted for as cash flowhedges. As of December 31, 2005, we have not entered into any interestrate derivative transactions that are designated as a hedge of the estimatedfair value of a recognized asset or liability or of an unrecognized firmcommitment (“fair value hedge”).

For our cash flow hedges, we record and report ourhedge instruments at estimated fair value on our balance sheet and record thechanges in their estimated fair value in accumulated other comprehensive income(loss). Changes in these amounts are reclassified to our statements ofoperations over the effective hedge period as the hedged item affects earnings.Our cash flow hedge instrument must be “highly effective,” as defined in SFAS No. 133,in achieving offsetting changes in the hedged item attributable to the riskthat we are hedging in order to qualify for initial and recurring hedgeaccounting treatment. We recognize any hedge ineffectiveness related to ourcash flow hedges as a component of interest expense during the period in whichit occurs. Prior to the end of the specified cash flow hedge period, theeffective portion of our hedge instrument gains and losses is recorded in otheraccumulated comprehensive income (loss). The estimated fair values of our hedgeinstruments are based on market prices provided by dealers that make markets insuch hedging instruments. For our cash flow hedges, we are required todiscontinue hedge accounting prospectively when we determine that (i) thehedging instruments are no longer effective in offsetting changes in the cashflows of a hedged transaction, (ii) we determine that it is no longerprobable that the forecasted transaction will occur, or (iii) thedesignation of the hedging instruments as hedges is no longer permitted orappropriate.

We are not required toaccount for our derivative contracts using hedge accounting as described above.If we decide not to designate the derivative contracts as hedges or if we failto fulfill the criteria necessary to qualify for hedge accounting, then thechanges in the estimated fair values of our derivative contracts would affectperiodic earnings immediately potentially resulting in the increased volatilityof our earnings. The qualification requirements for hedge accounting arecomplex and as a result we must evaluate, designate, and thoroughly documenteach hedge transaction at inception and perform ineffectiveness analysis andprepare related documentation at inception and on a recurring basis thereafter.As of December 31, 2005, the estimated fair value of our derivativestotaled $57.4 million. As of December 31, 2005, the estimated fair valueof interest rate derivatives accounted for as cash flow hedges totaledapproximately $55.6 million and the net change in unrealized gain on such cashflow hedges totaled approximately $45.6 million, which amount is recorded inaccumulated other comprehensive income in the consolidated statements ofchanges in stockholders’ equity. During 2005 we purchased an interest ratecorridor for a cost of $10.0 million which has an effective date of March 25,2006 and a maturity date of January 25, 2009. The purchase price of thecorridor will be amortized in accordance with SFAS No. 133 ImplementationIssue No. G20, *Cash Flow Hedges:Assessing and Measuring the Effectiveness of a Purchase Option Used in a CashFlow Hedge*, and will result in an increase in interest expense of$2.2 million, $3.8 

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million,and $4.0 million in 2006, 2007, and 2008, respectively, exclusive of anypayments we receive in connection with the corridor, if any.

***Impairments***

We evaluate our investmentportfolio for impairment as of each quarter end or more frequently if we becomeaware of any material information that would lead us to believe that aninvestment may be impaired. We evaluate whether the investment is consideredimpaired and whether the impairment is other-than-temporary. If we make adetermination that the impairment is other-than-temporary, we recognize animpairment loss equal to the difference between the amortized cost basis andthe estimated fair value of the investment. We consider many factors indetermining whether the impairment of an investment is other-than-temporary,including but not limited to the length of time the security has had a declinein estimated fair value below its amortized cost, the amount of the loss, theintent and our financial ability to hold the investment for a period of timesufficient for a recovery in its estimated fair value, recent events specificto the issuer or industry, external credit ratings and recent downgrades insuch ratings. As of December 31, 2005, we had aggregate unrealized losseson our securities classified as available-for-sale of approximately $45.3****million, which if not recovered may result in therecognition of future losses. As of December 31, 2005, $36.9 million ofthe aggregate unrealized losses were associated with investments rated Aaa byMoody’s and AAA by Standard and Poor’s.

***Allowance for Loan Losses***

We maintain an allowance for loan losses at a levelthat we believe is adequate based on an evaluation of known and inherent risksrelated to our loan investments. When determining the adequacy of the allowancefor loan losses we consider historical and industry loss experience, economicconditions and trends, the estimated fair values of our loans, credit qualitytrends and other factors that we determine are relevant. To estimate theallowance for loan losses, we first identify impaired loans. Loans aregenerally evaluated for impairment individually, but loans purchased on apooled basis with relatively smaller balances and substantially similarcharacteristics may be evaluated collectively for impairment. We consider a loanto be impaired when, based on current information and events, we believe it isprobable that we will be unable to collect all amounts due to us based on thecontractual terms of the loan. When a loan is impaired, the allowance for loanlosses is increased by the amount of the excess of the amortized cost basis ofthe loan over its estimated fair value. Increases in the allowance for loanlosses are recognized in our results of operations as a provision for loanlosses. When we make a determination that some or all of a loan isuncollectible, we charge-off or write-down the loan and the allowance for loanlosses is reduced.

Currently, our residential mortgage loans arerelatively homogeneous and the adequacy of the allowance for loan losses isbased on a review of relevant factors including, but not limited to, estimatedfair values, industry statistics, current economic conditions, loan portfoliocomposition, delinquency trends and credit losses realized to-date onunderlying loans. Because our mortgage loan portfolio is not seasoned, wereview these factors for similar portfolios of mortgage loans that havecomparable FICO® scores, loan-to-value ratios (“LTV”), loan balances, andgeographical diversity and that were originated through similar mortgage bankingchannels, and we use this information when assessing the adequacy of theallowance for loan losses. Our investments in commercial real estate mortgageloans and corporate loans are not homogeneous and we individually review eachof the loans for impairments and use relevant information in our analysis,including current estimated fair values, current valuation multiples, projectedoperating cash flow and projected liquidation cash flows.

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**Recent Accounting Pronouncements**

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*, which replaces APBOpinion No. 20, *Accounting Changes*and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements—An Amendment of APB Opinion No. 28*.SFAS No. 154 provides guidance on the accounting for and reporting ofaccounting changes and error corrections. It establishes retrospectiveapplication, or the latest practicable date, as the required method forreporting a change in accounting principle and the reporting of a correction ofan error. SFAS No. 154 is required to be adopted by the Company in thefirst quarter of 2006. We do not expect that the adoption of SFAS No. 154will have a material effect on our consolidated financial statements.

In November 2005, the FASB issued FASB StaffPosition FAS 115-1 and FAS 124-1, *The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments*(“FSP 115-1”), which provides guidance on determining when investments incertain debt and equity securities are considered impaired, whether thatimpairment is other-than-temporary, and on measuring such impairment loss. FSP115-1 also includes accounting considerations subsequent to therecognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized as other-than-temporaryimpairments. FSP 115-1 is required to be adopted by the Company in thefirst quarter of 2006. We do not expect that the adoption of FSP 115-1will have a material effect on our consolidated financial statements.

In February 2006, theFASB issued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments*. Key provisions of SFAS No. 155include: (1) a broad fair value measurement option for certain hybridfinancial instruments that contain an embedded derivative that would otherwiserequire bifurcation; (2) clarification that only the simplest separationsof interest payments and principal payments qualify for the exception affordedto interest-only strips and principal-only strips from derivative accountingunder paragraph 14 of SFAS No. 133 (thereby narrowing such exception); (3) arequirement that beneficial interests in securitized financial assets beanalyzed to determine whether they are freestanding derivatives or whether theyare hybrid instruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. We do not expect that the adoption of SFAS No. 155will have a material effect on our consolidated financial statements.

**Results of Operations**

**Yearended December 31, 2005 compared to period from August 12, 2004(Inception) through December 31, 2004**

*Summary*

Our net income for theyear ended December 31, 2005 totaled $55.1 million (or $0.92 perdiluted share) as compared to a net loss of $6.7 million (or $0.17 per dilutedshare) for the period from inception through December 31, 2004. During theyear ended December 31, 2005, our investment portfolio increased by 552.2%from $2.3 billion as of December 31, 2004 to $15.0 billion as of December 31,2005.

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*Net InvestmentIncome*

The following tablepresents the components of our net investment income for the year ended December 31,2005 and for period from August 12, 2004 (inception) through December 31,2004:

**ComparativeNet Investment Income Components (Amounts in thousands)**

| ** **                                                            | ** ** | **For the year ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (inception) through  December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Investment Income:                                                    |       |                                                               |       |                                                                                                                     |       |   |   |   |   |
| Residential mortgage loans and securities interest  income            |       |                                                               | $          | 281,985                                                                                                                  |       |   |   | $ | 2,041 |   |   |
| Corporate loans and securities interest income                        |       |                                                               | 95,852     |                                                                                                                     |       |   | 1,895 |   |   |
| Commercial real estate loans and securities interest  income          |       |                                                               | 19,284     |                                                                                                                     |       |   | 689 |   |   |
| Other interest income                                                 |       |                                                               | 3,335      |                                                                                                                     |       |   | 3,197 |   |   |
| Common and preferred stock dividend income                            |       |                                                               | 3,421      |                                                                                                                     |       |   | 296 |   |   |
| Net premium/discount (amortization) accretion                         |       |                                                               | (3,948     | )                                                                                                                        |       |   | 4 |   |   |
| Total investment income                                               |       |                                                               | 399,929    |                                                                                                                     |       |   | 8,122 |   |   |
| Interest Expense:                                                     |       |                                                               |       |                                                                                                                     |       |   |   |   |   |
| Repurchase agreements interest expense                                |       |                                                               | 237,985    |                                                                                                                     |       |   | 975 |   |   |
| Collateralized loan obligation senior secured notes  interest expense |       |                                                               | 28,269     |                                                                                                                     |       |   | — |   |   |
| Asset-backed secured liquidity notes interest  expense                |       |                                                               | 8,065      |                                                                                                                     |       |   | — |   |   |
| Secured revolving credit facility interest expense                    |       |                                                               | 245        |                                                                                                                     |       |   | — |   |   |
| Demand loan interest expense                                          |       |                                                               | 1,430      |                                                                                                                     |       |   | — |   |   |
| Other interest expense                                                |       |                                                               | 803        |                                                                                                                     |       |   | — |   |   |
| Interest rate swaps interest expense, net                             |       |                                                               | 2,921      |                                                                                                                     |       |   | — |   |   |
| Total interest expense                                                |       |                                                               | (279,718   | )                                                                                                                        |       |   | (975 | ) |   |
| Provision for loan losses                                             |       |                                                               | (1,500     | )                                                                                                                        |       |   | — |   |   |
| Net investment income                                                 |       |                                                               | $          | 118,711                                                                                                                  |       |   |   | $ | 7,147 |   |   |

 

As presented in the tableabove, our net investment income increased by $111.6 million in 2005 comparedto 2004. The change from 2004 to 2005 is primarily attributable to the increasein our investment portfolio during 2005. As of December 31, 2005, we held$15.0 billion in investments in loans and securities available-for-saleand had borrowings outstanding totaling $13.4 billion. Additionally, werecorded a provision for loans losses of $1.5 million during the year ended December 31,2005. In comparison, as of December 31, 2004, investments in loans andsecurities available-for-sale totaled $2.3 billion and borrowings outstandingtotaled $1.6 billion. In addition, the results for 2004 reflect less than afull year since we commenced operations on August 12, 2004.

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*Other Income*

The following tablepresents the components of other income for the year ended December 31,2005 and the period from August 12, 2004 (inception) through December 31,2004:

**ComparativeOther Income Components (Amounts in thousands)**

| ** **                                                                     | ** ** | **For the year ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (inception) through  December 31, 2004** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Net realized and unrealized  gain (loss) on derivatives and foreign exchange:  |       |                                                               |       |                                                                                                                     |       |   |   |   |   |
| Interest rate swaptions                                                        |       |                                                               | $          | (424                                                                                                                     | )          |   |   | $ | (28 | ) |   |
| Interest rate swaps                                                            |       |                                                               | 758        |                                                                                                                     |       |   | — |   |   |
| Credit default swaps                                                           |       |                                                               | (259       | )                                                                                                                        |       |   | (417 | ) |   |
| Total rate of return swaps                                                     |       |                                                               | 755        |                                                                                                                     |       |   | — |   |   |
| Foreign exchange contracts                                                     |       |                                                               | 2,211      |                                                                                                                     |       |   | (125 | ) |   |
| Foreign exchange translation                                                   |       |                                                               | (2,928     | )                                                                                                                        |       |   | — |   |   |
| Total realized and unrealized gain (loss) on  derivatives and foreign exchange |       |                                                               | 113        |                                                                                                                     |       |   | (570 | ) |   |
| Net realized gain  on investments                                              |       |                                                               | 4,117      |                                                                                                                     |       |   | 75 |   |   |
| Fee and other  income                                                          |       |                                                               | 3,330      |                                                                                                                     |       |   | 7 |   |   |
| Total other income (loss)                                                      |       |                                                               | $          | 7,560                                                                                                                    |       |   |   | $ | (488 | ) |   |

 

As presented in the tableabove, other income totaled $7.6 million for the year ended December 31,2005 as compared to a loss of $0.5 million for the period from August 12,2004 (inception) through December 31, 2004. The increase in total otherincome from prior period is primarily attributable to increased investmentactivity in 2005 and as previously noted, since we commenced operations on August 12,2004, 2004 results reflect less than a full year.

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*Non-InvestmentExpenses*

The following tablepresents the components of non-investment expenses for the year ended December 31,2005 and for period from August 12, 2004 (inception) through December 31,2004:

**ComparativeNon-Investment Expense Components (Amounts in thousands)**

| ** **                              | ** ** | **For the year ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (inception) through  December 31, 2004** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Related party management  compensation: |       |                                                               |       |                                                                                                                     |       |   |   |   |   |
| Base management fees                    |       |                                                               | $          | 20,982                                                                                                                   |       |   |   | $ | 5,112 |   |   |
| Share-based compensation                |       |                                                               | 29,809     |                                                                                                                     |       |   | 6,110 |   |   |
| Related party  management compensation  |       |                                                               | 50,791     |                                                                                                                     |       |   | 11,222 |   |   |
| Professional  services                  |       |                                                               | 4,121      |                                                                                                                     |       |   | 901 |   |   |
| Loan servicing  expense                 |       |                                                               | 5,143      |                                                                                                                     |       |   | — |   |   |
| Insurance expense                       |       |                                                               | 975        |                                                                                                                     |       |   | 335 |   |   |
| Directors  expenses                     |       |                                                               | 1,071      |                                                                                                                     |       |   | 341 |   |   |
| General and  administrative expenses    |       |                                                               | 5,945      |                                                                                                                     |       |   | 797 |   |   |
| Total non-investment  expenses          |       |                                                               | $          | 68,046                                                                                                                   |       |   |   | $ | 13,596 |   |   |

 

As presented in the table above, our non-investmentexpenses increased by $54.5 million for the year ended December 31, 2005compared to the period from August 12, 2004 (inception) through December 31,2004. The increase in non-investment expenses from prior period is primarilyattributable to our growth in 2005 and as previously noted; we commencedoperations on August 12, 2004 and therefore 2004 results reflect less thana full year of operations. The significant components of non-investment expenseare described below.

Management compensation to related parties consists ofbase management fees payable to our Manager pursuant to the ManagementAgreement, and share-based compensation related to restricted commonstock and common stock options granted to our Manager. The base management feepayable was calculated in accordance with the Management Agreement and is basedon an annual rate of 1.75% times “equity” as defined in the ManagementAgreement. Our Manager is also entitled to an incentive fee provided that ourquarterly “net income,” as defined in the Management Agreement, before theincentive fee exceeds a defined return hurdle. We did not exceed the applicablehurdle during either the year ended December 31, 2005 or the period from August 12,2004 (inception) through December 31, 2004; accordingly, no incentive feewas earned or paid.

General and administrativeexpenses consist of expenses incurred by our Manager on our behalf that arereimbursable to our Manager pursuant to the Management Agreement. We expectthat our general and administrative expenses will continue to increase as ourinvestment portfolio continues to increase. Professional services expenses consistof legal, accounting and other professional services. We expect that ourrecurring professional services expenses will continue to increase as ourinvestment portfolio continues to increase. Loan servicing expense consists offixed servicing fees paid to third-party servicers. We expect that loanservicing expense will continue to increase as our residential loan portfoliocontinues to increase.

*Income TaxProvision*

We have elected to be taxed as a REIT and intend tocontinue to comply with the provisions of the Code with respect thereto.Accordingly, we are not subject to federal income tax to the extent that ourdistributions to stockholders satisfy the REIT requirements and certain asset,income and ownership tests, 

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and recordkeepingrequirements are fulfilled. Even though we qualify for federal taxation as aREIT, we may be subject to some amount of federal, state, local and foreigntaxes based on our taxable income and we have provided for such taxes in theamount of $0.5 million for the year ended December 31, 2005.

KKR TRS Holdings, Inc., our domestic taxable REITsubsidiary, is taxed as a regular subchapter C corporation under the provisionsof the Code. KKR TRS Holdings, Inc. was formed to make, from time to time,certain investments that would not be REIT qualifying investments if madedirectly by us, and to earn income that would not be REIT qualifying income ifearned directly by us. For the year ended December 31, 2005, KKR TRSHoldings, Inc. had pre-tax net income of $6.0 million and theprovision for income taxes totaled $2.6 million. As of December 31, 2005,KKR TRS Holdings, Inc. had an income tax liability of $2.4 million.

KKR Financial CLO 2005-1, Ltd., KKRFinancial CLO 2005-2, Ltd., KKR Financial CDO 2005-1, Ltd., andKKR Financial CLO 2006-1, Ltd., are foreign taxable REIT subsidiariesthat were established to facilitate securitization transactions structured assecured financing transactions. They are organized as exempted companiesincorporated with limited liability under the laws of the Cayman Islands, andare generally exempt from federal and state income tax at the corporate entitylevel because they restrict their activities in the United States to trading instock and securities for their own account. Therefore, despite their status astaxable REIT subsidiaries, they generally will not be subject to corporateincome tax on their earnings, and no provisions for income taxes for the yearended December 31, 2005 were recorded; however, we will generally berequired to include their current taxable income in our calculation of REITtaxable income.

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**Financial Condition**

**Summary**

The tables below summarize the carrying value,amortized cost, and estimated fair value of our investment portfolio as of December 31,2005 and 2004, classified by interest rate type. Carrying value is the valuethat investments are recorded on our consolidated balance sheets and isestimated fair value for securities and amortized cost for loans held forinvestment and the lower of amortized cost or market value for loans held forsale. Estimated fair values set forth in the tables below are based on dealerquotes and/or nationally recognized pricing services.

The table below summarizesour investment portfolio as of December 31, 2005 classified by interestrate type:

**InvestmentPortfolio(Amounts in thousands)**

| ** **                              | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  %  by Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|----------------------------------------------------|------------|
| **Floating Rate:**                      |       |                    |       |                    |       |                           |       |                                               |       |   |   |   |   |   |   |
| Residential ARM  Loans                  |       |                    | $          | 2,175,929               |       |                           |       | $                                                  | 2,175,929  |   |   | $ | 2,163,932 |   |   | 14.5 | % |   |
| Residential ARM  Securities             |       |                    | 3,375,434  |                    |       |                           | 3,369,763  |                                               |       | 3,375,434 |   |   | 22.6 |   |   |
| Corporate Loans                         |       |                    | 1,872,277  |                    |       |                           | 1,872,277  |                                               |       | 1,886,372 |   |   | 12.6 |   |   |
| Corporate Debt  Securities              |       |                    | 279,280    |                    |       |                           | 277,030    |                                               |       | 279,280 |   |   | 1.9 |   |   |
| Commercial Real  Estate Loans           |       |                    | 486,096    |                    |       |                           | 486,096    |                                               |       | 485,775 |   |   | 3.3 |   |   |
| Commercial Real  Estate Debt Securities |       |                    | 63,032     |                    |       |                           | 63,168     |                                               |       | 63,032 |   |   | 0.4 |   |   |
| Total Floating Rate                     |       |                    | 8,252,048  |                    |       |                           | 8,244,263  |                                               |       | 8,253,825 |   |   | 55.3 |   |   |
| **Hybrid Rate:**                        |       |                    |       |                    |       |                           |       |                                               |       |   |   |   |   |   |   |
| Residential  Hybrid ARM Loans           |       |                    | 4,252,893  |                    |       |                           | 4,252,893  |                                               |       | 4,224,234 |   |   | 28.3 |   |   |
| Residential  Hybrid ARM Securities      |       |                    | 2,162,404  |                    |       |                           | 2,197,020  |                                               |       | 2,162,404 |   |   | 14.5 |   |   |
| Total Hybrid Rate                       |       |                    | 6,415,297  |                    |       |                           | 6,449,913  |                                               |       | 6,386,638 |   |   | 42.8 |   |   |
| **Fixed Rate:**                         |       |                    |       |                    |       |                           |       |                                               |       |   |   |   |   |   |   |
| Corporate Loans                         |       |                    | 25,000     |                    |       |                           | 25,000     |                                               |       | 25,000 |   |   | 0.2 |   |   |
| Corporate Debt  Securities              |       |                    | 202,474    |                    |       |                           | 202,748    |                                               |       | 202,474 |   |   | 1.4 |   |   |
| Commercial Real  Estate Loans           |       |                    | 35,646     |                    |       |                           | 35,646     |                                               |       | 35,657 |   |   | 0.2 |   |   |
| Commercial Real  Estate Debt Securities |       |                    | 19,880     |                    |       |                           | 19,833     |                                               |       | 19,880 |   |   | 0.1 |   |   |
| Total Fixed Rate                        |       |                    | 283,000    |                    |       |                           | 283,227    |                                               |       | 283,011 |   |   | 1.9 |   |   |
| Total                                   |       |                    | $          | 14,950,345              |       |                           |       | $                                                  | 14,977,403 |   |   | $ | 14,923,474 |   |   | 100.0 | % |   |

 

The table above excludes marketable equity securitieswith a fair value of $47.0 million and amortized cost of $47.2 million, andnon-marketable equity securities with a fair value of $52.5 million andamortized cost of $52.5 million as of December 31, 2005. As of December 31,2005, the aggregate amortized cost value of the Company’s investment portfolioexceeded the aggregate fair value of its portfolio by $54.1 million and,as of the same date, the Company had unrealized gains totaling $45.6 millionrelated to its cash flow hedges, as defined under SFAS No. 133. As ofDecember 31, 2005, the aggregate net unamortized purchase discount relatedto the Company’s investment portfolio was $6.7 million.

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The table below summarizesour investment portfolio as of December 31, 2004, classified by interestrate type:

**InvestmentPortfolio(Amounts in thousands)**

| ** **                              | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  %  by Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|----------------------------------------------------|------------|
| **Floating Rate:**                      |       |                    |       |                    |       |                           |       |                                               |       |   |   |   |   |   |   |
| Residential ARM  Loans                  |       |                    | $          | 233,120                 |       |                           |       | $                                                  | 233,120    |   |   | $ | 233,877 |   |   | 10.1 | % |   |
| Residential ARM  Securities             |       |                    | 1,582,711  |                    |       |                           | 1,581,824  |                                               |       | 1,582,711 |   |   | 68.7 |   |   |
| Corporate Loans                         |       |                    | 394,387    |                    |       |                           | 394,387    |                                               |       | 396,873 |   |   | 17.2 |   |   |
| Corporate Debt  Securities              |       |                    | 16,814     |                    |       |                           | 16,578     |                                               |       | 16,814 |   |   | 0.7 |   |   |
| Commercial Real  Estate Loans           |       |                    | 50,000     |                    |       |                           | 50,000     |                                               |       | 50,250 |   |   | 2.2 |   |   |
| Commercial Real  Estate Debt Securities |       |                    | 12,007     |                    |       |                           | 12,000     |                                               |       | 12,007 |   |   | 0.5 |   |   |
| Total Floating Rate                     |       |                    | 2,289,039  |                    |       |                           | 2,287,909  |                                               |       | 2,292,532 |   |   | 99.4 |   |   |
| **Hybrid Rate:**                        |       |                    |       |                    |       |                           |       |                                               |       |   |   |   |   |   |   |
| Residential  Hybrid ARM Loans           |       |                    | —     |                    |       |                           | —     |                                               |       | — |   |   | — |   |   |
| Residential  Hybrid ARM Securities      |       |                    | —     |                    |       |                           | —     |                                               |       | — |   |   | — |   |   |
| Total Hybrid Rate                       |       |                    | —     |                    |       |                           | —     |                                               |       | — |   |   | — |   |   |
| **Fixed Rate:**                         |       |                    |       |                    |       |                           |       |                                               |       |   |   |   |   |   |   |
| Corporate Loans                         |       |                    | 5,250      |                    |       |                           | 5,250      |                                               |       | 5,289 |   |   | 0.2 |   |   |
| Corporate Debt  Securities              |       |                    | 8,086      |                    |       |                           | 8,000      |                                               |       | 8,086 |   |   | 0.4 |   |   |
| Total Fixed Rate                        |       |                    | 13,336     |                    |       |                           | 13,250     |                                               |       | 13,375 |   |   | 0.6 |   |   |
| Total                                   |       |                    | $          | 2,302,375               |       |                           |       | $                                                  | 2,301,159  |   |   | $ | 2,305,907 |   |   | 100.0 | % |   |

 

The table above excludespreferred stock with an estimated fair value of $31.7 million and anamortized cost of $31.1 million as of December 31, 2004. As of December 31,2004, the aggregate net unamortized purchase discount related to our investmentportfolio was $5.2 million.

**Asset Quality**

*2005 Hurricanes*

During the third quarterof 2005, the Gulf Coast region of the United States was severely impacted byHurricanes Katrina and Rita. Our principal source of exposure to the hurricanesis through properties collateralizing our residential mortgage loans. As of December 31,2005, no losses have been realized from the effects of the hurricanes. Based onour expectation that losses will be realized from the hurricanes, we haverecorded a provision for loan losses of $1.3 million related to our residentialmortgage loan portfolio. We do not believe that the hurricanes have had amaterial impact on our corporate or commercial real estate loan portfolio.

*Asset QualityReview*

We evaluate and monitorthe asset quality of our investment portfolio by performing detailed creditreviews and by monitoring key credit statistics and trends. We monitor thecredit rating of our investment portfolio through the use of both Moody’sInvestors Services, Inc., or Moody’s, and Standard & Poor’sRatings Service, or Standard & Poor’s ratings, and Moody’s weightedaverage rating factor, or WARF. WARF is the quantitative equivalent of Moody’straditional rating categories (e.g., Ba1, Ba2, etc.) and is used by Moody’s inits credit enhancement calculations for securitization transactions. Bymonitoring both Moody’s and Standard & Poor’s ratings and Moody’s WARFwe can monitor trends and changes in the 

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creditratings of our investment portfolio. For residential mortgage loans andresidential mortgage-backed securities we monitor the credit quality ofthe underlying borrowers by monitoring trends and changes in the underlying borrowers’FICO® scores. Borrowers with lower FICO® scores default more frequently thanborrowers with higher FICO® scores. For residential and commercial real estatemortgage loans and mortgage-backed securities we monitor trends andchanges in LTV ratios. Increases in LTV ratios are likely to result in higherrealized credit losses when borrowers default.

*SecuritiesAvailable-for-Sale*

The following tablesummarizes the amortized cost of our debt investment securities portfolio byinvestment class stratified by Moody’s and Standard & Poor’s ratingscategory as of December 31, 2005:

**InvestmentSecurities(Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       |       | $          | 3,310,370                            |       |                                         | $          | 2,134,333                       |       | $                                                      | —     |      |       | $ | — |   |   | $ | 5,444,703 |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | 21,497     |                                 |       | 28,274                                       |       | —                          |       |                                                   | —     |      |       | 49,771 |   |
| A1/A+ through  A3/A-         |       |       | 15,498     |                                 |       | 17,916                                       |       | —                          |       |                                                   | —     |      |       | 33,414 |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | 10,998     |                                 |       | 8,566                                        |       | 41,537                          |       |                                                   | 38,491     |      |       | 99,592 |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 4,714      |                                 |       | 3,622                                        |       | 150,719                         |       |                                                   | 25,000     |      |       | 184,055 |   |
| B1/B+ through  B3/B-         |       |       | 2,856      |                                 |       | 2,064                                        |       | 153,483                         |       |                                                   | —     |      |       | 158,403 |   |
| Caa1/CCC+ and  lower         |       |       | —     |                                 |       | —                                       |       | 107,357                         |       |                                                   | 8,337      |      |       | 115,694 |   |
| Non-Rated                    |       |       | 3,830      |                                 |       | 2,245                                        |       | 26,682                          |       |                                                   | 11,173     |      |       | 43,930 |   |
| Total                        |       |       | $          | 3,369,763                            |       |                                         | $          | 2,197,020                       |       | $                                                      | 479,778    |      |       | $ | 83,001 |   |   | $ | 6,129,562 |   |

 

The following table showsthe amortized cost of our debt investment securities portfolio by investmentclass stratified by Moody’s and Standard & Poor’s ratings category asof December 31, 2004:

**InvestmentSecurities(Amounts in thousands)**

| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       |                                 | $          | 1,522,749                                    |       |                            |       | $                                                      | —     |      |       |   | $ | — |   |   |   | $ | — |   |   | $ | 1,522,749 |   |
| Aa1/AA+ through  Aa3/AA-     |       |                                 | 21,500     |                                         |       |                            | —     |                                                   |       |      | —     |   |   |   | — |   |   | 21,500 |   |
| A1/A+ through  A3/A-         |       |                                 | 15,500     |                                         |       |                            | —     |                                                   |       |      | —     |   |   |   | — |   |   | 15,500 |   |
| Baa1/BBB+ through  Baa3/BBB- |       |                                 | 11,000     |                                         |       |                            | —     |                                                   |       |      | 5,000      |   |   |   | 12,000 |   |   | 28,000 |   |
| Ba1/BB+ through  Ba3/BB-     |       |                                 | 4,579      |                                         |       |                            | —     |                                                   |       |      | 7,000      |   |   |   | — |   |   | 11,579 |   |
| B1/B+ through  B3/B-         |       |                                 | 2,695      |                                         |       |                            | —     |                                                   |       |      | 7,578      |   |   |   | — |   |   | 10,273 |   |
| Caa1/CCC+ and  lower         |       |                                 | —     |                                         |       |                            | —     |                                                   |       |      | 5,000      |   |   |   | — |   |   | 5,000 |   |
| Non-Rated                    |       |                                 | 3,801      |                                         |       |                            | —     |                                                   |       |      | —     |   |   |   | — |   |   | 3,801 |   |
| Total                        |       |                                 | $          | 1,581,824                                    |       |                            |       | $                                                      | —     |      |       |   | $ | 24,578 |   |   |   | $ | 12,000 |   |   | $ | 1,618,402 |   |

 

*Loans*

Our residential mortgage loan portfolio totaled $6.4billion as of December 31, 2005 and $0.2 billion as of December 31,2004. As of December 31, 2005 and December 31, 2004, we did not ownany real estate properties that we had acquired through foreclosure. Theweighted average original FICO® score and 

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weighted average originalLTV ratio of our residential ARM loan portfolio were 737****and67.2%, respectively, as of December 31, 2005. As of December 31,2004, the weighted average original FICO® score and weighted average LTV ratioof our residential ARM loan portfolio were 744 and 63.5%, respectively. As of December 31,2005, our residential ARM loan investment portfolio did not have any materialconcentrations in investor owned properties, multi-unit housing properties,condominium properties and/or cooperative properties. A material portion of ourresidential ARM loans are non-conforming mortgage loans, not due to creditquality, but because the mortgage loans have balances that exceed the maximumbalances necessary to qualify as a conforming mortgage loan.

During the year ended December 31, 2005, werecorded a provision for loan losses of $1.5 million related to our residentialmortgage loan portfolio. For the year ended December 31, 2005 we had nocharge-offs and none of our residential mortgage loans were in foreclosure. Ofthe $1.5 million provision for loan losses recorded during the year ended December 31,2005, $1.3 million was recorded during the third quarter of 2005 in response toHurricanes Katrina and Rita. As of December 31, 2005, no losses have beenrealized on mortgage loans located in the regions affected by the hurricanes.As of December 31, 2005, we believe that we are adequately reserved forlosses inherent in our residential mortgage loan portfolio as of that date. Asof December 31, 2004, we had not recorded an allowance for loan losses forour residential mortgage loan portfolio.

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of December 31, 2005 (dollar amounts in thousands):

| **Delinquency Status** | ** ** | ** ** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       |       | 82         |                          |       |                      | $          | 31,049 |   |   |
| 60 to 89 days               |       |       | 11         |                          |       |                      | 3,427      |   |   |
| 90 days or more             |       |       | 6          |                          |       |                      | 1,589      |   |   |
| In foreclosure              |       |       | —     |                          |       |                      | —     |   |   |
| Total                       |       |       | 99         |                          |       |                      | $          | 36,065 |   |   |

 

No residential mortgage loans were delinquent as of December 31,2004.

Our corporate loan portfolio totaled $1.9 billionas of December 31, 2005 and $0.4 billion as of December 31,2004. Our corporate loan portfolio consists of debt obligations ofcorporations, partnerships and other entities in the form of first and secondlien loans, mezzanine loans and bridge loans. As of December 31, 2005 andDecember 31, 2004, none of the corporate loans in our investment portfoliowere delinquent. We performed an allowance for loan losses analysis as ofDecember 31, 2005 and December 31, 2004, and we have made thedetermination that no allowance for loan losses was required for our corporateloan portfolio as of December 31, 2005 or December 31, 2004.

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The following tablesummarizes the amortized cost of our corporate loans portfolio stratified byMoody’s and Standard & Poor’s ratings category as of December 31,2005 and December 31, 2004:

**CorporateLoans(Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **As of  December 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|------------------------------|------------|------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       |       | $          | —                                      |       |                                        |       | $ | — |   |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | —     |                                        |       |                                        | —     |   |   |
| A1/A+ through  A3/A-         |       |       | —     |                                        |       |                                        | —     |   |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | 2,000      |                                        |       |                                        | —     |   |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 638,693    |                                        |       |                                        | 216,822    |   |   |
| B1/B+ through  B3/B-         |       |       | 1,127,400  |                                        |       |                                        | 182,815    |   |   |
| Caa1/CCC+ and  lower         |       |       | 21,410     |                                        |       |                                        | —     |   |   |
| Non-Rated                    |       |       | 107,774    |                                        |       |                                        | —     |   |   |
| Total                        |       |       | $          | 1,897,277                                   |       |                                        |       | $ | 399,637 |   |   |

 

Our commercial real estate loan portfolio totaled$521.7 million and $50.0 million as of December 31, 2005 and December 31,2004, respectively. Our commercial real estate loan portfolio consists ofsenior, mezzanine, and bridge loans that are secured by commercial real estate.As of December 31, 2005 none of the commercial real estate loans in ourinvestment portfolio were delinquent.

We performed an allowance for loan losses analysis asof December 31, 2005 and December 31, 2004, and we have made thedetermination that no allowance for loan losses was required for our commercialreal estate loan portfolio as of December 31, 2005 or December 31,2004.

The following tablesummarizes the amortized cost of our commercial real estate loans portfoliostratified by Moody’s and Standard & Poor’s ratings category as ofDecember 31, 2005 and December 31, 2004:

**CommercialReal Estate Loans(Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **As of  December 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|------------------------------|------------|------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       |       | $          | —                                      |       |                                        |       | $ | — |   |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | —     |                                        |       |                                        | —     |   |   |
| A1/A+ through  A3/A-         |       |       | —     |                                        |       |                                        | —     |   |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | —     |                                        |       |                                        | —     |   |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 60,929     |                                        |       |                                        | —     |   |   |
| B1/B+ through  B3/B-         |       |       | 74,853     |                                        |       |                                        | —     |   |   |
| Caa1/CCC+ and  lower         |       |       | 50,000     |                                        |       |                                        | 50,000     |   |   |
| Non-Rated                    |       |       | 335,960    |                                        |       |                                        | —     |   |   |
| Total                        |       |       | $          | 521,742                                     |       |                                        |       | $ | 50,000 |   |   |

 

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**Asset Repricing Characteristics**

*Summary*

The table below summarizesthe repricing characteristics of our investment portfolio as of December 31,2005 and December 31, 2004, and is classified by interest rate type:

**InvestmentPortfolio(Amounts in thousands)**

| ** **                              | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                         | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| Floating Rate:                          |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential ARM  Loans                  |       |                                            | $          | 2,175,929                                       |       |   |   | 14.5 | % |   |   | $ | 233,120 |   |   |   | 10.1 | % |   |
| Residential ARM  Securities             |       |                                            | 3,369,763  |                                            |       |   | 22.5 |   |   |   | 1,581,824 |   |   |   | 68.8 |   |   |
| Corporate Loans                         |       |                                            | 1,872,277  |                                            |       |   | 12.5 |   |   |   | 394,387 |   |   |   | 17.1 |   |   |
| Corporate Debt  Securities              |       |                                            | 277,030    |                                            |       |   | 1.9 |   |   |   | 16,578 |   |   |   | 0.7 |   |   |
| Commercial Real  Estate Loans           |       |                                            | 486,096    |                                            |       |   | 3.2 |   |   |   | 50,000 |   |   |   | 2.2 |   |   |
| Commercial Real  Estate Debt Securities |       |                                            | 63,168     |                                            |       |   | 0.4 |   |   |   | 12,000 |   |   |   | 0.5 |   |   |
| Total Floating Rate                     |       |                                            | 8,244,263  |                                            |       |   | 55.0 |   |   |   | 2,287,909 |   |   |   | 99.4 |   |   |
| Hybrid Rate:                            |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential  Hybrid ARM Loans           |       |                                            | 4,252,893  |                                            |       |   | 28.4 |   |   |   | — |   |   |   | — |   |   |
| Residential  Hybrid ARM Securities      |       |                                            | 2,197,020  |                                            |       |   | 14.7 |   |   |   | — |   |   |   | — |   |   |
| Total Hybrid Rate                       |       |                                            | 6,449,913  |                                            |       |   | 43.1 |   |   |   | — |   |   |   | — |   |   |
| Fixed Rate:                             |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate Loans                         |       |                                            | 25,000     |                                            |       |   | 0.2 |   |   |   | 5,250 |   |   |   | 0.2 |   |   |
| Corporate Debt  Securities              |       |                                            | 202,748    |                                            |       |   | 1.4 |   |   |   | 8,000 |   |   |   | 0.4 |   |   |
| Commercial Real  Estate Loans           |       |                                            | 35,646     |                                            |       |   | 0.2 |   |   |   | — |   |   |   | — |   |   |
| Commercial Real  Estate Debt Securities |       |                                            | 19,833     |                                            |       |   | 0.1 |   |   |   | — |   |   |   | — |   |   |
| Total Fixed Rate                        |       |                                            | 283,227    |                                            |       |   | 1.9 |   |   |   | 13,250 |   |   |   | 0.6 |   |   |
| Total                                   |       |                                            | $          | 14,977,403                                      |       |   |   | 100.0 | % |   |   | $ | 2,301,159 |   |   |   | 100.0 | % |   |

 

The table above excludesmarketable equity securities with a fair value of $47.0 million and amortizedcost of $47.2 million, and non-marketable equity securities with a fair valueof $52.5 million and amortized cost of $52.5 million as of December 31,2005.

*Residential ARMSecurities*

As of December 31,2005, substantially all of our residential ARM securities were comprised ofone-month LIBOR floating rate securities that reprice monthly and were subjectto a weighted average maximum net interest rate of 11.63% which is materiallyabove the then current weighted average net coupon of 4.62%. Our repricing riskon our portfolio of residential ARM securities increases materially if interestrates continue to increase to a level where the weighted average coupon rateapproaches the weighted average maximum net interest rate of 11.63% because theweighted average coupon is subject to a maximum rate, or cap, which isapproximately equal to the weighted average maximum interest rate of 11.63%.

*Residential HybridARM Securities*

As of December 31,2005, all of our residential hybrid ARM securities had underlying mortgageloans that were originated as 5/1 hybrid ARM loans. As of December 31,2005, we owned 100% of the securities that represent 100% of the beneficialinterest in the 5/1 hybrid ARM loans underlying our portfolio of 

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hybridARM securities. When the underlying residential hybrid mortgage loans convertfrom fixed rate to floating rate, the underlying mortgage loans will have aninterest rate based on one-year LIBOR or one-year constant maturity treasuryindex, or CMT, depending upon if the underlying mortgage loan is a LIBOR-or CMT-based mortgage loan. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and (ii) theweighted average post-roll date net margin. As of December 31, 2005 all ofthe mortgage loans underlying our residential hybrid ARM securities had apost-roll date index reset frequency of one year with 35% based on six-month orone-year LIBOR and 65% based on one-year CMT. Our repricing risk on ourportfolio of residential hybrid ARM loans increases materially if interestrates continue to increase to a level where, subsequent to the roll date, theweighted average net coupon rate approaches the weighted average post roll datemaximum net interest rate of 9.43% because the post roll date weighted averagenet coupon is subject to a maximum rate, or cap, which is approximately equalto the weighted average post roll date maximum net interest rate or 9.43%. Theweighted average coupon on the portfolio of residential hybrid securities is4.13% as of December 31, 2005. As of December 31, 2005, the weightedaverage months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 36. We did not own any residential hybridARM securities as of December 31, 2004.

*Residential ARMLoans*

As of December 31,2005, all of our residential ARM loans were comprised of one-month LIBORfloating rate loans that reprice monthly and were subject to a weighted averagemaximum net interest rate of****11.9%, whichis well above the then current weighted average net coupon of****5.05%. Our repricing risk on our portfolio of residentialARM loans increases materially if interest rates continue to increase to alevel where the weighted average net coupon rate approaches the weightedaverage maximum interest rate of 11.9% because the weighted average coupon issubject to a maximum rate, or cap, which is approximately equal to the weightedaverage maximum interest rate of 11.9%.

*Residential HybridARM Loans*

As of December 31,2005, all of our residential hybrid ARM loans were originated as either 3/1 or5/1 hybrid ARM loans. When the loans convert from fixed rate to floating rate,the underlying mortgage loans will have an interest rate based on one-yearLIBOR or one-year CMT. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and (ii) theweighted average post-roll date net margin. As of December 31, 2005 all ofour residential hybrid ARM loans had a post-roll date index reset frequency ofone-year with 43% based on six-month or one-year LIBOR and 57% based onone-year CMT. Our repricing risk on our portfolio of residential hybrid ARMloans increases materially if interest rates continue to increase to a levelwhere, subsequent to the roll date, the weighted average net coupon rateapproaches the weighted average post-roll date maximum net interest rateof 10.1%****because the post-roll date weightedaverage net coupon is subject to a maximum rate, or cap, which is approximatelyequal to the weighted average post-roll date maximum net interest rate or10.13%. The weighted average net coupon on the portfolio of residential hybridloans is 4.85% as of December 31, 2005. As of December 31, 2005, theweighted average months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 44. We did not own any residential hybridARM loans as of December 31, 2004.

*Corporate Loans andSecurities*

All of our floating rate corporate loans andsecurities have index reset frequencies of less than twelve months with themajority of the loans resetting at least quarterly. The weighted average couponon our 

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floating rate corporateloans and securities was 7.12% and 4.93% as of December 31, 2005 and December 31,2004, respectively. As of December 31, 2005 and December 31, 2004,the weighted average years to maturity of our floating rate corporate loans andsecurities was 6.3 years and 6.0 years, respectively.

As of December 31,2005, our fixed rate corporate debt securities had a weighted average coupon of10.58% and a weighted average years to maturity of****8.7years, as compared to 7.49% and 7.3 years, respectively, as of December 31,2004.

*Commercial RealEstate Loans and Securities*

All of our floating rate commercial real estate loansand securities have index reset frequencies of less than twelve months. Theweighted average coupon on our floating rate commercial real estate loans andsecurities was 8.70% and 5.60% as of December 31, 2005 and December 31,2004, respectively. As of December 31, 2005 and December 31, 2004,the weighted average years to maturity of our floating rate commercial realestate loans and securities was****3.7** **years and 5.7 years, respectively.

As of December 31,2005, our fixed rate commercial real estate loans and securities had a weightedaverage coupon of 7.95% and a weighted average years to maturity of7.7 years. We had no investments in fixed rate commercial real estateloans or securities as of December 31, 2004.

**Portfolio Purchases**

We purchased $15.6 billion par amount ofinvestments during the year ended December 31, 2005. For the period from August 12,2004 (inception) through December 31, 2004 we purchased $2.3 billion paramount of investments.

The table below summarizes our investment portfoliopurchases for the periods indicated and includes the par amount, or faceamount, of the securities and loans that were purchased:

**InvestmentPortfolio Purchases(Amounts in thousands)**

| ** **                              | ** ** | **Year ended  December 31, 2005** | ** ** | **Period from  August 12, 2004  (inception) through  December 31, 2004** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Par Amount**                              | ** ** | **%**                                                                                             | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                             | ** ** | ** **                                       | ** ** | ** **                                                                                        |       | ** ** | ** ** | ** ** | ** ** |
| Residential ARM  Securities             |       | $                                                | 2,918,325  |                                                                                              | 18.7       | % | $ | 1,604,594 |   | 69.1 | % |
| Residential  Hybrid ARM Securities      |       | 2,935,532                                        |       | 18.8                                                                                              |       | — |   | — |   |
| Corporate Debt  Securities              |       | 557,820                                          |       | 3.6                                                                                               |       | 24,500 |   | 1.1 |   |
| Commercial Real  Estate Debt Securities |       | 85,671                                           |       | 0.6                                                                                               |       | 12,000 |   | 0.5 |   |
| Total Securities Principal Balance      |       | 6,497,348                                        |       | 41.7                                                                                              |       | 1,641,094 |   | 70.7 |   |
| Loans:                                  |       |                                             |       |                                                                                              |       |   |   |   |   |
| Residential ARM  Loans                  |       | 2,172,771                                        |       | 13.9                                                                                              |       | 229,855 |   | 9.9 |   |
| Residential  Hybrid ARM Loans           |       | 4,547,632                                        |       | 29.2                                                                                              |       | — |   | — |   |
| Corporate Loans                         |       | 1,870,849                                        |       | 12.0                                                                                              |       | 400,774 |   | 17.3 |   |
| Commercial Real  Estate Loans           |       | 493,129                                          |       | 3.2                                                                                               |       | 50,000 |   | 2.1 |   |
| Total Loans Principal Balance           |       | 9,084,381                                        |       | 58.3                                                                                              |       | 680,629 |   | 29.3 |   |
| Grand Total  Principal Balance          |       | $                                                | 15,581,729 |                                                                                              | 100.0      | % | $ | 2,321,723 |   | 100.0 | % |

 

The table above excludes purchases of $28.3****million (purchase cost) of marketable equity securitiesduring the year ended December 31, 2005 and $31.2 million during theperiod from August 12, 2004 (inception) through December 31, 2004.Purchases of $52.5 million of non-marketable equity securities are 

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also excluded from thetable above. The investments in non-marketable securities consist of fourprivate equity transactions where we co-invested with one or more privateequity funds affiliated with KKR on a pari passu basis.

During the year ended December 31, 2005, wepurchased $5.9****billion of securities inconnection with****five securitization transactionsbacked by $4.5 billion of residential hybrid ARM loans and $1.4 billion ofresidential ARM loans. In each of the five securitization transactions, wepurchased all of the securities issued, including the subordinate classes.Included in the $5.9 billion of securities purchased, were $0.4 billion ofloans we contributed to the securitization transactions, resulting in a netpurchase of $5.5 billion of securities. Of the $5.9 billion of securitiespurchased, approximately 96% were rated AAA by Standard & Poor’s. Eachof the special-purpose entities that issued the securities are not consideredqualifying special-purpose entities as defined by SFAS No. 140 and aretreated as variable interest entities under FIN 46R. We have determined that weare the primary beneficiary of each of the special purpose entities that issuedthe securities; accordingly, we have recorded these investments as loans andnot securities on our Consolidated Balance Sheet.

In addition to the five securitization transactionspreviously described, during September 2005, we securitized $959.2 millionof residential ARM loans and retained all of the securities issued in thesecuritization transaction, including the subordinate classes. While weretained all of the securities from this transaction, the loans transferred inthis securitization are owned by a special purpose entity and the loans are notavailable to us, our creditors or our stockholders. Of the $959.2 million ofsecurities issued, approximately $908.8 million, or 95%, were rated AAA byStandard & Poor’s. Even though we transferred the loans to a separatebankruptcy-remote legal entity, we did not account for the transaction as asale as the securitization transaction did not meet the criteria for salestreatment under SFAS No. 140. Accordingly, we did not record a gain orloss in connection with the securitization transaction and have accounted forthe transferred assets as loans on our Consolidated Balance Sheet.

During January 2006, we invested $40 million in aseries of  corporate floating rate noteswhich were rated BB by Standard and Poor’s and were issued by an unaffiliatedthird party. KKR Financial Advisors II, LLC (“KFA II”), a wholly-ownedsubsidiary of our Manager, is the collateral manager for the unaffiliated thirdparty in connection with this corporate floating rate note transaction.

**Stockholders’ Equity**

Our stockholders’ equity at December 31, 2005 andDecember 31, 2004 totaled $1.7 billion and $756.7 million,respectively. Included in our stockholders’ equity as of December 31, 2005and December 31, 2004, is accumulated other comprehensive income totaling****$18.3 million and $1.7 million, respectively.

Our average stockholders’ equity and return on averagestockholders’ equity for the year ended December 31, 2005 were $1.3 billionand 4.5%, respectively. Return on average stockholders’ equity is defined as netincome divided by weighted average stockholders’ equity. Our weighted averagestockholders’ equity and return on average equity for the period fromAugust 12, 2004, the date we commenced operations, throughDecember 31, 2004, were $756.1 million and (2.3%), respectively. Ourweighted average stockholders’ equity for the period from July 7, 2004(date of incorporation) through December 31, 2004, is not consideredmeaningful, as substantive operations did not begin until August 12, 2004.

Our book value per fully diluted share as ofDecember 31, 2005 and December 31, 2004 was $20.59 and $18.46,respectively, and is computed based on 80,374,061****and41,004,492 shares issued and outstanding as December 31, 2005 andDecember 31, 2004, respectively.

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On April 5, 2005, our board of directorsauthorized a cash distribution of $0.25 per share to stockholders of record onApril 5, 2005. This distribution was paid on April 18, 2005. Theaggregate amount of the distribution, $10.3 million, exceeded net incomefor the quarter by $4.2 million.

On June 21, 2005, ourboard of directors declared a cash distribution for the quarter endedJune 30, 2005 on our common stock to stockholders of record onJune 21, 2005. On July 21, 2005, our board of directors set theamount of the cash distribution at $0.40 per share, paid on August 2,2005. The aggregate amount of the distribution**,**$16.4 million, exceeded net income for the quarter by $7.9 million.

On November 2, 2005,our board of directors declared a cash distribution of $0.32 per share forthe quarter ended September 30, 2005 to stockholders of record onNovember 16, 2005. The distribution was paid on November 30, 2005.The aggregate amount of the distribution, $25.7 million, exceeded netincome for the quarter by $7.3 million.

On February 1, 2006,our board of directors declared a cash distribution of $0.40 per share forthe quarter ended December 31, 2005 to stockholders of record onFebruary 15, 2006. The distribution was paid on February 28, 2006.The aggregate amount of the distribution,****$32.1 million,exceeded net income for the quarter by $10.1 million.

**Liquidityand Capital Resources**

We manage our liquiditywith the intention of providing the continuing ability to fund our operationsand fulfill our commitments on a timely and cost-effective basis. As ofDecember 31, 2005 and December 31, 2004, we had unencumbered assetstotaling $810.4** **million and$580.0 million, respectively, consisting of unpledged investments, cashand cash equivalents, and other assets. We also have the ability to borrowadditional amounts related to certain of our encumbered assets.

We believe that our liquidity level is in excess ofthat necessary to sufficiently enable us to meet our anticipated liquidityrequirements including, but not limited to, funding our purchases ofinvestments, required cash payments and additional collateral under ourborrowings and our derivative transactions, required periodic cash paymentsrelated to our derivative transactions, payment of fees and expenses related toour Management Agreement, payment of general corporate expenses and generalcorporate capital expenditures and distributions to our stockholders. As ofDecember 31, 2005, we owed our Manager $3.7 million for the paymentof management fees and reimbursable expenses pursuant to the ManagementAgreement.

An increase in prepayment rates substantially aboveour expectations could, however, cause a temporary liquidity shortfall due tothe timing of the necessary margin calls on the financing arrangements and theactual receipt of the cash related to principal paydowns. In addition, anymaterial event that impacts capital markets participants may also impair ourability to access additional liquidity. If our cash resources are at any timeinsufficient to satisfy our liquidity requirements, we may have to sell assetsor issue debt or additional equity securities.

Our ability to meet our long-term liquidity andcapital resource requirements may be subject to our ability to obtainadditional debt financing and equity capital. We may increase our capitalresources through offerings of equity securities (possibly including commonstock and one or more classes of preferred stock), commercial paper,medium-term notes, securitization transactions structured as securedfinancings, and senior or subordinated notes. If we are unable to renew,replace or expand our sources of financing on substantially similar terms, itmay have an adverse effect on our business and results of operations. Uponliquidation, holders of our debt securities and lenders with respect to otherborrowings, as well as any holders of preferred stock that we may issue in thefuture, will receive a distribution of our available assets prior to holders ofour common stock.

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The decisions by investorsand lenders to enter into equity and financing transactions with us will dependupon a number of factors, including our historical and projected financialperformance, compliance with the terms of our current credit arrangements,industry and market trends, the availability of capital and our investors’ andlenders’ policies and rates applicable thereto, and the relative attractivenessof alternative investment or lending opportunities.

Any material event thatimpacts capital markets participants may also impair our ability to accessadditional liquidity and we may therefore be required to sell some or all ofour portfolio investments in order to maintain sufficient liquidity. Such salesmay be at prices lower than the carrying value of our pledged investments,which would result in our recognition of such losses and reduced income.

In order to continue toqualify as a REIT and to eliminate corporate income taxes on the income wedistribute to our stockholders, we are required to distribute 90% to 100% ofour ordinary taxable income and short-term capital gains on an annual basis.

**Sources of Funds**

Our sources of fundinghave consisted of the net proceeds from our August 2004 private placementof common stock and our June 2005 IPO of common stock of$755.5 million and $848.8 million, respectively. During the periodfrom August 12, 2004 (Inception) through December 31, 2004, ourprimary source of funding after our August 2004 private placementconsisted of borrowings under repurchase agreements. During the year ended December 31,2005, our sources of borrowed funding consisted of borrowings under repurchaseagreements and securitization transactions structured as secured financings.Our securitization transactions are accounted for as secured borrowings underSFAS No. 140. The securitization transactions we have utilized for securedfinancings have consisted of CLOs and asset-backed secured liquidity notes.

*Equity Transactions*

On August 12, 2004,we completed our initial private placement of our common stock at $20.00 pershare that generated net proceeds of approximately $755.5 million. On June 29,2005, we completed our IPO of 37,500,000 shares of common stock that generatednet proceeds of approximately $848.8 million. We sold 37,471,250 commonshares at a price of $24.00 per share and selling stockholders sold 28,750shares. Our stock is listed on the New York Stock Exchange under the symbol “KFN”and began trading on June 24, 2005. On June 23, 2005, we effected areverse stock split of our common stock at a ratio of one share of common stockfor every two shares of common stock then outstanding.

*Securitization Transactions*

On March 30, 2005, weclosed KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”), a$1.0 billion collateralized loan obligation transaction that provides uswith secured financing for investments consisting of corporate loans andcertain other loans and securities. The investments that are owned by CLO 2005-1secure the CLO 2005-1 senior, mezzanine, and subordinate notes payable,and as a result, those investments are not available to us, our creditors orstockholders. CLO 2005-1 issued a total of $773.0 million of seniorsecured notes at par to investors and we retained $148.0 million of ratedmezzanine notes and $85.5 million of unrated subordinated notes. The ratedmezzanine notes consist of $64.0 million rated A2/A, $64.0 millionrated Baa3/BBB-, $15.0 million rated Ba2/BB-, and $5.0 million ratedB2/B-. All of the notes issued mature on April 26, 2017; however, we havethe right to call the notes at par any time after April 2008.

The manager for CLO 2005-1is KFA II. As compensation for the performance of its obligations under thecollateral management agreement, KFA II is entitled to receive a seniorcollateral management fee of 0.15% per annum based on the aggregate principalamount of certain collateral, as calculated on a quarterly basis pursuant tothe terms of the indenture. KFA II, in its sole and absolute discretion, mayelect to defer or permanently waive payment of all or any portion of theforegoing fees on any related payment 

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date.KFA II has elected to permanently waive the senior collateral management feesfrom March 30, 2005 through April 26, 2006 and has advised us that itintends, but is not legally obligated, to waive such fees in the future untilsuch time that our capital is fully deployed.****Therecan be no assurances that KFA II will waive the senior collateral managementfees for any period(s) subsequent to April 26, 2006.

On September 30,2005, we closed a $5.0 billion asset-backed secured liquidity note facility.This facility provides us with an alternative source of funding our residentialmortgage-backed securities by issuing asset-backed secured liquidity notes thatare rated A-1+, P-1, and F1+, by Standard and Poor’s, Moody’s andFitch Inc, respectively. Issuances of asset-backed secured liquidity notes arerecorded as borrowings on our Consolidated Balance Sheet. At December 31,2005, we had $2.0 billion of asset-backed secured liquidity notes outstanding.

On November 3, 2005,we closed KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”) our second$1.0 billion collateralized loan obligation transaction that provides us withsecured financing for investments consisting of corporate loans and certainother loans and securities. The investments that are owned by CLO 2005-2collateralize the CLO 2005-2 debt, and as a result, those investments arenot available to us, our creditors or stockholders. CLO 2005-2 issued atotal of $752.0 million of senior secured notes, including $150.0 million ofsenior delayed draw notes, at par to investors and we retained $168.0 millionof rated mezzanine notes and $98.5 million of unrated subordinate notes. Therated mezzanine notes consist of $64.0 million rated A2/A, $64.0 million ratedBaa2/BBB-, $30.0 million rated Ba2/BB-, and $10.0 million rated B2/B-. All ofthe notes issued mature on November 26, 2017; however, we have the rightto call the notes at par any time after November 2009.

The manager for CLO 2005-2is KFA II. As compensation for the performance of its obligations under thecollateral management agreement, KFA II is entitled to receive a seniorcollateral management fee of 0.15% per annum based on the aggregate principalamount of certain collateral, as calculated on a quarterly basis pursuant tothe terms of the indenture. KFA II, in its sole and absolute discretion, mayelect to defer or permanently waive payment of all or any portion of theforegoing fees on any related payment date. KFA II has elected to permanentlywaive the senior collateral management fees from November 3, 2005 through May 26,2006 and has advised us that it intends, but is not legally obligated, to waivesuch fees in the future until such time that our capital is fully deployed.There can be no assurances that KFA II will waive the senior collateralmanagement fees for any period(s) subsequent to May 26, 2006.

In preparation for futuresecuritization transactions, during the year ended December 31, 2005 weformed KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”), KKRFinancial CLO 2006-1, Ltd. (“CLO 2006-1”), and KKRFinancial CLO 2006-2, Ltd. (“CLO 2006-2”). These entities will beused to provide secured financing principally for the purchase of corporate andcommercial real estate loans and securities. CLO 2006-1 has executeda $500.0 million warehouse facility, in the form of a repurchase agreement. At December 31,2005, there was $117.7 million outstanding under the repurchase facility thatbears interest at a rate of 30-day LIBOR plus 0.65%. Additionally, CLO 2006-1had $76.1 million outstanding under a separate repurchase agreement from therepurchase facility as of December 31, 2005. CDO 2005-1 has executeda $300.0 million warehouse facility, in the form of a repurchase agreement. At December 31,2005 there was $263.8 million outstanding under this facility that bearsinterest at a rate of 30-day LIBOR plus 1.10%. CLO 2006-2 hasexecuted a $450.0 million warehouse facility, in the form of a repurchaseagreement. At December 31, 2005 there were no borrowings outstanding underthis facility, any borrowings would bear interest at a rate of 30-dayLIBOR plus 0.65%.

*Repurchase Agreements*

As of December 31,2005, we had $9.8 billion outstanding on repurchase facilities with tencounterparties with a weighted average effective rate of 4.47% and a weightedaverage remaining term to maturity of 24****days. Because weborrow under repurchase agreements based on the estimated fair value of itspledged investments, and because changes in interest rates can negativelyimpact the valuation of our 

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pledgedinvestments, our ongoing ability to borrow under our repurchase facilities maybe limited and our lenders may initiate margin calls in the event interestrates change or the value of our pledged securities decline as a result ofadverse changes in interest rates or credit spreads.

At December 31,2005, we had repurchase agreements with the following counterparties (amountsin thousands): 

| **Counterparty(2)**                                  | ** ** | ** ** | ** ** | **Amount  At  Risk(1)** | ** ** | **Weighted Average  Maturity  (Days)** | ** ** | **Weighted Average  Interest Rate** | ** ** |
|------------------------------------------------------|------------|------------|------------|-------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|
| Banc of America  Securities LLC.                     |       | $          | 4,122      |                    |       | 25                                          |       |                                          |       | 4.44 | % |   |
| Bear  Stearns & Co. Inc.                    |       | 191,755    |       |                    | 24         |                                        |       |                                          | 4.46       |   |   |
| Citigroup Global  Markets Ltd                        |       | 63,773     |       |                    | 25         |                                        |       |                                          | 4.44       |   |   |
| Credit Suisse  First Boston LLC.                     |       | 27,325     |       |                    | 27         |                                        |       |                                          | 4.43       |   |   |
| Deutsche Bank AG.                                    |       | 126,994    |       |                    | 18         |                                        |       |                                          | 5.47       |   |   |
| J. P. Morgan  Chase Bank, N.A                        |       | 61,461     |       |                    | 25         |                                        |       |                                          | 4.43       |   |   |
| Lehman Brothers  Holdings Inc.                       |       | 22,317     |       |                    | 25         |                                        |       |                                          | 4.43       |   |   |
| Merrill Lynch,  Pierce, Fenner & Smith Inc. |       | 45,461     |       |                    | 30         |                                        |       |                                          | 4.43       |   |   |
| Morgan  Stanley & Co. Inc.                  |       | 255,534    |       |                    | 22         |                                        |       |                                          | 4.52       |   |   |
| UBS Financial  Services Inc.                         |       | 14,314     |       |                    | 3          |                                        |       |                                          | 4.34       |   |   |
| Total                                                |       | $          | 813,056    |                    |       |                                        |       |                                          |       |   |   |   |

 

Notes:

(1)          Computed as an amountequal to the estimated fair value of securities or loans sold, plus accruedinterest income, minus the sum of repurchase agreement liabilities plus accruedinterest expense.

(2)          Counterpartyincludes subsidiaries and affiliates of each counterparty listed.

*Secured CreditFacility*

During June 2005, weentered into a $275 million secured credit facility that matures on June 15,2006, with affiliates of J.P. Morgan Securities Inc. and Citigroup GlobalMarkets Inc. as agents, joint bookrunners, arrangers and lenders underthat facility. Participants in the secured credit facility include J.P. MorganChase Bank, N.A., Citicorp North America, Inc., and Bank of America, N.A.Among other things, the facility limits the amount of distributions we may maketo 100% of our taxable income computed without giving effect to net operatingloss carryforwards and nonrecurring items (including, but not limited to, stock-based compensation expense and bad debt write-offs), prohibits distributions inthe event of certain defaults under the credit facility and specifies negativecovenants as to our leverage and net worth. Outstanding borrowings under ournew credit facility will bear interest at either (i) an alternate baserate per annum equal to the greater of (a) the prime rate in effect onsuch day, and (b) the federal funds effective rate in effect on such dayplus  1¤2 of 1% or (ii) an interest rate per annumequal to the rate of 30-day LIBOR for such interest period multiplied bya Statutory Reserve Rate (as defined in such credit facility), plus 1%. As ofDecember 31, 2005, we had $54.0 million of borrowings outstanding underthis facility.

*Capital Utilizationand Leverage*

As of December 31, 2005 and December 31,2004, we had stockholders’ equity totaling $1.7 billion and$756.7 million, respectively, and our leverage was****8.1times and 2.1 times, respectively.

As of December 31,2005, we believe that we have sufficient capital to increase borrowingssignificantly before becoming capital or leverage constrained.

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*Off-Balance Sheet Commitments*

As of December 31,2005, we had committed to purchase corporate loans with aggregate commitmentstotaling $61.5 million. In a typical corporate loan or commercial realestate loan syndication, there is a delay between the time we are informed ofour allocable portion of such loan and the actual funding of such loan.

As of December 31,2005, we had purchased or participated in corporate loan delayed drawtransactions with aggregate commitments totaling $72.9 million. In adelayed draw transaction, we have made available to the borrower a statedamount to be drawn as needed within a specified future period of time.

*Contractual Obligations*

The table below summarizesour contractual obligations as of December 31, 2005. The table belowexcludes accrued interest expenses, contractual commitments related to ourderivatives, and the Management Agreement that we have with our Manager becausethose contracts do not have fixed and determinable payments:

**ContractualObligations(Amounts in thousands)**

| ** **                            | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More than  5 years** | ** ** |
| Repurchase agreements                 |       | $                                         | 9,303,622  |   | $ | 9,303,622 |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |
| CLO 2005-1  senior secured notes      |       | 773,000                                   |       | — |   |   | — |   |   |   | — |   |   | 773,000 |   |
| CLO 2005-2  senior secured notes      |       | 727,000                                   |       | — |   |   | — |   |   |   | — |   |   | 727,000 |   |
| CDO 2005-1  repurchase agreements     |       | 263,801                                   |       | 263,801 |   |   | — |   |   |   | — |   |   | — |   |
| CLO 2006-1  repurchase agreements     |       | 193,835                                   |       | 193,835 |   |   | — |   |   |   | — |   |   | — |   |
| Demand loan                           |       | 40,511                                    |       | 40,511 |   |   | — |   |   |   | — |   |   | — |   |
| Secured revolving  credit facility    |       | 54,000                                    |       | 54,000 |   |   | — |   |   |   | — |   |   | — |   |
| Asset-backed  secured liquidity notes |       | 2,008,069                                 |       | 2,008,069 |   |   | — |   |   |   | — |   |   | — |   |
| Operating leases                      |       | 15,408                                    |       | 1,132 |   |   | 3,102 |   |   |   | 2,817 |   |   | 8,357 |   |
| Total                                 |       | $                                         | 13,379,246 |   | $ | 11,864,970 |   |   | $ | 3,102 |   |   |   | $ | 2,817 |   |   | $ | 1,508,357 |   |

 

**REIT Matters**

As of December 31,2005, we believe that we qualified as a REIT under the provisions of the Code.The Code requires that at the end of each calendar quarter at least 75% of ourtotal assets must be “real estate assets” as defined in the Code. The Code alsorequires that each year at least 75% of our gross income come from real estatesources and 95% of our gross income come from real estate sources and certainother passive sources itemized in the Code, such as dividends and interest. Asof December 31, 2005, we believe that we were in compliance with suchrequirements. As of December 31, 2005, we also believe that we met all ofthe REIT requirements regarding the ownership of our common stock and thedistributions of our taxable income.

To maintain our status asa REIT for federal income tax purposes, we are required to declare dividendsamounting to at least 90% of our taxable income for each year. In addition, foreach taxable year, to avoid certain federal excise taxes, we are required todeclare and pay dividends amounting to certain designated percentages of ourtaxable income by the end of such taxable year. For the period covered by ourcalendar year 2005 federal tax return, we met all of the distributionrequirements of a REIT. Because we expect to make distributions based ontaxable income, we expect that our distributions may at times be more or lessthan our reported earnings computed in accordance with GAAP.

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Total taxableincome and REIT taxable income are non-GAAP financial measurements, and do notpurport to be an alternative to reported net income (loss) determined inaccordance with GAAP as a measure of operating performance or to cash flowsfrom operating activities determined in accordance with GAAP as a measure ofliquidity. Total taxable income is the aggregate amount of taxable incomegenerated by us and by our domestic and foreign taxable REIT subsidiaries. REITtaxable income excludes the undistributed taxable income of our domestictaxable REIT subsidiary, which is not included in REIT taxable income untildistributed to us. There is no requirement that our domestic taxable REITsubsidiary distribute its earnings to us. REIT taxable income, however, includesthe taxable income of our foreign taxable REIT subsidiaries because we willgenerally be required to recognize and report their taxable income on a currentbasis. These non-GAAP financial measurements are important because we arestructured as a REIT and the Code requires that we pay substantially all of ourtaxable income in the form of distributions to our stockholders. The non-GAAPfinancial measurements of total taxable income and REIT taxable income arecritical in the determination of the amount of the minimum distributions thatwe must pay to our stockholders so as to comply with the rules set forthin the Code. Because not all companies use identical calculations, thispresentation of total taxable income and REIT taxable income may not be comparableto other similarly titled measures prepared and reported by other companies.The table below reconciles the differences between reported net income andtotal taxable income and REIT taxable income for the year ended December 31,2005 and the period from August 12, 2004 (Inception) through December 31,2004:

**Reconciliationof Reported GAAP Net Income (Loss) to Total Taxable Incomeand REIT Taxable Income (Loss)(Amounts in thousands, except per share amounts)**

| ** **                                                            | ** ** | **Estimated  For the  Year Ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (inception) through  December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **Amount**                                                                     | ** ** | **Per  Share**                                                                                                           | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income (loss)**                                       |       | $                                                                              | 55,081     |                                                                                                                     | $          | 0.92 |   | $ | (6,709 | ) | $ | (0.17 | ) |
| Interest income  and expense                                          |       | 194                                                                            |       | —                                                                                                                   |       | 11 |   | — |   |
| Share-based  compensation                                             |       | 30,007                                                                         |       | 0.50                                                                                                                     |       | (17,651 | ) | (0.43 | ) |
| Depreciation of  leasehold improvements and equipment                 |       | 421                                                                            |       | 0.01                                                                                                                     |       | 63 |   | — |   |
| Lease abandonment  expense                                            |       | 795                                                                            |       | 0.01                                                                                                                     |       | — |   | — |   |
| Provision for  loan losses                                            |       | 1,500                                                                          |       | 0.02                                                                                                                     |       | — |   | — |   |
| Losses on sales  of assets to third parties                           |       | (571                                                                           | )          | (0.01                                                                                                                    | )          | — |   | — |   |
| Gains on sales of  assets to affiliates                               |       | 5,687                                                                          |       | 0.09                                                                                                                     |       | — |   | — |   |
| Realized and  unrealized derivative gains and (losses)                |       | (1,895                                                                         | )          | (0.03                                                                                                                    | )          | 378 |   | 0.01 |   |
| Book/tax year end  difference adjustment for CLOs/CDOs                |       | (8,168                                                                         | )          | (0.13                                                                                                                    | )          | — |   | — |   |
| Other                                                                 |       | 8                                                                              |       | —                                                                                                                   |       | 4 |   | — |   |
| Income tax  expense (benefit)                                         |       | 3,144                                                                          |       | 0.05                                                                                                                     |       | (228 | ) | (0.01 | ) |
| **Total  taxable income (loss)**                                      |       | 86,203                                                                         |       | 1.43                                                                                                                     |       | (24,132 | ) | (0.60 | ) |
| Undistributed  taxable income of domestic taxable REIT subsidiary     |       | (4,077                                                                         | )          | (0.06                                                                                                                    | )          | 193 |   | — |   |
| **REIT  taxable income (loss)**                                       |       | $                                                                              | 82,126     |                                                                                                                     | $          | 1.37 |   | $ | (23,939 | ) | $ | (0.60 | ) |
| **Number of common shares  outstanding:**                             |       |                                                                           |       |                                                                                                                     |       |   |   |   |   |
| Weighted-average  diluted common shares outstanding during the period |       | 60,087                                                                         |       |                                                                                                                     |       | 39,796 |   |   |   |

 

Our board of directors hasadopted a policy to distribute to our stockholders amounts required to maintainour status as a REIT and to avoid federal excise taxes, in each case asdiscussed above. This distribution policy takes into account a number offactors, including, but not limited to, our actual results 

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of operations,our financial condition and our total taxable income and REIT taxable income.The actual amount and timing of distributions, if any, will be at thediscretion of our Board of Directors and may not be in even amounts throughoutour fiscal year. Pursuant to this policy, on April 5, 2005, our Board ofDirectors authorized a cash distribution of $0.25 per common share to ourstockholders of record on April 5, 2005. This distribution was paid on April 18,2005. The aggregate amount of the distribution was $10.3 million. On June 21,2005, our Board of Directors declared a cash distribution for the quarter endedJune 30, 2005 to stockholders of record on June 21, 2005. On July 21,2005 our Board of Directors set the amount of the cash distribution at $0.40per share. The aggregate amount of the distribution was $16.4 million andwas paid on August 2, 2005. On November 2, 2005, our Board ofDirectors declared a cash distribution for the quarter ended September 30,2005 on our common stock of $0.32 per share. This distribution was paid on November 30,2005 to stockholders of record as of the close of business on November 16,2005. The aggregate amount of the distribution was $25.7 million. The aggregateamount of distributions paid to common stockholders during the year ended December 31,2005, totaled $52.4 million, which is less than our estimated total taxableincome for the year ended December 31, 2005, of $86.2 million, as well asthe estimated REIT taxable income for the year ended December 31, 2005 of$82.1 million. On February 1, 2006, our Board of Directors declared a cashdistribution for the quarter ended December 31, 2005 of $0.40 per share.The aggregate amount of the distribution was $32.1 million, which was paidon February 28, 2006. Neither the payment of these distributions nor theexistence of our distribution policy guarantees that we will make futuredistributions to our stockholders of any particular level, or at all. Inaddition, the amounts of these distributions do not constitute any kind ofprojection as to the amount of future distributions, if any.

**Tax Treatment of Distributions**

***DividendIncome***

For federal income taxpurposes, distributions declared and paid in 2005 on our common stock total$0.97 per share.  No portion of thedistributions is considered a return of capital or long term capital gain.  All distributions are fully (100%) taxable asdividend income at ordinary rates to stockholders and no portion of thedividends are eligible for the 15% dividend rate or the corporate dividendsreceived deduction.

***ExcessInclusion Income***

Stockholders that are tax-exempt, or non-U.S.corporations or residents, or U.S. taxpayers, will be required to report 3.22%of our dividends to the IRS as “Excess Inclusion Income.”

·       Tax-exemptstockholders will be required to treat excess inclusion income as unrelatedbusiness taxable income (commonly referred to as “UBTI”);

·       Non-U.S.stockholders will be subject to the 30 percent U.S. federal withholding tax onthis excess inclusion income without reduction under any otherwise applicableincome tax treaty; and

·       U.S. stockholders,including taxpaying entities, must report taxable income that in no event willbe less than the amount of excess inclusion income.

***AMTAdjustments and Tax Preference Items***

There are special rules regarding the applicability ofthe alternative minimum tax (“AMT”) to REITs. Under these rules, items that are treated differently for regular taxand AMT purposes, namely the “AMT Adjustments and Tax Preference Items,” shouldbe apportioned between the REIT and its stockholders.  As a result of these special rules, stockholdersare required to report as AMT adjustments and tax preference items an amountequal to 3.84% of the 2005 dividends that they received.

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We recommend that stockholders discuss the taxconsequences of their investment, including the proper tax treatment of anyexcess inclusion income and AMT adjustments and tax preference items, withtheir tax advisor.

**Exemptionfrom Regulation under the Investment Company Act**

We intend to operate our business so as to be excludedfrom regulation under the Investment Company Act. Because we conduct some ofour business through wholly-owned subsidiaries, we must ensure not only that wequalify for an exclusion or exemption from regulation under the InvestmentCompany Act, but also that each of our subsidiaries so qualifies.

For KKR Financial Corp. itself, we will be relying ona provision designed for companies that do not issue redeemable securities andare primarily engaged in the business of purchasing or otherwise acquiringmortgages and other liens on and interests in real estate.

The Securities and Exchange Commission (“SEC”) has notpromulgated rules to address precisely what is required for a company tobe considered “primarily engaged in the business of purchasing or otherwiseacquiring mortgages and other liens on and interests in real estate.” A seriesof no-action letters issued by the Division of Investment Management (the “Division”)of the SEC, however, reflects the view that at least 55% of a company’s assetsmust consist of mortgage loans and other assets that are considered thefunctional equivalent of mortgage loans for purposes of the Investment CompanyAct (collectively, “qualifying real estate assets”), and an additional 25% of acompany’s assets must consist of real estate-related assets, leaving nomore than 20% of the company’s assets in miscellaneous assets. These no-actionletters also indicate what types of assets can be considered qualifying realestate assets. No-action letters issued by the Division are not binding exceptas they relate to the companies to whom they are addressed, so investors shouldbe aware that the Division may change its position regarding what assets mightconstitute qualifying real estate assets at any time. If the Division were tochange its position, we might be required to change our investment strategy tocomply with any new guidance provided by the Division. We cannot predictwhether such a change would be adverse to us.

Based on the no-action letters issued by the Division,we classify our investment in residential mortgage loans as qualifying realestate assets, as long as the loans are “fully secured” by an interest in realestate. That is, if the loan-to-value ratio of the loan is equal to or lessthan 100%, then we consider the mortgage loan a qualifying real estate asset.We do not consider loans with loan-to-value ratios in excess of 100% to bequalifying real estate assets for the 55% test, but only real estate-relatedassets for the 25% test.

We also consider agency whole pool certificates to bequalifying real estate assets. An agency whole pool certificate is acertificate issued or guaranteed as to principal and interest by federallychartered entities such as the Federal National Mortgage Association, betterknown as “Fannie Mae,” the Federal Home Loan Mortgage Corporation, better knownas “Freddie Mac,” and, in the case of the Government National MortgageAssociation, better known as “Ginnie Mae,” by the U.S. government, thatrepresents the entire beneficial interest in the underlying pool of mortgageloans. By contrast, an agency certificate that represents less than the entirebeneficial interest in the underlying mortgage loans is not considered to be aqualifying real estate asset for purpose of the 55% test, but constitutes areal estate-related asset for purposes of the 25% test.

Most non-agency mortgage-backed securities donot constitute qualifying real estate assets for purposes of the 55% test,because they represent less than the entire beneficial interest in the relatedpool of mortgage loans. The Division, however, has indicated in a series ofno-action letters that in certain circumstances a company’s investment innon-agency mortgage- backed securities is the “functional equivalent” ofowning the underlying mortgage loans. We own mortgage-backed securitiesthat we classify as qualifying real estate assets because we believe that weown the functional equivalent of the underlying mortgage loans.

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In several such instances,we own all of the securities issued by the related securitization trust. Thereare no other owners of the securities, and thus we view our investment,economically, as an investment in mortgage loans rather than an investment inmortgage-backed securities. For these transactions, we classify our entireinvestment as an investment in qualifying real estate assets for purposes ofthe 55% test.

In another instance, weown the most subordinate class of securities issued in the securitization,designated Class B-6, the class that is most likely to absorb losses on therelated pool of mortgage loans, and we have the right to decide whether toforeclose upon defaulted mortgage loans. Thus, based on a series of no-actionletters, we classify this investment as an investment in qualifying real estateassets for purposes of the 55% test. In addition to our ownership of Class B-6in this securitization, we also own all of the other subordinated classes inthe securitization: Classes B-5, B-4, B-3, B-2, B-1 and M. All of thesubordinate classes could have been issued as a single subordinate class, butto obtain varying ratings on the classes and to increase the liquidity of ourholdings, our subordinate interest was divided into separate classes. Losses onthe mortgage loans, to the extent they exceed the principal balance of theClass B-6, are allocated to Class B-6, B-5, B-4, B-3, B-2, B-1 and M, in thatorder. If losses are so great that the principal balance of Class B-6 isreduced to zero, then we, as the owner of the Class B-5 securities, would havethe right to decide whether to foreclose on defaulted mortgage loans. Thisright continues throughout the subordinate classes, such that the owner of themost subordinate class that is outstanding at any time has foreclosure rights.Because we own 100% of each class of subordinate securities in this structure,and each such class carries with it the right to foreclose if it ever becomesthe most subordinate class in the structure, we classify all of thesesubordinate securities as qualifying real estate assets for purposes of the 55%test. If we were to sell all or a portion of any of those subordinated classes,we would recharacterize the remaining portion of that class, together with anyclasses senior to that class, as real estate-related assets for the 25% test,rather than qualifying real estate assets for the 55% test. We own a portion ofa senior class issued in this same securitization, but because it is not asubordinated class, we do not consider it a qualifying real estate asset forpurposes of the 55% test, but merely a real estate-related asset for purposesof the 25% test.

We will use this sameanalysis to determine whether to classify investments we make in the future asqualifying real estate assets. If we acquire securities that, collectively, areexpected to receive all of the principal and interest paid on the related poolof underlying mortgage loans (less fees, such as servicing and trustee fees,and expenses of the securitization), and we have foreclosure rights withrespect to those mortgage loans, then we will consider those securities,collectively, to be qualifying real estate assets. If another entity acquiresany of the securities that are expected to receive cash flow from theunderlying mortgage loans, then we will consider whether we have the unilateralright to foreclose on the underlying loans and whether our investment is afirst loss position to decide whether it should be classified as a qualifyingreal estate asset. If we own more than one subordinate class, then, todetermine the classification of the subordinate classes that we own other thanthe first loss class, we would consider whether such classes are contiguouswith the first loss class (with no other classes absorbing losses after thefirst loss class and before any other subordinate classes that we own), whetherwe own the entire amount of each such class and whether we would continue tohave the unilateral right to foreclose in connection with each such class ifthe more subordinate classes were no longer outstanding. If the answers to anyof these questions is no, then we would not classify that particular class, orclasses senior to that class, as a qualifying real estate asset.

To the extent that ourinvestments in mortgage-backed securities do not constitute qualifyingreal estate assets for the 55% test, they will be classified as real estate-relatedassets for purposes of the 25% test. We do not expect that our investments incorporate leveraged loans or high yield corporate bonds will constitutequalifying real estate or real estate-related assets. Instead, they willconstitute miscellaneous assets, which can constitute no more than 20% of ourassets.

We believe that we havesatisfied the tests with respect to our assets, measured on an unconsolidatedbasis, since the first anniversary of our initial private placement of ourcommon stock in August 2004. It is 

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notentirely settled, however, that the tests are to be measured on anunconsolidated basis. To the extent the SEC provides further guidance on how tomeasure assets for these tests, we will adjust our measurement techniques.

In addition to monitoring our assets to qualify forthe exclusion from regulation as an investment company, we also must ensurethat each of our subsidiaries qualifies for its own exclusion or exemption.Some of our subsidiaries rely on the exemption provided if (i) thesecurities of the subsidiary are owned exclusively by persons who at the timeof acquisition of the securities are “qualified purchasers” as that term isdefined in the Investment Company Act and (ii) none of the non-real estatesubsidiaries is making or proposing to make a public offering of itssecurities. Other subsidiaries may qualify, on their own, for the exclusiondesigned for companies primarily engaged in the business of purchasing orotherwise acquiring mortgages and other liens on and interests in real estate,the same exclusion from regulation that we rely upon for our exclusion fromregulation. To the extent that we form subsidiaries in the future, we mustensure that they qualify for their own separate exclusion from regulation as aninvestment company.

We have not received ano-action letter from the Division regarding how our investment strategy fitswithin the exclusion from regulation under the Investment Company Act that weare using. To the extent that the Division provides more specific or differentguidance regarding the treatment of assets as qualifying real estate assets orreal estate-related assets, we may be required to adjust our investmentstrategy accordingly. Any additional guidance from the Division could provideadditional flexibility to us, or it could further inhibit our ability to pursuethe investment strategy we have chosen.

**Quantitativeand Qualitative Disclosures About Market Risk**

**Market Risks**

*Currency Risks*

From time to time, we maymake investments that are denominated in a foreign currency through which wemay be subject to foreign currency exchange risk.

*Inflation Risks*

Our investment portfoliocomprises the majority of our assets and our investments are financial innature. Changes in interest rates and credit spreads may have a materialadverse impact on our financial condition, results of operations and liquidity.Changes in interest rates do not necessarily correlate with inflation rates orchanges in inflation rates.

*Interest Rate Risk*

We believe that our primary market risk is interestrate risk. Interest rate risk is defined as the sensitivity of our current andfuture earnings to interest rate volatility, variability of spreadrelationships, the difference in repricing intervals between our assets andliabilities and the effect that interest rates may have on our cash flows andthe prepayment rates experienced on our investments that have imbedded borroweroptionality. The objective of interest rate risk management is to achieveearnings, preserve capital and achieve liquidity by minimizing the negativeimpacts of changing interest rates, asset and liability mix, and prepaymentactivity.

We are exposed to basis risk between our investmentsand our borrowings. Our floating rate investments and our variable rateborrowings do not reset on the same day or with the same frequency and, as aresult, we are exposed to basis risk with respect to index reset frequency. Ourfloating rate investments may reprice on indices that are different than theindices that are used to price our variable rate borrowings and, as a result,we are exposed to basis risk with respect to repricing index. The basis risksnoted above, in addition to other forms of basis risk that exist between ourinvestments and borrowings, may be material and could negatively impact futurenet interest margins.

69

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Interest rate risk impacts our interest income,interest expense, prepayments, and the fair value of our investments, interestrate derivatives, and liabilities. We manage interest rate risk and makeinterest rate risk decisions by evaluating our projected earnings underselected interest rate scenarios. We also use static measures of interest raterisk including duration. During periods of increasing interest rates we arebiased to purchase investments that are floating rate and we have had that biassince our inception. We manage our interest rate risk using various techniquesranging from the purchase of floating rate investments to the use of interestrate derivatives. We generally fund our variable rate investments with variablerate borrowings with similar interest rate reset frequencies. We fund our fixedrate and our hybrid investments with short-term variable rate borrowings and wemay use interest rate derivatives to hedge the variability of the cash flowsassociated with our existing or forecasted variable rate borrowings. Hedgingactivities are complex and accounting for interest rate derivatives as fairvalue or cash flow hedges in accordance with SFAS No. 133 is difficult. Wemay not be able to execute certain hedging strategies because we are a REIT andthere are complex rules regarding how our hedges impact our compliancewith the REIT requirements.

Prepayments will impact the average lives of our fixedrate and hybrid investments and, as a result, we are exposed to the risk thatthe amount of variable rate borrowings that we have swapped from floating rateto fixed rate is materially different than we expected because the average lifeof the fixed rate or hybrid investment has either extended or contracted. Ifthe difference is material, we may have to adjust the amount of our interestrate derivative position and such action could generate a loss if we terminatedany of the interest rate derivatives or it may negatively impact our futureearnings if we have to increase our interest rate derivative positions becausethe average lives of our investments have extended.

The periodic and lifetime interest rate caps containedin our residential ARM loans and securities may limit the repricing of ourresidential ARM loans and securities and, as a result, we are exposed to therisk that repricing of our investments is limited by the respective caps andour variable rate borrowings do not have any similar such caps. As a result ourincome on the investments that are subject to the periodic and lifetime capwould remain constant while our cost of financing using variable rate debtwould increase. The periodic and lifetime interest rate caps may negativelyimpact future net interest margins and the fair values of our residential ARMloan and security investments.  

The table below presentsan approximation of the sensitivity of the market value of our residentialmortgage loan and security portfolio using BondStudio®.  Application of this method results in anestimation of the percentage change in the market value of our residentialmortgage assets and interest rate derivatives per 50 basis point shift ininterest rates expressed in a measure commonly referred to as effectiveduration. Positive portfolio effective duration indicates that the market valueof the total portfolio will decline if interest rates rise and increase ifinterest rates decline.  Negativeportfolio effective duration indicates that the market value of the totalportfolio will decline if interest rates decline and increase if interest ratesrise.  The closer effective duration isto zero, the less interest rate changes are expected to affect the market valueof our residential mortgage loan and security portfolio and our investments.  Included in the table is a base caseeffective duration calculation for an interest rate scenario that assumesfuture rates are those implied by the yield curve as of February 28, 2006.  The other four scenarios assume interestrates are instantaneously 50 and 100 basis points lower and 50 and 100 basispoints higher than those implied by the yield curve as of February 28, 2006.

70

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**NetPortfolio Effective DurationDecember 31, 2005**

| ** **                           | ** ** | **Base Case** | ** ** | **Parallel -50 bps** | ** ** | **Parallel -100 bps** | ** ** | **Parallel +50 bps** | ** ** | **Parallel +100 bps** | ** ** |   |
|--------------------------------------|------------|--------------------|------------|--------------------------------|------------|---------------------------------|------------|--------------------------------|------------|---------------------------------|------------|--------|
| Residential mortgage  assets:        |       |               |       |                           |       |                            |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| ARM loans and securities             |       |               | 0.28       |                           |       |                            | 0.18       |                           |       |                            | 0.08       |   |   |   | 0.39 |   |   |   | 0.54 |   |   |
| Hybrid loans and securities          |       |               | 1.99       |                           |       |                            | 1.76       |                           |       |                            | 1.32       |   |   |   | 2.12 |   |   |   | 2.20 |   |   |
| Total residential assets             |       |               | 1.22       |                           |       |                            | 1.06       |                           |       |                            | 0.81       |   |   |   | 1.33 |   |   |   | 1.43 |   |   |
| Interest rate swaptions and corridor |       |               | (0.23      | )                              |       |                            | (0.22      | )                              |       |                            | (0.16      | )      |   |   | (0.20 | ) |   |   | (0.12 | ) |   |
| Amortizing interest rate swaps       |       |               | (1.72      | )                              |       |                            | (1.75      | )                              |       |                            | (1.78      | )      |   |   | (1.70 | ) |   |   | (1.67 | ) |   |
| Net portfolio  effective duration    |       |               | 0.14       |                           |       |                            | (0.03      | )                              |       |                            | (0.26      | )      |   |   | 0.26 |   |   |   | 0.41 |   |   |

 

Based on the assumptions used, the model outputsuggests a low degree of portfolio price change given the decreases andincreases in interest rates. The table above excludes corporate loans andsecurities and commercial rate loans and securities totaling $2.4 billionand $604.7 million, respectively, as of December 31, 2005.  Changes in assumptions including, but notlimited to, volatility, mortgage spreads, prepayment behavior and defaults, aswell as the timing and level of interest rate changes, will affect the resultsof the model. Therefore, actual results are likely to vary from modeledresults.

Although market value sensitivity analysis is widelyaccepted in identifying interest rate risk, it does not take into considerationchanges that may occur such as, but not limited to, changes in investment andfinancing strategies, changes in market spreads, and changes in businessvolumes.

The use of interest rate derivatives is a criticalpart of our interest risk management strategy. The table below summarizes thecontractual notional balance of our amortizing interest rate swaps and interestrate corridor as of December 31, 2005, and for each of the following five yearsthen ended.

**Hedge InstrumentsNotional Amounts(Amounts in millions)**

| ** **              | ** ** | **As of December 31, 2005** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|
| ** **              | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| Interest rate swaps     |       | $    4,308                  |       | $    4,525 |   | $    3,348 |   | $    2,022 |   | $    1,017 |   |
| Interest rate corridors |       | —                                          |       | 691 |   | 755 |   | 720 |   | — |   |
| Total                   |       | $    4,308                  |       | $    5,216 |   | $    4,103 |   | $    2,742 |   | $    1,017 |   |

 

71

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The following tablesummarizes the estimated net fair value of our derivative instruments held at December31, 2005 and December 31, 2004 (amounts in thousands):

**Derivative FairValue**
|                                 | ** ** | **As of  December 31, 2005** | ** **    | **As of  December 31, 2004** | ** ** |
|---------------------------------|------------|----------------------------------------|---------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**           |       |                                   |          |                                        |       |   |   |   |   |
| Interest rate corridors         |       |                                   | $ 14,762 |                                        |       |   | $   — |   |   |
| Interest rate swaps             |       |                                   | 40,796        |                                        |       |   | — |   |   |
| **Free-Standing  Derivatives:** |       |                                   |          |                                        |       |   |   |   |   |
| Interest rate swaptions         |       |                                   | 879           |                                        |       |   | 223 |   |   |
| Interest rate swaps             |       |                                   | 198           |                                        |       |   | — |   |   |
| Credit default swaps            |       |                                   | 71            |                                        |       |   | (625 | ) |   |
| Total rate of return swaps      |       |                                   | 727           |                                        |       |   | — |   |   |
| Foreign exchange contracts      |       |                                   | —        |                                        |       |   | (125 | ) |   |
| Net fair value                  |       |                                   | $ 57,433 |                                        |       |   | $ (527 | ) |   |

 

*Risk Management*

To the extent consistent with maintaining our REITstatus, we seek to manage our interest rate risk exposure to protect ourinvestment portfolio and related borrowings against the effects of majorinterest rate changes. We generally seek to manage our interest rate risk by:

·       Changingthe mix between our floating rate investments and our fixed rate investments;

·       Monitoringand adjusting, if necessary, the reset index and interest rates related to ourinvestments and our borrowings;

·       Attemptingto structure our borrowing agreements to have a range of different maturities,terms, amortizations and interest rate adjustment periods; and

·       Usinginterest rate derivatives to adjust the interest rate sensitivity of ourinvestment portfolio and our borrowings.

**Item7A.**                Quantitative andQualitative Disclosures about Market Risk

See discussion ofquantitative and qualitative disclosures about market risk in “Quantitative andQualitative Disclosures About Market Risk” section of Item 7 of this AnnualReport on Form 10-K.

**Item8.**                        FinancialStatements and Supplementary Data

The consolidated financialstatements of the Company and the related notes to the consolidated financialstatements, together with the Report of Independent Registered PublicAccounting Firm thereon, are set forth on pages F-1 through F-33 in this AnnualReport on Form 10-K.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

None.

**Item9A.**                Controls andProcedures

Under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, we conducted an evaluation of the effectiveness of thedesign and operation of our disclosure controls and procedures, as defined inRules 13a-15(e) 

72

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and 15d-15(e) underthe Securities Exchange Act of 1934, as amended, as of the end of the periodcovered by this report (the “Evaluation Date”). Based on this evaluation, ourprincipal executive officer and principal financial officer concluded as of theEvaluation Date that our disclosure controls and procedures were effective suchthat the information relating to us, including our consolidated subsidiaries,required to be disclosed in our Securities and Exchange Commission (“SEC”)reports (i) is recorded, processed, summarized and reported within thetime periods specified in SEC rules and forms, and (ii) isaccumulated and communicated to our management, including our principalexecutive and principal financial officer, as appropriate to allow timelydecisions regarding required disclosure.

As previously disclosed in our registration statementon Form S-11 (Registration No. 333-124103), in connectionwith its audit of our consolidated financial statements for the period endedDecember 31, 2004, our independent registered public accounting firm onMarch 8, 2005 identified to us three matters involving our internalcontrols over financial reporting that it considered to be reportableconditions under standards established by the American Institute of CertifiedPublic Accountants, which reportable conditions in its judgment constitutedmaterial weaknesses. Under these standards, in each of these areas the designor operation of our internal controls did not reduce to a relatively low levelthe risk that misstatements caused by error or fraud in amounts that would bematerial may occur and not be detected within a timely period.

The first reportable condition related to our failureto have well-established internal controls over our financial closing andreporting process. Specifically, through the March 8, 2005 letter date,several of our Manager’s employees in the areas of accounting and financialreporting had been with our Manager for a limited period of time, andadditional internal controls needed to be established with respect to thesegregation of duties of these individuals in the posting and review ofindividual journal entries. Moreover, additional specific internal controlswere required regarding verification and reconciliation of our general ledgeras our financial statements are closed on a monthly basis. The secondreportable condition related to our reliance on data gathering and processingmethods based upon information gathered after transaction dates that entail agreater risk of error. Specifically, in preparation of our financial statementsand underlying records, we relied on custodian statements, bank statements andother information gathered after the transaction dates to identify transactionsand amounts that needed to be recorded. These data-gathering and processingmethods entail greater risk of error than do methods involving timelyprocessing of transactions. The third reportable condition related to ourfailure to be as self sufficient with respect to the application of accountingpolicies for complex transactions as we ultimately need to be. As with thefirst reportable condition discussed above, the existence of this condition atMarch 8, 2005 principally related to the limited periods of time thatseveral of our Manager’s accounting and financial reporting staff had beenemployed by our Manager, and the need at such time for these individuals toestablish more robust procedures for the ongoing selection and application ofaccounting policies for many of our transactions.

We are actively remediating the identified reportableconditions. Specifically, subsequent to March 8, 2005 our Chief OperatingOfficer became our Chief Financial Officer and we hired individuals to fill thepositions of Controller; Assistant Controller; Treasurer; Chief AccountingOfficer; and Financial Analysis Manager. We are also enhancing our internalcontrol structure to ensure proper segregation of duties and the timelyrecording of transactions and timely preparation of reconciliations as wecontinue to prepare for compliance with Section 404 of the Sarbanes-OxleyAct of 2002. We will be required to issue a management report on our assessmentof internal controls over financial reporting in our Annual Report onForm 10-K for the year ended December 31, 2006.

There were no otherchanges in our internal control over financial reporting identified inconnection with the foregoing evaluation that occurred during the quarter endedDecember 31, 2005 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

73

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**Item 9B.     Other Information**

None.

**PARTIII**

**Item 10.**                 Directorsand Executive Officers of the Registrant

The information requiredby Item 10 is incorporated herein by reference to the Proxy Statement tobe filed with the SEC pursuant to Regulation 14A within 120 daysafter December 31, 2005.

**Item 11.      ExecutiveCompensation**

The information requiredby Item 11 is incorporated herein by reference to the Proxy Statement tobe filed with the SEC pursuant to Regulation 14A within 120 daysafter December 31, 2005.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related ShareholderMatters

The information requiredby Item 12 is incorporated herein by reference to the Proxy Statement to befiled with the SEC pursuant to Regulation 14A within 120 days afterDecember 31, 2005.

**Item 13.**                 CertainRelationships and Related Transactions

The information requiredby Item 13 is incorporated herein by reference to the Proxy Statement tobe filed with the SEC pursuant to Regulation 14A within 120 daysafter December 31, 2005.

**Item 14.**                 PrincipalAccountants Fees and Services

The information requiredby Item 14 is incorporated herein by reference to the Proxy Statement tobe filed with the SEC Pursuant to Regulation 14A within 120 daysafter December 31, 2005.

**PARTIV**

**Item 15.**                 Exhibitsand Financial Statement Schedules

**(a)1.and (a)2. Documents filed as part of this report:**

**1. and 2.**

All financial statement schedulesare omitted because of the absence of conditions under which they are requiredor because the required information is included in our consolidated financialstatements or notes thereto, included in Part II, Item 8, of this AnnualReport on Form 10-K.

**3. Exhibit Index:**
| Exhibit Number | ** ** | **Description**                                                                                                                                   |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*                |       | Articles of Amendment and Restatement of the  Registrant, dated August 10, 2004                                                              |
| 3.2*                |       | Form of Articles of Amendment, dated  June 23, 2005                                                                                     |
| 3.3*                |       | Form of  Articles of Amendment, dated June 23, 2005                                                                                     |
| 3.4*                |       | Amended and  Restated Bylaws of the Registrant                                                                                                    |
| 4.1*                |       | Form of  Certificate for Common Stock                                                                                                        |
| 4.2*                |       | Registration  Rights Agreement, dated as of August 12, 2004 between the Registrant and  Friedman, Billings, Ramsey & Co., Inc. |

74

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| 10.1*  |   | Management  Agreement, dated as of August 12, 2004, between Registrant and KKR  Financial Advisors LLC                                                                                                                                  |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2*  |   | Amended and  Restated 2004 Stock Incentive Plan                                                                                                                                                                                              |
| 10.3*  |   | Form of  Nonqualified Stock Option Agreement                                                                                                                                                                                            |
| 10.4*  |   | Form of  Restricted Stock Award Agreement                                                                                                                                                                                               |
| 10.5*  |   | Form of  Restricted Stock Award Agreement for Non-Employee Directors                                                                                                                                                                    |
| 10.6*  |   | Indenture, dated  as of March 30, 2005, by and among KKR Financial CLO 2005-1, Ltd.,  KKR Financial 2005-1, Corp. and JPMorgan Chase Bank, National Association                                                                         |
| 10.7*  |   | License  Agreement, dated as of August 12, 2004, between the Registrant and  Kohlberg Kravis Roberts & Co. L.P.                                                                                                                |
| 10.8*  |   | Letter Agreement,  dated as of August 12, 2004, between the Registrant and KKR Financial  Advisors LLC                                                                                                                                  |
| 10.9*  |   | Credit Agreement,  dated as of June 16, 2005, among the Registrant, KKR TRS  Holdings, Inc., the Lenders party thereto, and JPMorgan Chase Bank,  N.A., as Administrative Agent                                                    |
| 10.10* |   | First Amendment  to Credit Agreement, dated as of June 17, 2005, among the Registrant,  KKR TRS Holdings, Inc., the Existing Lenders party thereto, JPMorgan  Chase Bank, N.A., as Administrative Agent, and Bank of America, N.A. |
| 10.11* |   | Collateral  Management Agreement, dated as of March 30, 2005, between KKR Financial  CLO 2005-1, Ltd. and KKR Financial Advisors II, LLC                                                                                                |
| 10.12* |   | Fee Waiver  Letter, dated April 15, 2005, between KKR Financial CLO 2005-1,  Ltd., KKR Financial Advisors II, LLC and JPMorgan Chase Bank, N.A.                                                                                         |
| 21.1** |   | List of  Subsidiaries of the Registrant                                                                                                                                                                                                      |
| 31.1** |   | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under  the Securities Exchange Act of 1934, as amended                                                                                                               |
| 31.2** |   | Certification Pursuant to Rules 13a-14(a) and  15d-14(a) under the Securities Exchange Act of 1934, as amended.                                                                                                               |
| 32**   |   | Certification Pursuant to 18 U.S.C. Section 1350                                                                                                                                                                                        |

----

*                    Incorporatedby reference to the Registrant’s Registration Statement on Form S-11(Registration No. 333-124103), as amended. Such registrationstatement was originally filed with the Securities and Exchange Commission onApril 15, 2005.

**             Filed herewith.

75

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**SIGNATURES**

Pursuantto the requirements of Section 13 of the Securities Exchange Act of 1934,the Registrant has duly caused this annual report on Form 10-K forthe fiscal year ended December 31, 2005, to be signed on its behalf by theundersigned, and in the capacities indicated, thereunto duly authorized.

|        | KKR FINANCIAL  CORP. |
|--------|----------------------|
|   | (Registrant)         |   |
|   | By:                  | /s/ SATURNINO S. FANLO |
|   |                 | Name: | Saturnino S. Fanlo |
|   |                 | Title: | *Chief Executive Officer* |
|        |                      |  |  |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this Annual Reporton Form 10-K has been signed below by the following persons onbehalf of the Registrant and in the capacities and on the dates indicated.

|                           | **Signature** | ** **                                                            | ** ** |                      | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|---------------------------|---------------|-----------------------------------------------------------------------|------------|----------------------|-----------|------------|------------|--|----------|------------|
| s/ SATURNINO S. FANLO     |          | Chief Executive Officer  and Director                                 |       | March 29,  2006 |
| Saturnino S.  Fanlo       |          | (Principal  Executive Officer)                                        |       |                 |
| /s/  DAVID A. NETJES      |          | Chief Financial Officer  and                                          |       | March 29,  2006 |
| David A. Netjes           |          | Chief Operating Officer  (Principal Financial and Accounting Officer) |       |                 |
| /s/  PAUL M. HAZEN        |          | Chairman and Director                                                 |       | March 29,  2006 |
| Paul M. Hazen             |          |                                                                  |       |                 |
| /s/  WILLIAM F. ALDINGER  |          | Director                                                              |       | March 29,  2006 |
| William F.  Aldinger      |          |                                                                  |       |                 |
| /s/  PATRICK COWELL       |          | Director                                                              |       | March 29,  2006 |
| Patrick Cowell            |          |                                                                  |       |                 |
| /s/  KENNETH M. DEREGT    |          | Director                                                              |       | March 29,  2006 |
| Kenneth M. deRegt         |          |                                                                  |       |                 |
| /s/  VINCENT PAUL FINIGAN |          | Director                                                              |       | March 29,  2006 |
| Vincent Paul  Finigan     |          |                                                                  |       |                 |
| /s/  R. GLENN HUBBARD     |          | Director                                                              |       | March 29,  2006 |
| R. Glenn Hubbard          |          |                                                                  |       |                 |
| /s/  ROSS J. KARI         |          | Director                                                              |       | March 29,  2006 |
| Ross J. Kari              |          |                                                                  |       |                 |
| /s/  ELY L. LICHT         |          | Director                                                              |       | March 29,  2006 |
| Ely L. Licht              |          |                                                                  |       |                 |
| /s/  DEBORAH H. MCANENY   |          | Director                                                              |       | March 29,  2006 |
| Deborah H.  McAneny       |          |                                                                  |       |                 |
| /s/  SCOTT C. NUTTALL     |          | Director                                                              |       | March 29,  2006 |
| Scott C. Nuttall          |          |                                                                  |       |                 |

 

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**KKRFINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATEDFINANCIAL STATEMENTS**

**AND**

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

For Inclusion inForm 10-K

Filed with

Securities and ExchangeCommission

December 31, 2005

F-1

----

**KKR FINANCIAL CORP. AND SUBSIDIARIES**

Index toConsolidated Financial Statements

|                                                                  | ** ** | **Page** |
|------------------------------------------------------------------|------------|----------|
| Report of Independent Registered Public Accounting  Firm         |       | F-3      |
| Consolidated Balance Sheets                                      |       | F-4      |
| Consolidated  Statements of Operations                           |       | F-5      |
| Consolidated Statements of Changes in Stockholders’  Equity |       | F-6      |
| Consolidated Statements of Cash Flows                            |       | F-7      |
| Notes to Consolidated Financial Statements                       |       | F-8      |

 

 

 

F-2

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders ofKKR Financial Corp.San Francisco, California

We have audited the accompanying consolidated balancesheets of KKR Financial Corp. and subsidiaries (the “Company”) as of December 31,2005 and 2004, and the related consolidated statements of operations, changesin stockholders’ equity, and cash flows for the year ended December 31,2005 and the period from August 12, 2004 (inception) through December 31,2004. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of KKR Financial Corp. and subsidiaries as of December 31,2005 and 2004, and the results of their operations and their cash flows for theyear ended December 31, 2005 and the period from August 12, 2004(inception) through December 31, 2004, in conformity with accountingprinciples generally accepted in the United States of America.

/s/ DELOITTE & TOUCHE LLP

San Francisco, CaliforniaMarch 28, 2006

F-3

----

**KKR Financial Corp. and Subsidiaries****Consolidated BalanceSheets****(Amounts in thousands,except share information)**

| ** **                                                                                                                                                                                                    | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                    | ** ** | ** **                  | ** ** |                        | ** ** | ** ** |   |
| Cash and cash  equivalents                                                                                                                                                                                    |       | $                           | 16,110     |                        |       | $ | 7,219 |   |   |
| Restricted cash  and cash equivalents                                                                                                                                                                         |       | 80,223                      |       |                        | 1,321      |   |   |
| Securities  available-for-sale, $5,910,399 and $1,484,222 pledged as  collateral as of December 31, 2005 and December 31, 2004,  respectively                                                       |       | 6,149,506                   |       |                        | 1,651,280  |   |   |
| Loans, net of  allowance for loan losses of $1,500 and $0 as of December 31, 2005 and  December 31, 2004, respectively                                                                              |       | 8,846,341                   |       |                        | 682,757    |   |   |
| Derivative assets                                                                                                                                                                                             |       | 58,898                      |       |                        | 223        |   |   |
| Interest  receivable                                                                                                                                                                                          |       | 59,993                      |       |                        | 2,694      |   |   |
| Principal  receivable                                                                                                                                                                                         |       | 7,108                       |       |                        | —     |   |   |
| Non-marketable  equity securities                                                                                                                                                                             |       | 52,500                      |       |                        | —     |   |   |
| Deferred tax  asset                                                                                                                                                                                           |       | —                      |       |                        | 228        |   |   |
| Other assets                                                                                                                                                                                                  |       | 19,861                      |       |                        | 1,618      |   |   |
| **Total assets**                                                                                                                                                                                              |       | $                           | 15,290,540 |                        |       | $ | 2,347,340 |   |   |
| **Liabilities**                                                                                                                                                                                               |       |                        |       |                        |       |   |   |
| Repurchase  agreements                                                                                                                                                                                        |       | $                           | 9,761,258  |                        |       | $ | 1,558,274 |   |   |
| Collateralized  loan obligation senior secured notes                                                                                                                                                          |       | 1,500,000                   |       |                        | —     |   |   |
| Asset-backed  secured liquidity notes                                                                                                                                                                         |       | 2,008,069                   |       |                        | —     |   |   |
| Secured revolving  credit facility                                                                                                                                                                            |       | 54,000                      |       |                        |       |   |   |
| Secured demand  loan                                                                                                                                                                                          |       | 40,511                      |       |                        | 27,875     |   |   |
| Payable for  securities purchases                                                                                                                                                                             |       | 196,315                     |       |                        | —     |   |   |
| Accounts payable,  accrued expenses and other liabilities                                                                                                                                                     |       | 45,925                      |       |                        | 1,157      |   |   |
| Accrued interest  payable                                                                                                                                                                                     |       | 21,415                      |       |                        | 771        |   |   |
| Related party  payable                                                                                                                                                                                        |       | 3,673                       |       |                        | 1,765      |   |   |
| Income tax  liability                                                                                                                                                                                         |       | 2,763                       |       |                        | —     |   |   |
| Derivative  liabilities                                                                                                                                                                                       |       | 1,465                       |       |                        | 750        |   |   |
| **Total liabilities**                                                                                                                                                                                         |       | 13,635,394                  |       |                        | 1,590,592  |   |   |
| **Stockholders’ Equity**                                                                                                                                                                                 |       |                        |       |                        |       |   |   |
| Preferred stock,  $0.01 par value, 50,000,000 shares authorized and none issued and outstanding  at December 31, 2005 and December 31, 2004                                                         |       | —                      |       |                        | —     |   |   |
| Common stock,  $0.01 par value, 250,000,000 shares authorized and 80,374,061 shares issued  and outstanding at December 31, 2005 and 41,004,492 shares issued and  outstanding at December 31, 2004 |       | 804                         |       |                        | 410        |   |   |
| Additional paid-in-capital                                                                                                                                                                                    |       | 1,639,996                   |       |                        | 761,327    |   |   |
| Accumulated other  comprehensive income                                                                                                                                                                       |       | 18,344                      |       |                        | 1,720      |   |   |
| Accumulated  deficit                                                                                                                                                                                          |       | (3,998                      | )          |                        | (6,709     | ) |   |
| **Total stockholders’ equity**                                                                                                                                                                           |       | 1,655,146                   |       |                        | 756,748    |   |   |
| **Total  liabilities and stockholders’ equity**                                                                                                                                                          |       | $                           | 15,290,540 |                        |       | $ | 2,347,340 |   |   |

 

See notes to consolidated financial statements.

F-4

----

**KKRFinancial Corp. and SubsidiariesConsolidated Statementsof Operations(Amounts in thousands, except per share information)**

| ** **                                                                   | ** ** | **Year ended  December 31, 2005** | ** ** | **For the Period from  August 12, 2004  (Inception) through  December 31, 2004** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| **Net investment income:**                                                   |       |                                             |       |                                                                                                                     |       |   |   |   |   |
| Securities  interest income                                                  |       |                                             | $          | 186,510                                                                                                                  |       |   |   | $ | 2,715 |   |   |
| Loan interest  income                                                        |       |                                             | 206,663    |                                                                                                                     |       |   | 1,914 |   |   |
| Dividend income                                                              |       |                                             | 3,421      |                                                                                                                     |       |   | 296 |   |   |
| Other interest  income                                                       |       |                                             | 3,335      |                                                                                                                     |       |   | 3,197 |   |   |
| Total investment  income                                                     |       |                                             | 399,929    |                                                                                                                     |       |   | 8,122 |   |   |
| Interest expense                                                             |       |                                             | (279,718   | )                                                                                                                        |       |   | (975 | ) |   |
| Provision for  loan losses                                                   |       |                                             | (1,500     | )                                                                                                                        |       |   | — |   |   |
| Net investment  income                                                       |       |                                             | 118,711    |                                                                                                                     |       |   | 7,147 |   |   |
| **Other income:**                                                            |       |                                             |       |                                                                                                                     |       |   |   |   |   |
| Net realized and  unrealized gain (loss) on derivatives and foreign exchange |       |                                             | 113        |                                                                                                                     |       |   | (570 | ) |   |
| Net realized gain  on investments                                            |       |                                             | 4,117      |                                                                                                                     |       |   | 75 |   |   |
| Fee and other  income                                                        |       |                                             | 3,330      |                                                                                                                     |       |   | 7 |   |   |
| Total other  income (loss)                                                   |       |                                             | 7,560      |                                                                                                                     |       |   | (488 | ) |   |
| **Non-investment expenses:**                                                 |       |                                             |       |                                                                                                                     |       |   |   |   |   |
| Related party  management compensation                                       |       |                                             | 50,791     |                                                                                                                     |       |   | 11,222 |   |   |
| Professional  services                                                       |       |                                             | 4,121      |                                                                                                                     |       |   | 901 |   |   |
| Loan servicing  expense                                                      |       |                                             | 5,143      |                                                                                                                     |       |   | — |   |   |
| Insurance expense                                                            |       |                                             | 975        |                                                                                                                     |       |   | 335 |   |   |
| Directors  expenses                                                          |       |                                             | 1,071      |                                                                                                                     |       |   | 341 |   |   |
| General and  administrative expenses                                         |       |                                             | 5,945      |                                                                                                                     |       |   | 797 |   |   |
| Total non-investment  expenses                                               |       |                                             | 68,046     |                                                                                                                     |       |   | 13,596 |   |   |
| Income (loss)  before income tax expense (benefit)                           |       |                                             | 58,225     |                                                                                                                     |       |   | (6,937 | ) |   |
| Income tax  expense (benefit)                                                |       |                                             | 3,144      |                                                                                                                     |       |   | (228 | ) |   |
| Net income (loss)                                                            |       |                                             | $          | 55,081                                                                                                                   |       |   |   | $ | (6,709 | ) |   |
| Net income (loss) per  common share:                                         |       |                                             |       |                                                                                                                     |       |   |   |   |   |
| Basic                                                                        |       |                                             | $          | 0.93                                                                                                                     |       |   |   | $ | (0.17 | ) |   |
| Diluted                                                                      |       |                                             | $          | 0.92                                                                                                                     |       |   |   | $ | (0.17 | ) |   |
| Weighted-average  number of common shares outstanding:                       |       |                                             |       |                                                                                                                     |       |   |   |   |   |
| Basic                                                                        |       |                                             | 58,998     |                                                                                                                     |       |   | 39,796 |   |   |
| Diluted                                                                      |       |                                             | 60,087     |                                                                                                                     |       |   | 39,796 |   |   |
| Distributions declared  per common share                                     |       |                                             | $          | 0.97                                                                                                                     |       |   |   | $ | — |   |   |

 

See notes to consolidated financial statements.

F-5

----

**KKRFinancial Corp. and SubsidiariesConsolidated Statements of Changes in Stockholders’ Equity(Amounts in thousands)**

| ** **                                                      | ** ** | **Shares of  Common  Stock** | ** ** | **Common  Stock at  Par  Value** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| **Balance  at August 12, 2004**                            |       |                              | —     |                                  |       |                             | $          | —                                        |       |                     | $          | 1                                     |       |                                  | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | 1 |   |   |
| Net loss                                                        |       |                              | —     |                                  |       |                             | —     |                                          |       | —                   |       |                                  | —     |                                  |       |   | (6,709 | ) |   |   | (6,709 | ) |   |   | (6,709 | ) |   |
| Net change in  unrealized gain on securities available-for-sale |       |                              | —     |                                  |       |                             | —     |                                          |       | —                   |       |                                  | 1,720      |                                  |       |   | — |   |   |   | 1,720 |   |   |   | 1,720 |   |   |
| Comprehensive  loss                                             |       |                              |       |                                  |       |                             |       |                                          |       |                     |       |                                  |       |                                  |       |   |   |   |   |   | $ | (4,989 | ) |   |   |   |   |   |
| Issuance of  common stock, net of expenses                      |       |                              | 41,004     |                                  |       |                             | 410        |                                          |       | 760,865                  |       |                                  | —     |                                  |       |   | — |   |   |   |   |   |   |   | 761,275 |   |   |
| Amortization of  common stock options                           |       |                              | —     |                                  |       |                             | —     |                                          |       | 461                      |       |                                  | —     |                                  |       |   | — |   |   |   |   |   |   |   | 461 |   |   |
| **Balance  at December 31, 2004**                          |       |                              | 41,004     |                                  |       |                             | 410        |                                          |       | 761,327                  |       |                                  | 1,720      |                                  |       |   | (6,709 | ) |   |   |   |   |   |   | 756,748 |   |   |
| Net income                                                      |       |                              |       |                                  |       |                             |       |                                          |       |                     |       |                                  |       |                                  |       |   | 55,081 |   |   |   | 55,081 |   |   |   | 55,081 |   |   |
| Net change in  unrealized gain on cash flow hedges              |       |                              | —     |                                  |       |                             | —     |                                          |       | —                   |       |                                  | 45,559     |                                  |       |   | — |   |   |   | 45,559 |   |   |   | 45,559 |   |   |
| Net change in  unrealized loss on securities available-for-sale |       |                              | —     |                                  |       |                             | —     |                                          |       | —                   |       |                                  | (28,935    | )                                     |       |   | — |   |   |   | (28,935 | ) |   |   | (28,935 | ) |   |
| Comprehensive  income                                           |       |                              | —     |                                  |       |                             | —     |                                          |       | —                   |       |                                  | —     |                                  |       |   | — |   |   |   | $ | 71,705 |   |   |   |   |   |   |
| Cash  distributions on common stock                             |       |                              | —     |                                  |       |                             | —     |                                          |       | —                   |       |                                  | —     |                                  |       |   | (52,370 | ) |   |   |   |   |   |   | (52,370 | ) |   |
| Issuance of  common stock, net of expenses                      |       |                              | 39,375     |                                  |       |                             | 394        |                                          |       | 848,423                  |       |                                  | —     |                                  |       |   | — |   |   |   |   |   |   |   | 848,817 |   |   |
| Amortization of  restricted common stock                        |       |                              | —     |                                  |       |                             | —     |                                          |       | 28,104                   |       |                                  | —     |                                  |       |   | — |   |   |   |   |   |   |   | 28,104 |   |   |
| Forfeiture of  restricted common stock                          |       |                              | (5         | )                                     |       |                             | —     |                                          |       | (13                      | )          |                                  | —     |                                  |       |   | — |   |   |   |   |   |   |   | (13 | ) |   |
| Amortization of  common stock options                           |       |                              | —     |                                  |       |                             | —     |                                          |       | 2,155                    |       |                                  | —     |                                  |       |   | — |   |   |   |   |   |   |   | 2,155 |   |   |
| **Balance at December 31,  2005**                          |       |                              | 80,374     |                                  |       |                             | $          | 804                                           |       |                     | $          | 1,639,996                             |       |                                  | $          | 18,344 |   |   |   | $ | (3,998 | ) |   |   |   |   |   |   | $ | 1,655,146 |   |   |

 

See notes to consolidatedfinancial statements.

F-6

 

----

**KKRFinancial Corp. and SubsidiariesConsolidated Statements of Cash Flows(Amounts in thousands)**

| ** **                                                                            | ** ** | **Year ended  December 31, 2005** | ** **   | **For the Period from  August 12, 2004  (Inception) through  December  31, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------|--------------|--------------------------------------------------------------------------------------------------------------------------------|------------|
| **Cash flows from operating activities:**                                             |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Net income (loss)                                                                     |       |                                             | $            | 55,081                                                                                                                         |       |   |   | $ | (6,709 | ) |   |
| Adjustments to reconcile net income (loss) to cash  provided by operating activities: |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Unrealized gain (loss)  on derivatives                                                |       |                                             | (851         | )                                                                                                                              |       |   | 527 |   |   |
| Realized gain on  foreign exchange                                                    |       |                                             | (68          | )                                                                                                                              |       |   | — |   |   |
| Provision for loan  losses                                                            |       |                                             | 1,500        |                                                                                                                           |       |   | — |   |   |
| Share-based  compensation                                                             |       |                                             | 30,246       |                                                                                                                           |       |   | 6,226 |   |   |
| Net gain on sale  of securities available-for-sale                                    |       |                                             | (2,667       | )                                                                                                                              |       |   | — |   |   |
| Net gain on sale  of loans                                                            |       |                                             | (1,450       | )                                                                                                                              |       |   | — |   |   |
| Depreciation and  amortization                                                        |       |                                             | 10,634       |                                                                                                                           |       |   | 81 |   |   |
| Deferred income  tax expense (benefit)                                                |       |                                             | 925          |                                                                                                                           |       |   | (228 | ) |   |
| Changes in assets and liabilities:                                                    |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Interest  receivable                                                                  |       |                                             | (57,621      | )                                                                                                                              |       |   | (2,694 | ) |   |
| Other assets                                                                          |       |                                             | (10,047      | )                                                                                                                              |       |   | (710 | ) |   |
| Related party  payable                                                                |       |                                             | 1,908        |                                                                                                                           |       |   | 1,765 |   |   |
| Accounts payable,  accrued expenses and other liabilities                             |       |                                             | 46,833       |                                                                                                                           |       |   | 1,157 |   |   |
| Accrued interest  payable                                                             |       |                                             | 20,644       |                                                                                                                           |       |   | 771 |   |   |
| Net cash provided  by operating activities                                            |       |                                             | 95,067       |                                                                                                                           |       |   | 186 |   |   |
| **Cash flows from investing activities:**                                             |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Purchase of  securities available-for-sale                                            |       |                                             | (6,279,068   | )                                                                                                                              |       |   | (1,664,369 | ) |   |
| Principal payments  on securities available-for-sale                                  |       |                                             | 1,561,034    |                                                                                                                           |       |   | 14,813 |   |   |
| Proceeds from sale  of securities available-for-sale                                  |       |                                             | 381,134      |                                                                                                                           |       |   | — |   |   |
| Purchase of loans                                                                     |       |                                             | (9,219,553   | )                                                                                                                              |       |   | (683,377 | ) |   |
| Principal payments  on loans                                                          |       |                                             | 846,504      |                                                                                                                           |       |   | 620 |   |   |
| Proceeds from sale  of loans                                                          |       |                                             | 207,160      |                                                                                                                           |       |   | — |   |   |
| Purchases of  non-marketable equity securities                                        |       |                                             | (52,500      | )                                                                                                                              |       |   | — |   |   |
| Purchase of  derivatives                                                              |       |                                             | (1,477       | )                                                                                                                              |       |   | — |   |   |
| Net additions to  restricted cash and cash equivalents                                |       |                                             | (78,902      | )                                                                                                                              |       |   | (1,321 | ) |   |
| Purchase of  leasehold improvements and equipment                                     |       |                                             | (1,716       | )                                                                                                                              |       |   | (993 | ) |   |
| Net cash used in  investing activities                                                |       |                                             | (12,637,384  | )                                                                                                                              |       |   | (2,334,627 | ) |   |
| **Cash flows from financing activities:**                                             |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Net proceeds from  issuance of common shares                                          |       |                                             | 848,817      |                                                                                                                           |       |   | 755,510 |   |   |
| Proceeds from borrowings:                                                             |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Repurchase  agreements                                                                |       |                                             | 116,764,832  |                                                                                                                           |       |   | 2,285,274 |   |   |
| Asset-backed  secured liquidity notes                                                 |       |                                             | 3,265,145    |                                                                                                                           |       |   | — |   |   |
| Collateralized  loan obligation senior secured notes                                  |       |                                             | 1,500,000    |                                                                                                                           |       |   | — |   |   |
| Secured revolving  credit facility                                                    |       |                                             | 87,000       |                                                                                                                           |       |   | — |   |   |
| Secured demand  loan                                                                  |       |                                             | 12,636       |                                                                                                                           |       |   | 27,875 |   |   |
| Other capitalized  costs                                                              |       |                                             | (8,288       | )                                                                                                                              |       |   | — |   |   |
| Purchase of  interest rate derivatives                                                |       |                                             | (10,072      | )                                                                                                                              |       |   | — |   |   |
| Repayments of borrowings:                                                             |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Repurchase  agreements                                                                |       |                                             | (108,561,848 | )                                                                                                                              |       |   | (727,000 | ) |   |
| Asset-backed  secured liquidity notes                                                 |       |                                             | (1,261,644   | )                                                                                                                              |       |   | — |   |   |
| Secured revolving  credit facility                                                    |       |                                             | (33,000      | )                                                                                                                              |       |   | — |   |   |
| Distributions on  common stock                                                        |       |                                             | (52,370      | )                                                                                                                              |       |   | — |   |   |
| Net cash provided  by financing activities                                            |       |                                             | 12,551,208   |                                                                                                                           |       |   | 2,341,659 |   |   |
| **Net  increase in cash and cash equivalents**                                        |       |                                             | 8,891        |                                                                                                                           |       |   | 7,218 |   |   |
| **Cash and  cash equivalents at beginning of period**                                 |       |                                             | 7,219        |                                                                                                                           |       |   | 1 |   |   |
| **Cash and  cash equivalents at end of period**                                       |       |                                             | $            | 16,110                                                                                                                         |       |   |   | $ | 7,219 |   |   |
| **Supplemental cash flow information:**                                               |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Cash paid for  interest                                                               |       |                                             | $            | 259,074                                                                                                                        |       |   |   | $ | 230 |   |   |
| Cash paid for  taxes                                                                  |       |                                             | $            | 152                                                                                                                            |       |   |   | $ | — |   |   |
| **Non-cash investing and financing  activities:**                                     |       |                                             |         |                                                                                                                           |       |   |   |   |   |
| Unsettled  securities trades                                                          |       |                                             | $            | 196,315                                                                                                                        |       |   |   | $ | — |   |   |
| Issuance of  restricted common stock                                                  |       |                                             | $            | 42,405                                                                                                                         |       |   |   | $ | 24,178 |   |   |

 

See notes to consolidated financial statements.

F-7

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements**

**Note 1.**Organization

KKR Financial Corp. (the “Company” or “KKR Financial”)is a specialty finance company that invests in multiple asset classes and usesleverage to generate competitive leveraged risk-adjusted returns. The Companycurrently makes investments in the following asset classes: (i) residentialmortgage loans and mortgage-backed securities; (ii) corporate loansand debt securities; (iii) commercial real estate loans and debtsecurities; (iv) asset-backed securities; and (v) marketableand non-marketable equity securities. The Company also makes opportunisticinvestments in other asset classes from time to time.

The Company was organized as a Maryland corporation onJuly 7, 2004, and commenced operations on August 12, 2004 (“Inception”).KKR Financial Advisors LLC (the “Manager”) manages the Company pursuant to amanagement agreement (the “Management Agreement”). The Manager is an affiliateof Kohlberg Kravis Roberts & Co. L.P. The Company is taxed as a realestate investment trust (“REIT”) and is required to comply with the provisionsof the Internal Revenue Code of 1986, as amended (the “Code”), with respectthereto.

On August 12, 2004,the Company completed its initial private placement of shares of its commonstock at $20.00 per share that generated net proceeds of approximately$755.5 million. On June 29, 2005, the Company completed its initialpublic offering (the “IPO”) of 37,500,000 shares of common stock that generatednet proceeds of approximately $848.8 million. The Company sold 37,471,250common shares at a price of $24.00 per share and selling stockholders sold28,750 shares. The Company’s stock is listed on the New York Stock Exchangeunder the symbol “KFN” and began trading on June 24, 2005. On June 23,2005 the Company effectuated a reverse stock split of its common stock at aratio of one share of common stock for every two shares of common stock thenoutstanding. The accompanying consolidated financial statements have beenadjusted to give effect to the reverse stock split for all periods presented.

**Note 2.**Summary ofSignificant Accounting Policies

**Basis of Presentation**

The accompanyingconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America (“GAAP”).The consolidated financial statements include the accounts of the Company andits taxable REIT subsidiaries: KKR TRS Holdings, Inc. (“KKR TRS”); KKRFinancial CLO 2005-1, Ltd. (“CLO 2005-1”); KKR Financial CLO 2005-2, Ltd.(“CLO 2005-2”); KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”),and KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”). TheCompany intends to make a taxable REIT subsidiary election with respect to KKRFinancial CLO 2006-2, Ltd. (“CLO 2006-2”) in the future. KKR TRSwas formed to make, from time to time, certain investments that would not beREIT qualifying investments if made directly by the Company, and to earn incomethat would not be REIT qualifying income if earned directly by the Company. CLO2005-1, CLO 2005-2, CLO 2006-1, and CLO 2006-2 areentities established to execute collateralized loan obligation (“CLO”) securedfinancing transactions. CDO 2005-1 is an entity established to complete acollateralized debt obligation (“CDO”) secured financing transaction. Theconsolidated financial statements also include the accounts of the Company’squalified REIT subsidiaries: KKR Financial Mortgage Corp. (“KKR Mortgage”); KKRQRS #1, Inc. (“KKR QRS”); and KKR Pacific Funding Trust and KKR PacificFunding Depositor Corporation (collectively, “KKR Pacific”). KKR Mortgage wasformed to sell, from time to time, the Company’s whole loan mortgage pools inresidential mortgage-backed securitization (“RMBS”) transactions. KKR QRS wasformed to hold the residual interests in RMBS transactions structured as realestate mortgage investment conduits (“REMICs”) for tax 

F-8

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2. Summaryof Significant Accounting Policies (Continued)**

purposes.KKR Pacific was formed to finance the Company’s RMBS investments through theissuance of asset-backed secured liquidity notes. The term “Company” refers tothese entities collectively, unless otherwise noted. The entities consolidatedby the Company are either wholly-owned subsidiaries or entities established tocomplete secured financing transactions that are considered to be variableinterest entities and for which the Company is the primary beneficiary. Foradditional information, see “Consolidation” below. Certain amounts for priorperiods have been reclassified to conform to the December 31, 2005presentation.

**Use of Estimates**

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the amounts reported in the Company’sconsolidated financial statements and accompanying notes. Actual results coulddiffer from management’s estimates.

**Consolidation**

The Company consolidates all non-variable interestentities in which it holds a greater than 50 percent voting interest. TheCompany also consolidates all variable interest entities (“VIEs”) for which itis considered to be the primary beneficiary pursuant to Financial AccountingStandards Board (“FASB”) Interpretation No. 46R, *Consolidation of Variable Interest Entities—aninterpretation of ARB No. 51*, as revised (“FIN 46R”). Ingeneral, FIN 46R requires an enterprise to consolidate a VIE when theenterprise holds a variable interest in the VIE and is deemed to be the primarybeneficiary of the VIE. An enterprise is the primary beneficiary if it absorbsa majority of the VIE’s expected losses, receives a majority of the VIE’sexpected residual returns, or both.

CLO 2005-1, CLO 2005-2, CLO 2006-1,CLO 2006-2, and CDO 2005-1 are VIEs and are not considered to bequalifying special-purpose entities (“QSPE”) as defined by Statement ofFinancial Accounting Standards No. 140, *Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities* (“SFAS No. 140”). The Company has determined it isthe primary beneficiary of these entities and has included the accounts ofthese entities in these consolidated financial statements.

All inter-companybalances and transactions have been eliminated in consolidation.

**Cash and Cash Equivalents**

Cash and cash equivalentsinclude cash on hand, cash held in banks and highly liquid investments withoriginal maturities of three months or less. Interest income earned on cash andcash equivalents is recorded in other interest income.

**RestrictedCash and Cash Equivalents**

Restricted cash and cashequivalents represent amounts that are held by third parties under certain ofthe Company’s financing and derivative transactions. Interest income earned onrestricted cash and cash equivalents is recorded in other interest income.

F-9

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2. Summary of Significant AccountingPolicies (Continued)**

**SecuritiesAvailable-for-Sale**

The Company classifies its investments in securitiesas available-for-sale as the Company may sell them prior to maturity and doesnot hold them principally for the purpose of selling them in the near term.These investments are carried at estimated fair value, with unrealized gainsand losses reported in accumulated other comprehensive income. Estimated fairvalues are based on quoted market prices, when available, or on estimatesprovided by independent pricing sources or dealers who make markets in suchsecurities. Upon the sale of a security, the realized net gain or loss iscomputed on a specific identification basis.

The Company monitors itsavailable-for-sale investment portfolio for impairments. A loss is recognizedwhen it is determined that a decline in the estimated fair value of a securitybelow its amortized cost is other-than-temporary. The Company considers manyfactors in determining whether the impairment of a security is deemed to beother-than-temporary, including but not limited to the length of time thesecurity has had a decline in estimated fair value below its amortized cost,the amount of the unrealized loss, the intent and ability of the Company tohold the security for a period of time sufficient for a recovery in value,recent events specific to the issuer or industry, external credit ratings andrecent changes in such ratings.

Unamortized premiums anddiscounts on non-residential mortgage-backed securities are recognized ininterest income over the contractual life, adjusted for actual prepayments, ofthe securities using the effective interest method. For securities representingbeneficial interests in securitizations (i.e., residential mortgage-backedsecurities), unamortized premiums and discounts are recognized over thecontractual life, adjusted for estimated prepayments and estimated creditlosses of the securities using the effective interest method. Actual prepaymentand credit loss experience is reviewed quarterly and effective yields arerecalculated when differences arise between prepayments and credit lossesoriginally anticipated compared to amounts actually received plus anticipatedfuture prepayments.

**Non-marketable Equity Securities**

Non-marketable equitysecurities consist primarily of private equity investments. These investmentsare accounted for under the cost method. The Company reviews these investmentsquarterly for possible other-than-temporary impairment. The Company reduces thecarrying value of the investment and recognizes a loss when the Companyconsiders a decline in estimated fair value to be other-than-temporary.

**Loans**

The Company purchases pools of residential mortgagewhole loans and participations in corporate leveraged loans and commercial realestate loans in the primary and secondary market. Loans are held for investmentand the Company initially records loans at their purchase prices. The Companysubsequently accounts for loans based on their outstanding principal plus orminus unaccreted purchase discounts and unamortized purchase premiums. Incertain instances, where the credit fundamentals underlying a particular loanhave materially changed in such a manner that the Company’s expectedreturn  may decrease, the Company mayelect to sell a loan held for investment due to adverse changes in credit 

F-10

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2. Summaryof Significant Accounting Policies (Continued)**

fundamentals. Once thedetermination has been made by the Company that it will no longer hold the loanfor investment, the Company accounts for the loan at the lower of amortizedcost or estimated fair value.

Interest income on loansincludes interest at stated coupon rates adjusted for accretion of purchasediscounts and the amortization of purchase premiums. For corporate andcommercial real estate loans,   unamortizedpremiums and discounts are recognized in interest income over the contractuallife, adjusted for actual prepayments, of the loans using the effectiveinterest method. For residential mortgage loans, unamortized premiums anddiscounts are recognized over the contractual life, adjusted for estimatedprepayments using the effective interest method.

**Allowance andProvision for Loan Losses**

The Company maintains an allowance for loan losses ata level that management considers adequate based on an evaluation of known andinherent risks in the loan portfolio, including historical and industry lossexperience, economic conditions and trends, estimated fair values and thequality of collateral, estimated fair values of the loans and other relevantfactors.

To estimate the allowance for loan losses, the Companyfirst identifies impaired loans. Loans are generally evaluated for impairmentindividually, but loans purchased on a pooled basis with relatively smallerbalances and substantially similar characteristics may be evaluatedcollectively for impairment. The Company considers a loan to be impaired when,based on current information and events, management believes it is probablethat the Company will be unable to collect all amounts due pursuant to thecontractual terms of the loan agreement. When a loan is impaired, the allowancefor loan losses is increased by the amount of the excess of the amortized costbasis of the loan over its estimated fair value. Estimated fair value may bedetermined based on (i) observable market quotes; (ii) the estimatedsales price of the collateral less estimated disposition costs; or (iii) thepresent value of projected future net cash flows. Increases in the allowancefor loan losses are recognized in the statements of operations as a provisionfor loan losses. A charge-off or write-down of a loan is recorded, and theallowance for loan losses is reduced, when the loan or a portion thereof isconsidered uncollectible and of such little value that further pursuit ofcollection is not warranted.

An impaired loan may beleft on accrual status during the period the Company is pursuing repayment ofthe loan; however, the loan is placed on non-accrual status at such time as: (i) managementbelieves that scheduled debt service payments will not be met within the coming12 months; (ii) the loan becomes 90 days delinquent; (iii) managementdetermines the borrower is incapable of, or has ceased efforts toward, curingthe cause of the impairment; or (iv) the net realizable value of theunderlying collateral securing the loan approximates the Company’s carryingvalue of such loan. While on non-accrual status, previously recognized accruedinterest is reversed and interest income is recognized only upon actualreceipt.

**LeaseholdImprovements and Equipment**

Leasehold improvements andequipment are carried at cost less depreciation and amortization and reviewedfor impairment whenever events or changes in circumstances indicate that thecarrying amount of the assets might not be recoverable. Equipment isdepreciated using the straight-line method over the estimated useful lives ofthe respective assets of three years. Leasehold improvements are amortized on a

F-11

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2. Summaryof Significant Accounting Policies (Continued)**

straight-linebasis over the shorter of their estimated useful lives or lease terms.Leasehold improvements and equipment, net of accumulated depreciation andamortization, are included in other assets.

**Borrowings**

The Company finances theacquisition of its investments, including loans and securitiesavailable-for-sale, primarily through the use of secured borrowings in the formof securitization transactions structured as secured financings, repurchaseagreements, asset-backed secured liquidity notes, warehouse facilities, demandloans, and other secured and unsecured borrowings. The Company recognizesinterest expense on all borrowings on an accrual basis.

**Derivative Financial Instruments**

The Company recognizes all derivatives on the consolidatedbalance sheet at estimated fair value. In accordance with SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, as amended and interpreted (“SFAS No. 133”), theCompany designates and documents each derivative contract as one of thefollowing at the time the contract is executed: (i) a hedge of arecognized asset or liability or an unrecognized firm commitment; (ii) ahedge of a forecasted transaction or of the variability of cash flows to bereceived or paid related to a recognized asset or liability; (iii) a hedgeof a net investment in a foreign operation; or (iv) a derivativeinstrument not designated as a hedging instrument.

In accordance with SFAS No. 133,the Company designates certain of its derivative instruments as cash flowhedges and formally documents its hedge relationships, including identificationof the hedging instruments and the hedged items, as well as its risk managementobjectives and strategies for undertaking the hedge transaction, prior to theexecution of the derivative contract. The Company assesses the effectiveness ofthe hedge both at inception and on an on-going basis and determines whether thehedge is highly effective in offsetting changes in cash flows of the hedgeditem. The Company records the effective portion of changes in the estimatedfair value of the cash flow hedges in accumulated other comprehensive incomeand subsequently reclassifies the related amount of accumulated othercomprehensive income to earnings in the consolidated statements of operationswhen the hedging relationship is terminated. If it is determined that aderivative has ceased to be a highly effective hedge, the Company willdiscontinue hedge accounting for such transaction. For derivatives that are notdesignated as hedges (“free-standing derivatives”), all changes in estimatedfair value are recognized in the consolidated statements of operations.

**Foreign Currency**

The Company makes investments in non-U.S. dollardenominated securities and loans. As a result, the Company is subject to therisk of fluctuation in the exchange rate between the U.S. dollar and theforeign currency in which it makes an investment. In order to reduce thecurrency risk, the Company may hedge the applicable foreign currency. Allinvestments denominated in foreign currency are converted to the U.S. dollarusing prevailing exchange rates on the balance sheet date. Income, expenses,gains and losses on investments denominated in foreign currency are convertedto the U.S. dollar using the prevailing exchange rates on the dates when theyare recorded. Foreign exchange gains and losses are recorded in theconsolidated statements of operations.

F-12

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2.**Summaryof Significant Accounting Policies (Continued)

**Manager Compensation**

The Company’s ManagementAgreement provides for the payment of a base management fee to the Manager, aswell as an incentive fee if the Company’s financial performance exceeds certainbenchmarks. See Note 11 for further discussion of the specific terms ofthe computation and payment of the incentive fee. The base management fee andthe incentive fee are accrued and expensed during the period for which they areearned by the Manager.

**Share-Based Payments**

The Company accounts forshare-based compensation issued to its Directors and to its Manager usingthe fair value based methodology prescribed by SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”).Compensation cost related to restricted common stock issued to the Company’sDirectors is measured at its estimated fair value at the grant date, and isamortized and expensed over the vesting period on a straight-line basis.Compensation cost related to restricted common stock and common stock optionsissued to the Manager is initially measured at estimated fair value at thegrant date, and is remeasured on subsequent dates to the extent the awards areunvested. The Company has elected to use the graded vesting attribution methodpursuant to SFAS No. 123(R) to amortize compensation expense for therestricted common shares and common stock options granted to the Manager.

**Income Taxes**

The Company has elected to be taxed as a REIT and isrequired to comply with the provisions of the Code with respect thereto.Accordingly, the Company is not subject to federal income tax to the extentthat its distributions to stockholders satisfy the REIT requirements andcertain asset, income and ownership tests and recordkeeping requirements are fulfilled.Even though the Company qualifies for federal taxation as a REIT, it may besubject to some amount of federal, state, local and foreign taxes based on theCompany’s taxable income.

KKR TRS, CLO 2005-1,CLO 2005-2, CLO 2006-1, CLO 2006-2 and CDO 2005-1 are notconsolidated for federal income tax return purposes. For financial reportingpurposes, current and deferred taxes are provided for on the portion ofearnings recognized by the Company with respect to its interest in KKR TRS, adomestic taxable REIT subsidiary, because it is taxed as a regular subchapter Ccorporation under the provisions of the Code. Deferred income tax assets andliabilities are computed based on temporary differences between the GAAPconsolidated financial statements and the federal income tax basis of assetsand liabilities as of each consolidated balance sheet date. CLO 2005-1,CLO 2005-2, CLO 2006-1 and CDO 2005-1, the Company’s foreigntaxable REIT subsidiaries, and CLO 2006-2, which will elect to be a taxableREIT subsidiary in the future, are organized as exempted companies incorporatedwith limited liability under the laws of the Cayman Islands, and are generallyexempt from federal and state income tax at the corporate entity level becausethey restrict their activities in the United States to trading in stock andsecurities for their own account. Therefore, despite their status as taxableREIT subsidiaries, they generally will not be subject to corporate income taxon their earnings, and no provision for income taxes for the year ended December 31,2005 is required; however, the Company will generally be required to includetheir current taxable income in its calculation of REIT taxable income.

F-13

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2. Summary of Significant AccountingPolicies (Continued)**

**Earnings Per Share**

In accordance with SFAS No. 128,*Earnings per Share*, the Companypresents both basic and diluted earnings (loss) per common share (“EPS”) in itsconsolidated financial statements and footnotes thereto. Basic earnings (loss)per common share (“Basic EPS”) excludes dilution and is computed by dividingnet income or loss allocable to common stockholders by the weighted averagenumber of common shares, including vested restricted common shares, outstandingfor the period. Diluted earnings per share (“Diluted EPS”) reflects thepotential dilution of common stock options and unvested restricted commonstock, if they are not anti-dilutive. See Note 3 for earnings per commonshare computations.

**Recent Accounting Pronouncements**

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections,* which replaces APBOpinion No. 20, *Accounting Changes*and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements—An Amendment of APB Opinion No. 28.*SFAS No. 154 provides guidance on the accounting for and reporting ofaccounting changes and error corrections. It establishes retrospectiveapplication, or the latest practicable date, as the required method forreporting a change in accounting principle and the reporting of a correction ofan error. SFAS No. 154 is required to be adopted by the Company in thefirst quarter of 2006. The Company does not expect that the adoption of SFAS No. 154will have a material impact on its consolidated financial statements.

In November 2005, the FASB issued FASB StaffPosition FAS 115-1 and FAS 124-1, *The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments*(“FSP 115-1”), which provides guidance on determining when investments incertain debt and equity securities are considered impaired, whether thatimpairment is other-than-temporary, and on measuring such impairment loss. FSP115-1 also includes accounting considerations subsequent to therecognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. FSP 115-1 is required to be adopted bythe Company in the first quarter of 2006. The Company does not expect that theadoption of FSP 115-1 will have a material impact on its consolidatedfinancial statements.

In February 2006, theFASB issued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments*. Key provisions of SFAS No. 155include: (1) a broad fair value measurement option for certain hybridfinancial instruments that contain an embedded derivative that would otherwiserequire bifurcation; (2) clarification that only the simplest separationsof interest payments and principal payments qualify for the exception affordedto interest-only strips and principal-only strips from derivative accountingunder paragraph 14 of SFAS No. 133 (thereby narrowing such exception); (3) arequirement that beneficial interests in securitized financial assets beanalyzed to determine whether they are freestanding derivatives or whether theyare hybrid instruments that contain embedded derivatives requiring bifurcation;(4) clarification that concentrations of credit risk in the form ofsubordination are not embedded derivatives; and (5) elimination of theprohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, 

F-14

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 2. Summaryof Significant Accounting Policies (Continued)**

includinginterest-only strips and principal-only strips, required to be accounted for inaccordance with SFAS No. 133. The Company does not expect that theadoption of SFAS No. 155 will have a material effect on its consolidatedfinancial statements.

**Note 3.**Earnings perShare

The Company calculatesbasic net income per common share by dividing net income for the period by theweighted-average shares of its common stock outstanding for the period.Diluted net income per common share takes into account the effect of dilutiveinstruments, such as common stock options and unvested restricted common stock,but uses the average share price for the period in determining the number ofincremental shares that are to be added to the weighted-average number ofshares of its common stock outstanding. The following table presents areconciliation of basic and diluted net income per common share for the yearended December 31, 2005 (amounts in thousands, except per shareinformation):

| ** **                                                                | ** ** | **Year ended  December 31, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| **Basic:**                                                                |       |                                             |       |   |   |
| Net income                                                                |       |                                             | $          | 55,081 |   |   |
| Weighted-average  number of common shares outstanding                     |       |                                             | 58,998     |   |   |
| Basic net income  per common share                                        |       |                                             | $          | 0.93 |   |   |
| **Diluted:**                                                              |       |                                             |       |   |   |
| Net income                                                                |       |                                             | $          | 55,081 |   |   |
| Weighted-average  number of common shares outstanding                     |       |                                             | 58,998     |   |   |
| Plus: Incremental  shares from assumed conversion of dilutive instruments |       |                                             | 1,089      |   |   |
| Adjusted weighted-average  number of common shares outstanding            |       |                                             | 60,087     |   |   |
| Diluted net income per  common share                                      |       |                                             | $          | 0.92 |   |   |

 

For the period fromInception through December 31, 2004, the Company incurred a net loss of$0.17 per common share. Inclusion of common stock options and unvestedrestricted common stock in the diluted loss per common share calculation wouldreduce the net loss per common share amount; therefore, they are consideredanti-dilutive. As a result, the Company’s diluted loss per common share isequal to its basic loss per common share for such period.

F-15

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 4.**SecuritiesAvailable-for-Sale

Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of December 31, 2005, which are carried at estimatedfair value (amounts in thousands):

| **Description**                         | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| Residential  mortgage-backed securities |       | $          | 5,566,783  |                |       | $                            | 9,893      |                            |       |                           | $          | (38,838 | ) |   | $ | 5,537,838 |   |
| Commercial  mortgage-backed securities  |       | 83,001     |       |                | 94         |                         |       |                            | (183       | )                              |       | 82,912 |   |
| Asset-backed  securities                |       | 21,846     |       |                | 73         |                         |       |                            | —     |                           |       | 21,919 |   |
| Corporate  securities                   |       | 457,932    |       |                | 7,829      |                         |       |                            | (5,926     | )                              |       | 459,835 |   |
| Common and  preferred stock             |       | 47,158     |       |                | 232        |                         |       |                            | (388       | )                              |       | 47,002 |   |
| Total                                   |       | $          | 6,176,720  |                |       | $                            | 18,121     |                            |       |                           | $          | (45,335 | ) |   | $ | 6,149,506 |   |

 

The following tablesummarizes the Company’s securities classified as available-for-sale as of December 31,2004, which are carried at estimated fair value (amounts in thousands):

| **Description**                         | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| Residential  mortgage-backed securities |       | $          | 1,581,824  |                |       | $                            | 911        |                            |       |                           | $          | (24 | ) |   | $ | 1,582,711 |   |
| Commercial  mortgage-backed securities  |       | 12,000     |       |                | 7          |                         |       |                            | —     |                           |       | 12,007 |   |
| Asset-backed  securities                |       | 5,000      |       |                | —     |                         |       |                            | —     |                           |       | 5,000 |   |
| Corporate  securities                   |       | 19,578     |       |                | 477        |                         |       |                            | (155       | )                              |       | 19,900 |   |
| Common and  preferred stock             |       | 31,158     |       |                | 504        |                         |       |                            | —     |                           |       | 31,662 |   |
| Total                                   |       | $          | 1,649,560  |                |       | $                            | 1,899      |                            |       |                           | $          | (179 | ) |   | $ | 1,651,280 |   |

 

All securities in an unrealized loss position at December 31,2005 and December 31, 2004 have been in an unrealized loss position forless than one year. The Company’s review of such securities indicates that thedecrease in estimated fair value was not due to permanent changes in theunderlying credit fundamentals or in the amount of principal and interestexpected to be received. In addition, the Company has the financial wherewithaland management has the intent to hold the securities for a period of timesufficient for a recovery in the estimated fair value. Therefore, managementdoes not believe any of the securities held are other-than-temporarily impairedat December 31, 2005 or December 31, 2004.

During the year ended December 31, 2005, theCompany’s gross realized gains from the sales of securities were $2.8 million.The Company had gross realized losses from the sales of securities during theyear ended December 31, 2005 of $0.1 million and did not sell anysecurities during the period from Inception through December 31, 2004.

F-16

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 4. SecuritiesAvailable-for-Sale (Continued)**

The following tablesummarizes the estimated fair value of debt securities by contractual maturityas of December 31, 2005 (dollars in thousands):

| **Description**         | ** ** | ** ** | ** ** | **Estimated Fair Value** | ** ** | **Weighted Average Coupon** | ** ** |
|-------------------------|------------|------------|------------|------------------------------------|------------|---------------------------------------|------------|
| Due within one  year    |       |       | $          | —                             |       |                                  |       | — | % |   |
| One to five years       |       |       | 73,991     |                               |       |                                  | 7.39       |   |   |
| Five to ten years       |       |       | 370,563    |                               |       |                                  | 9.15       |   |   |
| Greater than ten  years |       |       | 5,657,950  |                               |       |                                  | 4.50       |   |   |
| Total                   |       |       | $          | 6,102,504                          |       |                                  |       |   |   |   |

 

Mortgage-backed and asset-backed securities includedin the table above were allocated based on contractual principal maturitiesassuming no prepayments.

Note 6 to theseconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged securities available-for-sale for borrowingsunder repurchase agreements, asset-backed secured liquidity notes, and allother secured financing transactions. The following table summarizes theestimated fair value of securities pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of December 31, 2005:

| ** **                                                                     | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities(1)** | ** ** |   |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|--------|
| Pledged as  collateral for borrowings under repurchase agreements              |       |                                         | $          | 4,534,257                                   |       |                         |       | $      | 65,352 |   |   |   | $ | 286,365 |   |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       |                                         | 720,370    |                                        |       |                         | —     |   |   |   | — |   |   |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       |                                         | —     |                                        |       |                         | —     |   |   |   | 82,888 |   |   |
| Pledged as  collateral for borrowings under secured demand loan                |       |                                         | —     |                                        |       |                         | 45,057     |   |   |   | — |   |   |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       |                                         | —     |                                        |       |                         | 5,021      |   |   |   | 171,089 |   |   |
| Total                                                                          |       |                                         | $          | 5,254,627                                   |       |                         |       | $      | 115,430 |   |   |   | $ | 540,342 |   |   |

----

(1)          Includes asset-backedsecurities.

F-17

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 5.Loans**

Thefollowing table summarizes the Company’s loans as of December 31, 2005(amounts in thousands):

| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized  Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|--------------------------|------------|
| Residential  mortgage loans                               |       | $             | 6,405,701  |                                |       | $                        | 23,121     |   |   | $ | 6,428,822 |   |
| Corporate loans                                           |       | 1,900,385     |       |                                | (3,108     | )                        |       | 1,897,277 |   |
| Commercial real  estate loans                             |       | 522,750       |       |                                | (1,008     | )                        |       | 521,742 |   |
| Allowance for  loan losses for residential mortgage loans |       | (1,500        | )          |                                | —     |                     |       | (1,500 | ) |
| Total loans held for investment                           |       | 8,827,336     |       |                                | 19,005     |                     |       | 8,846,341 |   |
| Loans held for  sale                                      |       | —        |       |                                | —     |                     |       | — |   |
| Total loans, net  of allowance for loan losses            |       | $             | 8,827,336  |                                |       | $                        | 19,005     |   |   | $ | 8,846,341 |   |

 

Thefollowing table summarizes of the Company’s loans as of December 31, 2004(amounts in thousands):

| ** **                       | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized  Cost** | ** ** |
|----------------------------------|------------|---------------|------------|-------------------------------------|------------|--------------------------|------------|
| Corporate loans                  |       | $             | 400,218    |                                |       | $                        | (581       | ) |   | $ | 399,637 |   |
| Residential  mortgage loans      |       | 229,855       |       |                                | 3,265      |                     |       | 233,120 |   |
| Commercial real  estate loans    |       | 50,000        |       |                                | —     |                     |       | 50,000 |   |
| Total loans held  for investment |       | $             | 680,073    |                                |       | $                        | 2,684      |   |   | $ | 682,757 |   |

 

Thefollowing is a reconciliation of carrying amounts of residential mortgage loansfor the year ended December 31, 2005 (amount in thousands):

| Balance at  January 1, 2005   |   | $         |  229,855 |   |
|------------------------------------|--------|-----------|---------------|--------|
| Loan purchases  (principal)        |   | 6,720,923 |          |
| Principal  payments                |   | (545,077  | )             |
| Net unamortized  premium           |   | 23,121    |          |
| Balance at  December 31, 2005 |   | $         | 6,428,822     |   |

 

During the year ended December 31, 2005, theCompany purchased $5.9****billion ofsecurities in connection with****fivesecuritization transactions backed by $4.5 billion of residential hybrid ARMloans and $1.4 billion of residential ARM loans. In each of the fivesecuritization transactions, the Company purchased all of the securitiesissued, including the subordinate classes. Included in the $5.9 billion ofsecurities purchased, were $0.4 billion of loans contributed to thesecuritization transactions by the Company, resulting in a net purchase by theCompany of $5.5 billion of securities. Of the $5.9 billion of securitiespurchased, approximately 96% were rated AAA by Standard & Poor’s. Eachof the special-purpose entities that issued the securities are not consideredqualifying special-purpose entities as defined by SFAS No. 140 and aretreated as VIEs under FIN 46R. The Company has determined that it is theprimary beneficiary of each of the special-purpose entities that issued thesecurities; accordingly, the Company recorded its investments as loans and notsecurities.

F-18

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 5. Loans(Continued)**

During September 2005, the Company securitized$959.2 million of residential ARM loans and retained all of the securitiesissued in the securitization transaction, including the subordinate classes.While the Company retained all of the securities, which are legal assets of theCompany, the loans transferred in this securitization are owned by a specialpurpose entity and the loans are not available to the Company, its creditors orstockholders. Of the $959.2 million of securities issued, approximately $908.8million, or 95%, were rated AAA by Standard & Poor’s. While theCompany transferred the loans to a separate bankruptcy-remote legal entity, theCompany did not account for the transaction as a sale as the securitizationtransaction did not meet the criteria for sales treatment under SFAS No. 140.Accordingly, the Company did not record a gain or loss in connection with thesecuritization transaction and accounts for the transferred assets as loans onits consolidated balance sheet.

Thefollowing table summarizes the geographic distribution of the Company’sresidential mortgage loan portfolio as of December 31, 2005 (dollaramounts in thousands):

| **State or Territory** | ** ** | ** ** | ** ** | **Number of**

**Loans** | ** ** | **Principal Amount** | ** ** | **% of  Principal  Amount** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------|------------|---------------------------|------------|----------------------------------|------------|
| California                       |       |       | 4,123      |                          |       |                      | $          | 2,411,737                        |       |   |   | 37.7 | % |   |
| Florida                          |       |       | 1,141      |                          |       |                      | 537,735    |                             |       |   | 8.4 |   |   |
| New York                         |       |       | 598        |                          |       |                      | 384,853    |                             |       |   | 6.0 |   |   |
| New Jersey                       |       |       | 538        |                          |       |                      | 284,718    |                             |       |   | 4.4 |   |   |
| Virginia                         |       |       | 564        |                          |       |                      | 261,646    |                             |       |   | 4.1 |   |   |
| Other                            |       |       | 5,804      |                          |       |                      | 2,525,012  |                             |       |   | 39.4 |   |   |
| Total                            |       |       | 12,768     |                          |       |                      | $          | 6,405,701                        |       |   |   | 100.0 | % |   |

 

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of December 31, 2005 (dollar amounts in thousands):

| **Delinquency Status** | ** ** | ** ** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       |       | 82         |                          |       |                      | $          | 31,049 |   |   |
| 60 to 89 days               |       |       | 11         |                          |       |                      | 3,427      |   |   |
| 90 days or more             |       |       | 6          |                          |       |                      | 1,589      |   |   |
| In foreclosure              |       |       | —     |                          |       |                      | —     |   |   |
| Total                       |       |       | 99         |                          |       |                      | $          | 36,065 |   |   |

 

No residential mortgage loans were delinquent as of December 31,2004. Additionally, no corporate loans or commercial real estate loans weredelinquent as of December 31, 2005 or December 31, 2004.

Thefollowing table summarizes the changes in the allowance for loan losses for theCompany’s residential mortgage loan portfolio during the year ended December 31,2005 (amounts in thousands):

| Balance,  beginning of year |   | $      | — |   |
|-----------------------------|--------|--------|--------|--------|
| Provision for loan  losses  |   | 1,500  |   |
| Charge-offs                 |   | — |   |
| Balance, end of year        |   | $      | 1,500  |   |

 

F-19

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 5. Loans(Continued)**

As of December 31, 2004, the Company had notrecorded an allowance for loan losses for the Company’s residential mortgageloan portfolio. Additionally, as of December 31, 2005 and December 31,2004, the Company had not recorded an allowance for loan losses for itscommercial real estate or corporate loan portfolios. In reviewing the Company’sportfolio of commercial real estate loans and corporate loans, the Companydetermined that no loans were impaired as of December 31, 2005 or December 31,2004.

Note 6to these consolidated financial statements describes the Company’s borrowingsunder which the Company has pledged loans for borrowings under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions. The following table summarizes the carrying value ofloans pledged as collateral under repurchase agreements, asset-backed securedliquidity notes, and all other secured financing transactions as of December 31,2005:

| ** **                                                                     | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       |                                 | $          | 4,904,779                |       |                                        |       | $ | 145,217 |   |   |   | $ | 380,090 |   |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       |                                 | 1,366,300  |                     |       |                                        | —     |   |   |   | — |   |   |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       |                                 | —     |                     |       |                                        | 59,965     |   |   |   | 10,000 |   |   |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       |                                 | —     |                     |       |                                        | 1,715,100  |   |   |   | 40,000 |   |   |
| Total                                                                          |       |                                 | $          | 6,271,079                |       |                                        |       | $ | 1,920,282 |   |   |   | $ | 430,900 |   |   |

 

**Note 6. Borrowings**

The Company leverages its portfolio of securities andloans through the use of repurchase agreements, asset-backed secured liquiditynotes, warehouse facilities, demand loans, and securitization transactionsstructured as secured financings. Each of the borrowing vehicles used by theCompany bears interest at floating rates based on a spread above the LondonInterBank Offered Rate (“LIBOR”) or asset-backed secured liquidity noteinterest rates.

F-20

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 6. Borrowings(Continued)**

Certain information withrespect to the Company’s borrowings as of December 31, 2005 is summarizedin the following table (amounts in thousands):

| ** **                            | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral (1)** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Repurchase agreements                 |       | $                           | 9,303,622  |                                   |       | 4.33                                                       | %          |                                             |       | 24 |   |   |   | $ | 9,472,231 |   |   |
| Demand loan                           |       | 40,511                      |       |                                   | 4.63       |                                                       |       |                                             | 13         |   |   |   | 45,057 |   |   |
| Secured revolving  credit facility    |       | 54,000                      |       |                                   | 5.38       |                                                       |       |                                             | 13         |   |   |   | 152,241 |   |   |
| Asset-backed  secured liquidity notes |       | 2,008,069                   |       |                                   | 4.42       |                                                       |       |                                             | 14         |   |   |   | 2,080,072 |   |   |
| CLO 2005-1  senior secured notes      |       | 773,000                     |       |                                   | 4.49       |                                                       |       |                                             | 4,134      |   |   |   | 996,681 |   |   |
| CLO 2005-2  senior secured notes      |       | 727,000                     |       |                                   | 4.59       |                                                       |       |                                             | 4,348      |   |   |   | 946,969 |   |   |
| CLO 2006-1  repurchase agreements     |       | 193,835                     |       |                                   | 4.86       |                                                       |       |                                             | 5          |   |   |   | 436,756 |   |   |
| CDO 2005-1  repurchase agreements     |       | 263,801                     |       |                                   | 5.47       |                                                       |       |                                             | 18         |   |   |   | 388,783 |   |   |
| Total                                 |       | $                           | 13,363,838 |                                   |       |                                                       |       |                                             |       |   |   |   |   | $ | 14,518,790 |   |   |

----

(1)          Collateralfor borrowings consists of securities available-for-sale, loans, andnon-marketable equity investments.

Certain information with respect to the Company’sborrowings as of December 31, 2004 is summarized in the following table(amounts in thousands):

| ** **             | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral** | ** ** |
|------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------|------------|
| Repurchase  agreements |       | $                           | 1,558,274  |                                       |       | 2.51                                                       | %          |                                    |       | 20 |   |   | $ | 1,736,687 |   |
| Demand loan            |       | 27,875                      |       |                                       | 2.79       | %                                                          |       |                                    | 1          |   |   | 31,662 |   |
| Total                  |       | $                           | 1,586,149  |                                       |       |                                                       |       |                                    |       |   |   |   | $ | 1,768,349 |   |

 

As of December 31,2005, the Company had $9.8 billion outstanding on repurchase facilitieswith ten counterparties with a weighted average effective borrowing rate of4.47% and a weighted average remaining term to maturity of 24****days. Because the Company borrows under repurchaseagreements based on the estimated fair value of its pledged investments, andbecause changes in interest rates can negatively impact the valuation of itspledged investments, the Company’s ongoing ability to borrow under itsrepurchase facilities may be limited and its lenders may initiate margin callsin the event interest rates change or the value of its pledged securitiesdecline as a result of adverse changes in interest rates or credit spreads.

F-21

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 6. Borrowings(Continued)**

At December 31, 2005,the Company had repurchase agreements with the following counterparties(amounts in thousands): 

| **Counterparty(2)**                                  | ** ** | ** ** | ** ** | **Amount  At  Risk(1)** | ** ** | **Weighted Average  Maturity  (Days)** | ** ** | **Weighted Average  Interest Rate** | ** ** |
|------------------------------------------------------|------------|------------|------------|-------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|
| Banc of America  Securities LLC.                     |       | $          | 4,122      |                    |       | 25                                          |       |                                          |       | 4.44 | % |   |
| Bear  Stearns & Co. Inc.                    |       | 191,755    |       |                    | 24         |                                        |       |                                          | 4.46       |   |   |
| Citigroup Global  Markets Ltd                        |       | 63,773     |       |                    | 25         |                                        |       |                                          | 4.44       |   |   |
| Credit Suisse  First Boston LLC.                     |       | 27,325     |       |                    | 27         |                                        |       |                                          | 4.43       |   |   |
| Deutsche Bank AG.                                    |       | 126,994    |       |                    | 18         |                                        |       |                                          | 5.47       |   |   |
| J. P. Morgan  Chase Bank, N.A                        |       | 61,461     |       |                    | 25         |                                        |       |                                          | 4.43       |   |   |
| Lehman Brothers  Holdings Inc.                       |       | 22,317     |       |                    | 25         |                                        |       |                                          | 4.43       |   |   |
| Merrill Lynch,  Pierce, Fenner & Smith Inc. |       | 45,461     |       |                    | 30         |                                        |       |                                          | 4.43       |   |   |
| Morgan  Stanley & Co. Inc.                  |       | 255,534    |       |                    | 22         |                                        |       |                                          | 4.52       |   |   |
| UBS Financial  Services Inc.                         |       | 14,314     |       |                    | 3          |                                        |       |                                          | 4.34       |   |   |
| Total                                                |       | $          | 813,056    |                    |       |                                        |       |                                          |       |   |   |   |

----

Notes:

(1)       Computedas an amount equal to the estimated fair value of securities or loans sold,plus accrued interest income, minus the sum of repurchase agreement liabilitiesplus accrued interest expense.

(2)       Counterpartyincludes subsidiaries and affiliates of each counterparty listed.

At December 31, 2004, theCompany had repurchase agreements with the following counterparties (amounts inthousands):

**RepurchaseAgreements**

| **Counterparty(2)**             | ** ** | ** ** | ** ** | **Amount  At Risk(1)** | ** ** | **Weighted Average  Maturity  (Days)** | ** ** | **Weighted Average  Interest Rate** | ** ** |
|---------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------------------|------------|------------------------------------------|------------|
| Credit Suisse  First Boston LLC |       | $          | 48,619     |                        |       | 20                                          |       |                                     |       | 2.48 | % |   |
| Bear, Stearns  & Co. Inc.   |       | 106,695    |       |                        | 31         |                                        |       |                                     | 2.84       | % |   |
| J.P. Morgan  Securities Inc     |       | 23,942     |       |                        | 18         |                                        |       |                                     | 2.55       | % |   |
| Total                           |       | $          | 179,256    |                        |       |                                        |       |                                     |       |   |   |   |

----

Notes:

(1)          Computed as an amountequal to the estimated fair value of securities or loans sold, plus accruedinterest income, minus the sum of repurchase agreement liabilities plus accruedinterest expense.

(2)          Counterpartyincludes subsidiaries and affiliates of each counterparty listed.

On March 30,2005, the Company closed CLO 2005-1, a $1.0 billion CLO transactionthat provides financing for investments consisting of corporate loans andcertain other loans and securities. The investments that are owned by CLO 2005-1collateralize the CLO 2005-1 debt, and as a result, those  

F-22

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 6. Borrowings (Continued)**

investments are notavailable to the Company, its creditors or stockholders. CLO 2005-1issued a total of $773.0 million of senior secured notes at par toinvestors. In addition, the Company retained $148.0 million of ratedmezzanine notes and $85.5 million of unrated subordinated notes issued byCLO 2005-1.

The senior notes issued toinvestors by CLO 2005-1 consist of three classes of notes as follows: (i) $615.0 millionof class A-1 notes bearing interest at three-month LIBOR plus 0.27%;(ii) $58.0 million of class B notes bearing interest atthree-month LIBOR plus 0.45%; and (iii) $100.0 million ofclass A-2 Delayed Draw notes bearing interest on the drawn amount atthree-month LIBOR plus 0.27%. All of the notes issued mature on April 26,2017, though the Company has the right to call the notes at par any time after April 2008.

During April 2005 theCompany formed CDO 2005-1 and began borrowing on a $300.0 millionwarehouse facility, in the form of a repurchase agreement, to purchasecommercial real estate obligations. The repurchase facility bears interest at arate of 30-day LIBOR plus 1.10% and as of December 31, 2005, therewas $263.8 million outstanding.

During June 2005, theCompany entered into a $275.0 million secured revolving credit facility.This revolving credit facility matures on June 30, 2006, and, as of December 31,2005, the Company had $54.0 million of borrowings outstanding. Therevolving credit facility bears interest at 30-day LIBOR plus 1.00%.

On September 30, 2005, the Company closed a $5.0 billionasset-backed secured liquidity note facility. This facility provides theCompany with an alternative source of funding its residential mortgage-backedsecurities by issuing asset-backed secured liquidity notes that are rated A-1+,P-1, and F1+, by Standard and Poor’s, Moody’s Investors Service, or Moody’s,and Fitch Inc, respectively. Issuances of asset-backed secured liquidity notesare recorded as borrowings on the Company’s consolidated balance sheet. At December 31,2005, the Company had $2.0 billion of asset-backed secured liquidity notes outstanding.

On November 3, 2005, the Company closed CLO 2005-2,its second $1.0 billion CLO transaction that provides financing for investmentsconsisting of corporate loans and certain other loans and securities. Theinvestments that are owned by CLO 2005-2 collateralize the CLO 2005-2debt, and as a result, those investments are not available to the Company, itscreditors or stockholders. CLO 2005-2 issued a total of $752.0 million ofsenior secured notes at par to investors. In addition, the Company retained$168.0 million of rated mezzanine notes and $98.5 million o f unratedsubordinate notes issued by CLO 2005-2.

The senior notes issued to investors by CLO 2005-2consist of three classes of notes as follows: (i) $545.0 million ofclass A-1 notes bearing interest at three-month LIBOR plus 0.26%; (ii) $57.0 millionof class B notes bearing interest at three-month LIBOR plus 0.43%; and (iii) $150.0 millionof class A-2 Delayed Draw notes bearing interest on the drawn amountat three-month LIBOR plus 0.26% (at December 31, 2005, $125.0 million ofthe delayed draw notes were drawn). All of the notes issued mature on November 26,2017, though the Company has the right to call the notes at par any time after November 2009.

During 2005, the Company formed CLO 2006-1 andduring December 2005 executed a $500.0 million warehouse facility, in theform of a repurchase agreement, to finance the purchase of corporate 

F-23

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 6. Borrowings(Continued)**

loans and certain other loans and securities. Therepurchase facility bears interest at a rate of 30-day LIBOR plus 0.65%and as of December 31, 2005, there was****$117.7 millionoutstanding. Additionally, CLO 2006-1 had $76.1 million outstanding undera separate repurchase agreement from the repurchase facility as of December 31,2005. Also during December 2005, the Company formed CLO 2006-2 andexecuted a $450.0 million warehouse facility, in the form of a repurchaseagreement, to finance the purchase of corporate loans and certain other loansand securities. The repurchase facility bears interest at a rate of 30-dayLIBOR plus 0.65% and as of December 31, 2005, there were no borrowingsoutstanding.

The table below summarizes our contractual obligations(excluding interest) under our borrowing agreements as of December 31,2005 (amounts in thousands):

| ** **                            | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **Total**                                 | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More than  5 years** | ** ** |
| Repurchase  agreements                |       | $                                         | 9,303,622  |   |   | $ | 9,303,622 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |
| CLO 2005-1  senior secured notes      |       | 773,000                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 773,000 |   |
| CLO 2005-2  senior secured notes      |       | 727,000                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 727,000 |   |
| CDO 2005-1  repurchase agreements     |       | 263,801                                   |       |   | 263,801 |   |   |   | — |   |   |   | — |   |   | — |   |
| CLO 2006-1  repurchase facilities     |       | 193,835                                   |       |   | 193,835 |   |   |   | — |   |   |   | — |   |   | — |   |
| Demand loan                           |       | 40,511                                    |       |   | 40,511 |   |   |   | — |   |   |   | — |   |   | — |   |
| Secured revolving  credit facility    |       | 54,000                                    |       |   | 54,000 |   |   |   | — |   |   |   | — |   |   | — |   |
| Asset-backed  secured liquidity notes |       | 2,008,069                                 |       |   | 2,008,069 |   |   |   | — |   |   |   | — |   |   | — |   |
| Total                                 |       | $                                         | 13,363,838 |   |   | $ | 11,863,838 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,500,000 |   |

 

**Note 7.Derivative Financial Instruments**

The Company usesderivative financial instruments to hedge all or a portion of the interest raterisk associated with its borrowings under repurchase agreements andasset-backed secured liquidity notes. Certain of the techniques used to hedgeexposure to interest rate fluctuations may also be used to protect againstdeclines in the market value of assets that result from general trends in debtmarkets or from fluctuations in currency values, to the extent the Companymakes non-U.S. dollar-denominated investments. The principal objective of sucharrangements is to minimize the risks and/or costs associated with the Company’soperating and financial structure as well as to hedge specific anticipatedtransactions. The counterparties to these contractual arrangements are majorfinancial institutions with which the Company and its affiliates may also haveother financial relationships. In the event of nonperformance by thecounterparties, the Company is potentially exposed to losses. However, becauseof the high credit ratings of the counterparties with which the Company hasentered into derivative transactions, the Company does not anticipate that anyof the counterparties will fail to fulfill their obligations.

F-24

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 7. DerivativeFinancial Instruments (Continued)**

The table below summarizes the estimated net fairvalue of the derivative instruments as of December 31, 2005 and December 31,2004 (amounts in thousands):

| ** **                      | ** ** | **As of  December 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**           |       |                                        |       |                                        |       |   |   |   |   |
| Interest rate corridors         |       |                                        | $          | 14,762                                      |       |   |   | $ | — |   |   |
| Interest rate swaps             |       |                                        | 40,796     |                                        |       |   | — |   |   |
| **Free-Standing  Derivatives:** |       |                                        |       |                                        |       |   |   |   |   |
| Interest rate swaptions         |       |                                        | 879        |                                        |       |   | 223 |   |   |
| Interest rate swaps             |       |                                        | 198        |                                        |       |   | — |   |   |
| Credit default swaps            |       |                                        | 71         |                                        |       |   | (625 | ) |   |
| Total rate of return swaps      |       |                                        | 727        |                                        |       |   | — |   |   |
| Foreign exchange contracts      |       |                                        | —     |                                        |       |   | (125 | ) |   |
| Net fair value                  |       |                                        | $          | 57,433                                      |       |   |   | $ | (527 | ) |   |

 

During the year ended December 31, 2005 and theperiod ended December 31, 2004, the terms of the Company’s derivativesdesignated as cash flow hedges matched the related hedged items and, as aresult, the Company recognized zero ineffectiveness from cash flow hedges inincome. The following table summarizes by derivative instrument type the effecton income from free-standing derivatives for the periods:

| **Free-Standing Derivatives:**                                     | ** ** | ** ** | ** ** | **For the year ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (inception) through  December 31, 2004** | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Interest rate swaptions                                                 |       |       | $          | (424                                                               | )          |                                                                                                                     |       | $ | (28 | ) |   |
| Interest rate  swaps                                                    |       |       | 499        |                                                               |       |                                                                                                                     | —     |   |   |
| Credit default  swaps                                                   |       |       | (259       | )                                                                  |       |                                                                                                                     | (283       | ) |   |
| Total rate of  return swaps                                             |       |       | 755        |                                                               |       |                                                                                                                     | —     |   |   |
| Foreign exchange  contracts                                             |       |       | 2,211      |                                                               |       |                                                                                                                     | (125       | ) |   |
| Net realized and unrealized  gains (losses) on freestanding derivatives |       |       | $          | 2,782                                                              |       |                                                                                                                     |       | $ | (436 | ) |   |

 

**Note 8.Accumulated Other Comprehensive Income**

The components ofaccumulated other comprehensive income were as follows (amounts in thousands):

| ** **                                                      | ** ** | **As of  December 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized  (losses) gains on available-for-sale securities |       |                                        | $          | (27,215                                     | )          |   |   | $ | 1,720 |   |   |
| Net unrealized  gains on cash flow hedges                       |       |                                        | 45,559     |                                        |       |   | — |   |   |
| Accumulated other  comprehensive income                         |       |                                        | $          | 18,344                                      |       |   |   | $ | 1,720 |   |   |

 

F-25

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 8. AccumulatedOther Comprehensive Income (Continued)**

The changes in the components of other comprehensiveincome were as follows (amounts in thousands):

| ** **                                                     | ** ** | **Year ended  December 31, 2005** | ** ** | **Year ended  December 31, 2004** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Unrealized gains on  securities available-for-sale:            |       |                                             |       |                                             |       |   |   |   |   |
| Unrealized holding gains (losses) arising during  period       |       |                                             | $          | (26,268                                          | )          |   |   | $ | 1,720 |   |   |
| Reclassification adjustments for gains realized in  net income |       |                                             | (2,667     | )                                                |       |   | — |   |   |
| Unrealized gains  (losses) on securities available-for-sale    |       |                                             | (28,935    | )                                                |       |   | 1,720 |   |   |
| Unrealized gains  on cash flow hedges                          |       |                                             | 45,559     |                                             |       |   | — |   |   |
| Other comprehensive  income                                    |       |                                             | $          | 16,624                                           |       |   |   | $ | 1,720 |   |   |

 

**Note 9.Commitments**

**Operating Lease**

As ofDecember 31, 2005, the Company was obligated under two non-cancelableoperating leases with terms of ten years and two years, respectively. Themajority of the future lease payments are related to a ten-year operating leasefor executive offices that the Company will relocate to in 2006. The totallease payments to be made over the ten-year period, including certain free rentperiods, are being recognized as office lease expense on a straight-line basisover the ten-year period. This expense is included in general andadministrative expense on the Consolidated Statements of Operations. Total rentexpense under operating leases for the years ended December 31, 2005 and2004 was $0.7 million and $0.2 million, respectively. Minimum futureobligations on leases in effect at December 31, 2005, are approximately asfollows (amounts in thousands):

| **Year**             | ** ** | ** ** | ** ** | **Amount** | ** ** |
|----------------------|------------|------------|------------|------------|------------|
| 2006                 |       | $          | 1,132      |       |
| 2007                 |       | 1,723      |       |
| 2008                 |       | 1,379      |       |
| 2009                 |       | 1,388      |       |
| 2010                 |       | 1,429      |       |
| 2011 and  thereafter |       | 8,357      |       |
| Total                |       | $          | 15,408     |       |

 

**Loan Commitments**

As part of its strategy ofinvesting in corporate loans and commercial real estate loans, the Companycommits to purchase interests in primary market loan syndications, whichobligate the Company to acquire a predetermined interest in such loans at aspecified price on a to-be-determined settlement date. Consistent with standardindustry practices, once the Company has been informed of the amount of itssyndication allocation in a particular loan by the syndication agent, theCompany bears the risks and 

F-26

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 9. Commitments(Continued)**

benefitsof changes in the fair value of the syndicated loan from that date forward. Asof December 31, 2005, the Company had committed to purchase or participatein approximately $61.5 million of corporate loans at December 31, 2005. Inaddition, the Company had an obligation to fund delayed draw commitments, uponrequest, totaling $72.9 million at December 31, 2005. Under the terms ofthe delayed draw commitments the Company receives a commitment fee of between1.38% and 2.13% per annum for the period from the date of its commitment to thedate that the delayed draw is funded.

**Note 10. StockOptions and Restricted Stock**

The Company has adopted astock incentive plan (the “2004 Stock Incentive Plan”) that provides for thegrant of qualified incentive common stock options that meet the requirements ofSection 422 of the Code, non-qualified common stock options, stockappreciation rights, restricted common stock and other share-basedawards. The 2004 Stock Incentive Plan was amended on May 26, 2005. TheCompensation Committee of the Board of Directors administers the plan. Stockoptions may be granted to the Manager, Directors, officers and any keyemployees of the Manager and to any other individual or entity performingservices for the Company.

The exercise price for anystock option granted under the 2004 Stock Incentive Plan may not be less than100% of the fair market value of the shares of common stock at the time thecommon stock option is granted. Each common stock option must terminate no morethan ten years from the date it is granted. The 2004 Stock Incentive Plan, asamended, authorizes that a total of 7,964,625 shares may be used to satisfyawards under the plan. The Company made its initial grants under the 2004 StockIncentive Plan on August 12, 2004, and August 19, 2004, the datesthat the Company closed its initial private placement of common stock and thedate that the over-allotment option was exercised, respectively.

The following table summarizes restricted common stocktransactions:

| ** **                                        | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested  shares as of August 19, 2004**   |       | 1,193,867   |       |          | 15,000     |      |       | 1,208,867 |   |
| Issued                                            |       | —      |       |          | —     |      |       | — |   |
| Vested                                            |       | —      |       |          | —     |      |       | — |   |
| Forfeited                                         |       | —      |       |          | —     |      |       | — |   |
| **Unvested  shares as of December 31, 2004** |       | 1,193,867   |       |          | 15,000     |      |       | 1,208,867 |   |
| Issued                                            |       | 1,875,000   |       |          | 28,321     |      |       | 1,903,321 |   |
| Vested                                            |       | (397,956    | )          |          | (10,000    | )         |       | (407,956 | ) |
| Forfeited                                         |       | —      |       |          | (5,000     | )         |       | (5,000 | ) |
| **Unvested shares as of  December 31, 2005** |       | 2,670,911   |       |          | 28,321     |      |       | 2,699,232 |   |

 

The shares of restrictedcommon stock granted to the directors were valued using the fair market valueat the time of grant, which was $24.90 and $20.00 per share, for the shares ofrestricted common stock granted in 2005 and 2004, respectively. Pursuant toSFAS No. 123(R), the Company is required to value any unvested shares ofrestricted common stock granted to the Manager at the current market price. TheCompany valued the unvested restricted common stock at $23.99 and $20.00 pershare at December 31, 2005 and December 31, 2004, respectively.

F-27

----

**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 10. StockOptions and Restricted Stock (Continued)**

The following table summarizes common stock optiontransactions:

| ** **                                    | ** ** | **Number  of Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Outstanding  as of August 19, 2004**   |       | 1,989,779                   |       |                                           | $          | 20.00 |   |   |
| Granted                                       |       | —                      |       |                                           | —     |   |   |
| Exercised                                     |       | —                      |       |                                           | —     |   |   |
| Forfeited                                     |       | —                      |       |                                           | —     |   |   |
| **Outstanding  as of December 31, 2004** |       | 1,989,779                   |       |                                           | $          | 20.00 |   |   |
| Granted                                       |       | —                      |       |                                           | —     |   |   |
| Exercised                                     |       | —                      |       |                                           | —     |   |   |
| Forfeited                                     |       | —                      |       |                                           | —     |   |   |
| **Outstanding as of  December 31, 2005** |       | 1,989,779                   |       |                                           | $          | 20.00 |   |   |

 

None of the common stock options outstanding wereexercised at December 31, 2005 and December 31, 2004, respectively.As of December 31, 2005, 663,260****common stockoptions were exercisable, and no common stock options were exercisable as of December 31,2004. The common stock options are valued using the Black-Scholes modelusing the following assumptions:

| ** **     | ** ** | **As of  December 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|----------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Expected life  |       |                                        | 8.6 years  |                                        |       |   | 9.6 years |   |   |
| Discount rate  |       |                                        | 4.50%      |                                        |       |   | 4.44% |   |   |
| Volatility     |       |                                        | 20%        |                                        |       |   | 20% |   |   |
| Dividend yield |       |                                        | 9%         |                                        |       |   | 9% |   |   |

 

The estimated fair value of the common stock optionswas $1.90 and $0.98 at December 31, 2005 and December 31, 2004,respectively. For the year ended December 31, 2005 and the period from August 12,2004 (Inception) through December 31, 2004, the components of share-basedcompensation expense are as follows (amounts in thousands): 

| ** **                                      | ** ** | **Year  ended  December 31, 2005** | ** ** | **Period from  August 12, 2004  (Inception) through  December 31, 2004** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| Options granted  to Manager                     |       |                                         | $          | 2,155                                                                                                  |       |   |   | $ | 461 |   |   |
| Restricted shares  granted to Manager           |       |                                         | 27,654     |                                                                                                   |       |   | 5,649 |   |   |
| Restricted shares  granted to certain directors |       |                                         | 437        |                                                                                                   |       |   | 116 |   |   |
| Total share-based  compensation expense         |       |                                         | $          | 30,246                                                                                                 |       |   |   | $ | 6,226 |   |   |

 

**Note 11.** Management Agreement and Related PartyTransactions

The Manager manages theCompany’s day-to-day operations, subject to the direction and oversight of theCompany’s Board of Directors. The Management Agreement was executed on August 12,2004. The initial term expires on December 31, 2006 and shall beautomatically renewed for a one-year term on each 

F-28

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 11.** Management Agreement and Related Party Transactions(Continued)

anniversary datethereafter. Following the initial term, the Management Agreement may beterminated upon the affirmative vote of at least two-thirds of the Company’sindependent directors, or by a vote of the holders of a majority of theoutstanding shares of the Company’s common stock.

The Management Agreementprovides, among other things, that the Company pays to the Manager, in exchangefor managing the day-to-day operations of the Company, certain fees andreimbursements, consisting of a base management fee, an incentive fee, andreimbursement for out-of-pocket and certain other costs incurred by the Managerand on behalf of the Company. All rent incurred by the Manager is paid by theCompany and the Company is a party to the lease.

The Management Agreement contains certain provisionsrequiring the Company to indemnify the Manager with respect to all losses ordamages arising from acts not constituting bad faith, willful misconduct, orgross negligence. The Company has evaluated the impact of these guarantees onits consolidated financial statements and determined that they are immaterial.

For the year ended December 31, 2005, the Companyincurred $21.0 million in base management fees. In addition, the Companyrecognized share-based compensation expense related to common stockoptions and restricted common stock granted to the Manager of$29.8 million for the year ended December 31, 2005 (seeNote 10). The Company also reimbursed the Manager $4.9 million forexpenses for the year ended December 31, 2005. The Company incurred basemanagement fees and reimbursed the Manager for expenses of $5.1 millionand $1.8 million, respectively, for the period from Inception through December 31,2004. In addition, the Company recognized share-based compensationexpense related to common stock options and restricted common stock granted tothe Manager of $6.1 million for the period from Inception through December 31,2004. Base management fees incurred and share-based compensation expenserelating to common stock options and restricted common stock granted to theManager are included in management compensation to related party on theConsolidated Statements of Operations. Expenses incurred by the Manager andreimbursed by the Company are reflected in the respective consolidatedstatement of operations non-investment expense category based on the nature ofthe expense.

No incentive fees were earned or paid to the Managerduring the year ended December 31, 2005 or during the period fromInception to December 31, 2004.

An affiliate of the Company’s Manager has entered intoseparate management agreements with the respective investment vehicles for CLO2005-1 and CLO 2005-2 and is entitled to receive fees for the servicesperformed as collateral manager. To date, the collateral manager has waivedapproximately $1.5 million of management fees payable to it from CLO 2005-1,which covers the period commencing in March 2005 and ending in April 2006 andhas waived approximately $0.8 million of management fees payable to it from CLO2005-2, which covers the period commencing November 2005 and ending in May2006. The waivers for CLO 2005-1 and CLO 2005-2 expire in April 2006 and May2006, respectively, and there is no guarantee that the collateral manager willwaive such management fees subsequent to those dates.

During the fourth quarterof 2005, the Company co-invested $52.5 million on a pari passu basis with KKRin four separate private equity transactions.

F-29

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 12.** IncomeTaxes

Eventhough the Company qualifies for federal taxation as a REIT, it may be subjectto some amount of federal, state, local and foreign taxes based on the Company’staxable income. KKR TRS, however, is taxed as a regular subchapter Ccorporation under the Code. The income tax provision for the Company (REIT) andKKR TRS (TRS) for the year ended December 31, 2005 and the period from August 12,2004 (inception) through to December 31, 2004 consisted of the followingcomponents (amounts in thousands):

| ** **                          | ** ** | **Year ended**

**December 31,  2005** | ** ** | **Period from  August 12, 2004  (inception)  through  December 31,  2004** | ** ** |
|-------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| Current  provision:                 |       |                                             |       |                                                                                      |       |   |   |   |   |
| Federal—TRS                    |       |                                             | $          | 1,473                                                                                     |       |   |   | $ | — |   |   |
| Federal—REIT                   |       |                                             | 352        |                                                                                      |       |   | — |   |   |
| State—TRS                      |       |                                             | 242        |                                                                                      |       |   | — |   |   |
| Foreign—REIT                   |       |                                             | 152        |                                                                                      |       |   | — |   |   |
| Total current  provision            |       |                                             | 2,219      |                                                                                      |       |   | — |   |   |
| Deferred  provision (benefit):      |       |                                             |       |                                                                                      |       |   |   |   |   |
| Federal—TRS                    |       |                                             | 788        |                                                                                      |       |   | (190 | ) |   |
| State—TRS                      |       |                                             | 137        |                                                                                      |       |   | (38 | ) |   |
| Total deferred  provision (benefit) |       |                                             | 925        |                                                                                      |       |   | (228 | ) |   |
| Total provision for  income taxes   |       |                                             | $          | 3,144                                                                                     |       |   |   | $ | (228 | ) |   |

 

The above tax expense (benefit) was based on KKR TRS’seffective tax rate of 40.75% at December 31, 2005 and 42.02% at December 31,2004. It was equivalent to the combined rate of the Federal statutory incometax rate and the State statutory income tax rate, net of Federal benefit.

The components of thedeferred tax assets and liabilities as of December 31, 2005 and December 31,2004 are as follows (amounts in thousands):

| ** **                            | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Deferred tax assets:                  |       |                        |       |                        |       |   |   |   |   |
| Unrealized  loss—derivatives     |       |                        | $          | —                      |       |   |   | $ | 147 |   |   |
| Net operating  loss carryforward      |       |                        | —     |                        |       |   | 81 |   |   |
| Gross deferred tax asset              |       |                        | $          | —                      |       |   |   | $ | 228 |   |   |
| Deferred tax  liabilities:            |       |                        |       |                        |       |   |   |   |   |
| Unrealized  gain—derivatives     |       |                        | $          | 697                         |       |   |   | $ | — |   |   |
| Net operating  loss carryforward      |       |                        | —     |                        |       |   | — |   |   |
| Gross deferred tax liabilities        |       |                        | $          | 697                         |       |   |   | $ | — |   |   |
| Net deferred tax asset (liability)    |       |                        | $          | (697                        | )          |   |   | $ | 228 |   |   |
| Valuation  allowance                  |       |                        | —     |                        |       |   | — |   |   |
| Total deferred tax asset  (liability) |       |                        | $          | (697                        | )          |   |   | $ | 228 |   |   |

 

F-30

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 12.** Income Taxes (Continued)

For federal income taxpurposes, the distributions declared and paid during 2005 on the Company’scommon stock are 100% taxable as dividend income at ordinary rates and noportion of the dividends is eligible for the 15% dividend tax rate or thecorporate dividends received deduction.

**Note 13.** LeaseholdImprovements and Equipment

The following is asummary of the Company’s leasehold improvements and equipment, which areincluded in other assets in the consolidated balance sheet at December 31,2005 and 2004 (dollars in thousands):

| ** **                                 | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Leasehold  improvements                    |       |                        | $          | 1,274                       |       |   |   | $ | 385 |   |   |
| Furniture and  equipment                   |       |                        | 1,435      |                        |       |   | 608 |   |   |
|                                       |       |                        | 2,709      |                        |       |   | 993 |   |   |
| Accumulated  depreciation and amortization |       |                        | (641       | )                           |       |   | (85 | ) |   |
| Total property and  equipment, net         |       |                        | $          | 2,068                       |       |   |   | $ | 908 |   |   |

 

Depreciation and amortization expense was $0.6 millionand $0.1 million for the years ended December 31, 2005 and 2004,respectively.

**Note 14.** FairValue of Financial Instruments

SFAS No. 107, *Disclosure About Fair Value of Financial Instruments*,requires disclosure of the fair value of financial instruments for which it ispracticable to estimate that value. The fair value of securities available-for-sale,loans, derivatives, and loan commitments is based on quoted market prices orestimates provided by independent pricing sources. The fair value of cash andcash equivalents, interest payable, repurchase agreements, collateralized loanobligation senior secured notes, asset-backed secured liquidity notes, securedrevolving credit facility, secured demand loan and interest payable,approximates cost as of December 31, 2005 and December 31, 2004, dueto the short-term nature of these instruments.

F-31

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 14.** Fair Value of Financial Instruments (Continued)

The table below disclosesthe carrying value and the fair value of the Company’s financial instruments asof December 31, 2005 (dollars in thousands): 

| ** **                                          | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| Financial Assets:                                   |       |                 |       |                           |       |   |   |   |
| Cash and cash equivalents                           |       | $                    | 96,333     |                           |       | $ | 96,333 |   |   |   |
| Securities available-for-sale                       |       | 6,149,506            |       |                           | 6,149,506  |   |   |   |
| Loans, net of allowance for loan losses of $1,500   |       | 8,846,341            |       |                           | 8,820,970  |   |   |   |
| Non-marketable equity securities                    |       | 52,500               |       |                           | 52,500     |   |   |   |
| Interest receivable                                 |       | 59,993               |       |                           | 59,993     |   |   |   |
| Derivatives                                         |       | 58,898               |       |                           | 58,898     |   |   |   |
| Financial Liabilities:                              |       |                 |       |                           |       |   |   |   |
| Repurchase agreements                               |       | $                    | 9,761,258  |                           |       | $ | 9,761,258 |   |   |   |
| Collateralized loan obligation senior secured notes |       | 1,500,000            |       |                           | 1,500,000  |   |   |   |
| Asset-backed secured liquidity notes                |       | 2,008,069            |       |                           | 2,008,069  |   |   |   |
| Secured revolving credit facility                   |       | 54,000               |       |                           | 54,000     |   |   |   |
| Secured demand loan                                 |       | 40,511               |       |                           | 40,511     |   |   |   |
| Interest payable                                    |       | 21,415               |       |                           | 21,415     |   |   |   |
| Derivatives                                         |       | 1,465                |       |                           | 1,465      |   |   |   |
| Off-Balance Sheet Items:                            |       |                 |       |                           |       |   |   |   |
| Loan commitments                                    |       | $                    | —     |                           |       | $ | 346 |   |   |   |

 

The table below disclosesthe carrying value and the fair value of the Company’s financial instruments asof December 31, 2004 (dollars in thousands):

| ** **                    | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|-------------------------------|------------|----------------------|------------|--------------------------------|------------|
| Financial Assets:             |       |                 |       |                           |       |   |   |   |
| Cash and cash equivalents     |       | $                    | 8,540      |                           |       | $ | 8,540 |   |   |   |
| Securities available-for-sale |       | 1,651,280            |       |                           | 1,651,280  |   |   |   |
| Loans                         |       | 682,757              |       |                           | 686,290    |   |   |   |
| Interest receivable           |       | 2,694                |       |                           | 2,694      |   |   |   |
| Derivatives                   |       | 223                  |       |                           | 223        |   |   |   |
| Financial Liabilities:        |       |                 |       |                           |       |   |   |   |
| Repurchase agreements         |       | $                    | 1,558,274  |                           |       | $ | 1,558,274 |   |   |   |
| Demand loan                   |       | 27,875               |       |                           | 27,875     |   |   |   |
| Interest payable              |       | 771                  |       |                           | 771        |   |   |   |
| Derivatives                   |       | 750                  |       |                           | 750        |   |   |   |
| Off-Balance Sheet Items:      |       |                 |       |                           |       |   |   |   |
| Loan commitments              |       | $                    | —     |                           |       | $ | 642 |   |   |   |

 

F-32

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**KKR Financial Corp. and Subsidiaries Notes to Consolidated Financial Statements (Continued)**

**Note 15. Summary of Quarterly Information (Unaudited)**

The following is apresentation of the quarterly results of operations (amounts in thousands,except per share information):

| ** **                                             | ** ** | **2005**            | ** ** | **2004**           | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|--------------------|------------|
| ** **                                             | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Period from  August 12, 2004  (inception) to  September 30,  2004** | ** ** |
| **Net investment income:**                             |       |                |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Total investment income                                |       | $                   | 178,770    |               | $          | 116,587 |   | $ | 69,026 |   | $ | 35,546 |   | $ | 6,656 |   |   | $ | 1,466 |   |   |
| Interest expense                                       |       | (133,456            | )          | (77,532            | )          | (48,281 | ) | (20,449 | ) | (975 | ) |   | — |   |   |
| Provision for loan  losses                             |       | (200                | )          | (1,300             | )          | — |   | — |   |   |   |   |   |   |   |
| Net investment income                                  |       | 45,114              |       | 37,755             |       | 20,745 |   | 15,097 |   | 5,681 |   |   | 1,466 |   |   |
| **Other income:**                                      |       |                |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Total other income  (loss)                             |       | 2,984               |       | 1,879              |       | 1,859 |   | 838 |   | (488 | ) |   | — |   |   |
| **Non-investment expenses:**                           |       |                |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Related party management  compensation                 |       | 17,721              |       | 14,331             |       | 10,731 |   | 8,008 |   | 7,421 |   |   | 3,801 |   |   |
| Professional services                                  |       | 1,504               |       | 1,432              |       | 788 |   | 397 |   | 680 |   |   | 221 |   |   |
| Loan servicing expense                                 |       | 3,144               |       | 1,369              |       | 363 |   | 267 |   | — |   |   | — |   |   |
| Insurance expense                                      |       | 267                 |       | 275                |       | 216 |   | 217 |   | 216 |   |   | 119 |   |   |
| Directors expenses                                     |       | 352                 |       | 368                |       | 152 |   | 199 |   | 242 |   |   | 99 |   |   |
| General and  administrative expenses                   |       | 1,838               |       | 2,630              |       | 858 |   | 619 |   | 141 |   |   | 656 |   |   |
| Total non-investment  expenses                         |       | 24,826              |       | 20,405             |       | 13,108 |   | 9,707 |   | 8,700 |   |   | 4,896 |   |   |
| Income (loss) before  income tax expense (benefit)     |       | 23,272              |       | 19,229             |       | 9,496 |   | 6,228 |   | (3,507 | ) |   | (3,430 | ) |   |
| Income tax expense  (benefit)                          |       | 1,263               |       | 775                |       | 994 |   | 112 |   | (228 | ) |   | — |   |   |
| Net income (loss)                                      |       | $                   | 22,009     |               | $          | 18,454 |   | $ | 8,502 |   | $ | 6,116 |   | $ | (3,279 | ) |   | $ | (3,430 | ) |   |
| Net income (loss) per common share:                    |       |                |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       | $                   | 0.28       |               | $          | 0.24 |   | $ | 0.21 |   | $ | 0.15 |   | $ | (0.08 | ) |   | $ | (0.09 | ) |   |
| Diluted                                                |       | $                   | 0.28       |               | $          | 0.24 |   | $ | 0.21 |   | $ | 0.15 |   | $ | (0.08 | ) |   | $ | (0.09 | ) |   |
| Weighted-average number of common shares  outstanding: |       |                |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                                  |       | 77,675              |       | 77,486             |       | 40,212 |   | 39,796 |   | 39,796 |   |   | 39,796 |   |   |
| Diluted                                                |       | 78,787              |       | 78,492             |       | 40,994 |   | 40,301 |   | 39,796 |   |   | 39,796 |   |   |
| Distributions declared per common share                |       | $                   | 0.32       |               | $          | — |   | $ | 0.40 |   | $ | 0.25 |   | $ | — |   |   | $ | — |   |   |

 

**Note 16.** SubsequentEvents

On February 1, 2006,the Company’s Board of Directors declared a cash distribution for the quarterended December 31, 2005 on the Company’s common stock of $0.40 per share.The distribution was paid on February 28, 2006 to stockholders of recordas of the close of business on February 15, 2006.

During January 2006, the Company invested $40 millionin a series of corporate floating rate notes which were rated BB by Standardand Poor’s and were issued by an unaffiliated third party. KKR FinancialAdvisors II, LLC, a wholly-owned subsidiary of the Company’s Manager, isthe collateral manager for the unaffiliated third party in connection with thiscorporate floating rate note transaction.

F-33

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