**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**(Mark One)**

**x**                               ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the fiscal year ended December 31, 2006**

**or**

**o**                                  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**For the transition period from                    to                    **

**Commission file number: 001-32542**

**KKR FINANCIAL CORP.**

(Exactname of registrant as specified in its charter)

| **Maryland**                                       |   | **20-1426618**      |
|----------------------------------------------------|--------|---------------------|
| (State or other jurisdiction of                    |   | (I.R.S. Employer    |
| incorporation or organization)                     |   | Identification No.) |
| **555 California Street, 50****th**** Floor** |   | ** **          |
| **San Francisco, CA**                              |   | **94104**           |
| (Address of principal executive offices)           |   | (Zip Code)          |

 

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

Securitiesregistered pursuant 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                      |

 

Securitiesregistered pursuant to section 12(g) of the Act: **None**

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

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. o Yes   x No

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. x Yes   o No

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (§ 229.405 of this chapter) is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):
| Large accelerated filer x |   | Accelerated filer  o |   | Non-accelerated  filer o |
|---------------------------|--------|----------------------|--------|--------------------------|

 

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

**The aggregate market value of the voting common stock heldby non-affiliates of the registrant as of June 30, 2006 was $1,507,257,396,based on the closing price of the common stock on such date as reported on theNew York Stock Exchange.**

Thenumber of shares of the registrant’s common stock outstanding as of February 20,2007 was 80,464,713.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portionsof the registrant’s Proxy Statement for the 2007 Annual Stockholders’ Meetingto be held May 3, 2007 and to be filed within 120 days after the close ofthe registrant’s fiscal year are incorporated by reference into Part IIIof this Annual Report on Form 10-K.

 

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*Except where otherwise expressly stated or the contextsuggests 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 Kravis Roberts & Co. L.P. and its affiliatedcompanies.*

**CAUTIONARYSTATEMENT 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 andaccompanying 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 presentlyidentified. Other factors that may impact our actual results are discussedunder “Risk Factors” in Item 1A of this Annual Report on Form 10-K.We do not undertake, and specifically disclaim, any obligation to publiclyrelease the result of any revisions that may be made to any forward-lookingstatements to reflect the occurrence of anticipated or unanticipated events orcircumstances after the date of such statements.

**WEBSITE ACCESS TOCOMPANY’S REPORTS**

Our Internet website address is *www.kkrkfn.com*. Our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Exchange Act are available free of charge through our websiteas soon as reasonably practicable after they are electronically filed with, orfurnished to, the Securities and Exchange Commission, or SEC. Our CorporateGovernance Guidelines, board of directors’ committee charters (including thecharters of the Audit Committee, Compensation Committee, and Nominating andCorporate Governance Committee) and Code of Business Conduct and Ethics areavailable on our website. Information on our website does not constitute a partof, and is not incorporated by reference into, this Annual Report on Form 10-K.

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**KKR FINANCIAL CORP.2006 FORM 10-K ANNUAL REPORTTABLE OF CONTENTS**
|                   | ** ** | ** **                                                                                                          | ** ** | **Page** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|
| **Part I**   |       |                                                                                                                |       |
| Item 1.           |       | Business                                                                                                            |       | 1        |   |
| Item 1A.          |       | Risk Factors                                                                                                        |       | 9        |   |
| Item  1B.         |       | Unresolved  Staff Comments                                                                                          |       | 35       |   |
| Item 2.           |       | Properties                                                                                                          |       | 35       |   |
| Item 3.           |       | Legal  Proceedings                                                                                                  |       | 35       |   |
| Item  4.          |       | Submission  of Matters to a Vote of Security Holders                                                                |       | 35       |   |
| **Part II**  |       |                                                                                                                |       |
| Item  5.          |       | Market  for Registrant’s Common Equity, Related Shareholder Matters and Issuer  Purchases of Equity Securities |       | 36       |   |
| 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                                                         |       | 76       |   |
| Item  8.          |       | Financial  Statements and Supplementary Data                                                                        |       | 76       |   |
| Item  9.          |       | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               |       | 76       |   |
| Item  9A.         |       | Controls  and Procedures                                                                                            |       | 76       |   |
| Item 9B.          |       | Other  Information                                                                                                  |       | 76       |   |
| **Part III** |       |                                                                                                                |       |
| Item 10.          |       | Directors, Executive Officers and Corporate Governance                                                              |       | 77       |   |
| Item  11.         |       | Executive  Compensation                                                                                             |       | 77       |   |
| Item  12.         |       | Security  Ownership of Certain Beneficial Owners and Management and Related Shareholder  Matters     |       | 77       |   |
| Item 13.          |       | Certain Relationships and Related Transactions, and  Director Independence                                          |       | 77       |   |
| Item  14.         |       | Principal  Accountants Fees and Services                                                                            |       | 77       |   |
| **Part IV**  |       |                                                                                                                |       |
| Item  15.         |       | Exhibits  and Financial Statement Schedules                                                                         |       | 78       |   |

 

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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 with the objective of generatingcompetitive risk-adjusted returns. We seek to achieve our investment objectiveby allocating 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; (iv) asset-backedsecurities; and (v) marketable and non-marketable equity securities. Wealso make opportunistic investments in other asset classes from time to time.

Our objective is to provide competitive returns to ourinvestors through a combination of distributions and capital appreciation. Aspart of our multi-asset class strategy, we seek to invest opportunistically inthose asset classes that can generate competitive leveraged risk-adjustedreturns, subject to maintaining our status as a real estate investment trust,or REIT, under the Internal Revenue Code of 1986, as amended, or the Code, andour exemption from regulation under the Investment Company Act of 1940, asamended, or the Investment Company Act. Our income is generated primarily fromthe difference between the interest and dividend income earned on ourinvestments and the cost of our borrowings, plus (i) realized andunrealized gains and losses on our derivatives that are not accounted for ashedges, (ii) realized gains and losses from the sales of investments, and (iii) feeincome.

We are externally managed and advised by KKR FinancialAdvisors LLC, our Manager, pursuant to a management agreement. Our Manager isan affiliate of KKR, a leading sponsor of private equity funds and otherinvestment vehicles. Certain individuals associated with KKR serve on our boardof directors and our Manager’s investment 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, we completed our initial publicoffering, or IPO. Our common stock is listed on the NYSE under the symbol “KFN”and began trading on June 24, 2005.

Our board of directors hasapproved a restructuring transaction, or the “Conversion Transaction”, whereby wewould become a subsidiary of a recently formed Delaware limited liabilitycompany that would be publicly traded. The Delaware limited liability company,named KKR Financial Holdings LLC, will not be taxed as a REIT, but is intendedto be a pass-through entity for U.S. federal income tax purposes. TheConversion Transaction would result in each share of currently issued andoutstanding KKR Financial Corp. stock being converted into an equal number oflimited liability company shares in KKR Financial Holdings LLC. The ConversionTransaction is subject to shareholder approval and, if approved, we expect thatit will be completed by June 30, 2007.

**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 or members of our Manager or one or more of its affiliates. Theexecutive offices of our Manager are located at 555 California Street, 50th Floor, San Francisco, California 94104 and thetelephone number of our Manager’s executive 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 

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Manageris at all times subject to the direction of our board of directors and has onlysuch functions and authority as we delegate to it.

**Our Strategy**

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 and debtsecurities; (iii) commercial real estate loans and debt securities; (iv)asset-backed securities; and (v) marketable and non-marketable equitysecurities. We also make opportunistic investments in other asset classes fromtime to time. Our objective is to provide competitive returns to our investorsthrough a combination of distributions and capital appreciation. As part of ourmulti-asset class strategy, we seek to invest opportunistically in those assetclasses that can generate competitive leveraged risk-adjusted returns, subjectto maintaining our status as a REIT and our exemption from regulation under theInvestment Company Act.

Our Manager utilizes its access to the resources andprofessionals of KKR, along with the same philosophy of value creation that KKRemploys in managing private equity funds, in order to create a portfolio thatis constructed 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, currentand projected supply and demand, credit and market risk concentration considerations,current and projected macroeconomic considerations, liquidity, all-in cost offinancing and financing availability, and maintaining our REIT status andexemption from the Investment Company Act.

From time to time, we makecertain investments, including debt, equity and derivative investments,utilizing KKR TRS Holdings, Inc., or TRS Inc., our domestic taxable REIT subsidiary.We will opportunistically pursue this strategy whenever we are constrained bythe rules related to maintaining our REIT status and exemption from theInvestment Company Act and, in the case of non-real estate or derivativeinvestments, whenever the projected returns on these investments, net of incometaxes, are comparable to the projected leveraged risk-adjusted returns on investmentsthat are made in the REIT. We are not required to distribute the earnings of ourdomestic taxable REIT subsidiary; accordingly, we may retain in our domestictaxable REIT subsidiary some or all of its net income.

**Our FinancingStrategy**

We use leverage in order to increase potential returnsto our investors. As of December 31, 2006, our leverage was 9.1 times theamount of our stockholders’ equity. Our investment guidelines (“InvestmentGuidelines”) 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. Ouruse of leverage may, however, also have the effect of increasing losses wheneconomic conditions are unfavorable.

We maintain access to various sources of capital tomitigate the risk that we are unable to source additional capital when it isnecessary or desirable. We also maintain access to various forms of financing,including collateralized loan obligations, warehouse facilities, repurchaseagreements, asset-backed secured liquidity notes, total rate of return swaps,junior subordinated notes in the form of trust preferred securities, a seniorsecured credit facility, and demand note. The majority of our residential mortgageloans and residential mortgage-backed security investments are financed usingrepurchase agreements and asset-backed secured liquidity notes. Our repurchaseagreement counterparties include large commercial and investment banks. 

The manner in which wefinance our non-residential mortgage investments is dependent upon the natureand form of the investment and its corresponding credit rating. Our investmentsin non-residential 

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mortgagerelated investments are financed using collateralized loan obligations,warehouse agreements, repurchase agreements, total rate of return swaps, juniorsubordinated notes in the form of trust preferred securities, our seniorsecured credit facility, and demand note.

**Our Hedging andInterest Rate Risk Management Strategy**

Our repurchase agreements are floating rate and generallyhave maturities of 30 days. As a result, interest rates are generally resetevery 30 days. Our floating rate residential mortgage investments generallyhave interest rates that are reset every 30 days. Our hybrid residentialmortgage investments initially have fixed interest rates and after the initialfixed rate period has expired are converted to floating rate with interestrates that generally reset annually.

We use interest rate derivatives to hedge a portion ofour interest rate risk associated with our borrowings. Our use of interest ratederivatives must comply with the provisions of the Code applicable to REITs;accordingly, as a REIT, the applicable provisions of the Code may materiallyrestrict our ability to enter into certain hedging transactions that maymitigate our interest rate risk or market risk.

We engage in avariety of interest rate management strategies that seek to mitigate changes ininterest rates or potentially other influences on the market values of ourassets. Our interest rate management strategies may include:

**·****     **interestrate swaps;

**·****     **interestrate swaptions;

**·****     **cancellableinterest rate swaps;

**·****     **interestrate caps;

**·****     **interestrate corridors;

**·****     **eurodollarfutures contracts and options; and

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

Our strategies may also be used in an attempt toprotect us against unfavorable changes in the market value of our assets andliabilities.

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 for the LondonInterbank Offered Rate (“LIBOR”). The repurchase agreements generally havematurities of 30 days and carry interest rates that correspond to LIBOR ratesfor those same periods. The interest rate swap agreements are intended to fixour borrowing cost and are not held for speculative or trading purposes.

Interest ratemanagement strategies do not eliminate interest rate risk and market risk butseek to mitigate interest rate risk and market risk. For example, if bothlong-term and short-term interest rates were to increase significantly, itcould be expected that:

**·****     **theweighted-average life of the fixed rate mortgage investments would be extendedbecause prepayments of the underlying mortgage loans would decrease; and

**·****     **themarket value of fixed rate mortgage investments would decrease.

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In order for our interest rate derivatives to qualifyas fair value or cash flow hedges under SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, or SFASNo. 133, we must fulfill many complex requirements including, but notlimited to, hedge correlation 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 investment portfolio.Match funding is the financing of our investments on a basis where the durationof the investments approximates the duration of the borrowings used to financethe investments. For any period during which our investment portfolio andrelated borrowings 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 accurately predictprepayment rates. The yield on our investment portfolio may be affected by thedifference 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 and certain fixed rate investments. There arelimitations in our ability to hedge all of the negative consequences associatedwith changes in interest rates and prepayment rates. Furthermore, we aresubject to the costs associated with hedging our interest rate risk and marketrisk.

**CreditLosses.**   We believe that we will experience creditlosses on our investment portfolio and such credit losses will have an adverseaffect on our investment 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 secure theirfinancing facilities.

**Investment CompanyAct Exemption**

We operate our business so as to be exempt fromregulation under the Investment Company Act. We monitor our portfolio ofinvestments to confirm that we and each of our subsidiaries continue to qualifyfor the applicable exemptions from the definition of an investment companyunder the Investment Company Act. We monitor our portfolio to ensure that atleast 55% of our assets constitute “qualifying real estate assets,” and anadditional 25% of our assets constitute “real estate-related assets” oradditional qualifying real estate assets, thereby allowing us to qualify forthe exemption from the definition of an investment company as provided for inSection 3(c)(5)(C) of the Investment Company Act. We measure and satisfy thetests with respect to our assets on an unconsolidated basis.

We generally expect that a material amount of ourinvestments in residential mortgage loans, residential mortgage-backedsecurities and commercial real estate debt will be considered qualifying realestate assets under the Section 3(c)(5)(C) exemption from the InvestmentCompany Act. We also generally expect that any residential mortgage loans,residential mortgage-backed securities and commercial real estate debt that weinvest in that do not constitute qualifying real estate assets will constitutereal estate-related assets. The treatment of our other real estate investmentswill be based on the characteristics of the underlying collateral and ourrights with respect to the collateral, including 

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whether we have foreclosurerights with respect to the underlying real estate collateral. Our investmentsin corporate leveraged loans, corporate mezzanine loans, high yield corporatesecurities, asset-backed securities, and marketable and non-marketable equitysecurities will not constitute qualifying real estate assets or realestate-related assets.

Maintaining our exemptionfrom regulation under the Investment Company Act limits our ability to makecertain favorable investments and we must make investments in qualifying realestate assets or real estate-related assets to ensure that we maintain ourexemption under the Investment Company Act.

**ManagementAgreement**

We are party to a management agreement with ourManager, pursuant to which our Manager will provide for the day-to-daymanagement of our operations.

The management agreement requires our Manager tomanage our business affairs in conformity with the Investment Guidelines thatare approved by a majority of our independent directors. Our Manager is underthe direction of our board of directors. Our Manager is responsible for (i) theselection, purchase and sale of our portfolio investments, (ii) ourfinancing and risk management activities, and (iii) providing us withinvestment advisory services.

The management agreement expires on December 31,2007 and is automatically renewed for a one-year term each anniversary datethereafter. Our independent directors review our Manager’s performance annuallyand the management agreement may be terminated annually (upon 180 day priorwritten notice) 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 (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 feesagreed to by at least two-thirds of our independent directors and our Manager.We must provide a 180 day prior written notice of any such termination and ourManager will be paid a termination fee equal to four times the sum of theaverage annual base management fee and the average annual incentive fee for thetwo 12-month periods preceding the date of termination, calculated as of theend of the most recently completed fiscal quarter prior to the date oftermination, which may make it more difficult for us to terminate themanagement agreement.

We may also terminate the management agreement withoutpayment of the termination fee with a 30 day prior written notice forcause, which is defined as (i) our Manager’s continued material breach ofany provision 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 managementagreement by providing us with a 180 day prior written notice. Our Manager mayalso terminate the management agreement upon 60 days prior written notice if wedefault in the performance of any material term of the management agreement andthe default continues for a period of 30 days after written notice to us,whereupon we would be required to pay our Manager the termination fee describedabove.

We do not employ personneland therefore rely on the resources and personnel of our Manager to conduct ouroperations. For performing these services under the management agreement, ourManager 

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receivesa base management fee and incentive compensation based on our performance. OurManager also receives reimbursements for certain expenses, which are made onthe first business day of each calendar month.

**Base Management Fee.****  **We pay our Manager a base management fee monthly inarrears in an amount equal to 1¤12of our equity multiplied by 1.75%. We believe that the base management fee thatour Manager is entitled to receive is generally comparable to the basemanagement fee received by the managers of comparable externally managedspecialty finance companies. Our Manager uses the proceeds from its managementfee in part to pay compensation to its officers and employees who,notwithstanding that certain of them also are officers of us, receive no cashcompensation directly from us.

For purposes ofcalculating the base management fee, our equity means, for any month, the sumof the net proceeds from any issuance of our common stock, after deducting anyunderwriting discount and commissions and other expenses and costs relating tothe issuance, plus our retained earnings at the end of such month (withouttaking into account any non-cash equity compensation expense incurred incurrent or prior periods), which amount shall be reduced by any amount that wepay for the repurchases of our common stock. The foregoing calculation of thebase management fee is adjusted to exclude special one-time events pursuant tochanges in accounting principles generally accepted in the United States, orGAAP, as well as non-cash charges, after discussion between our Manager and ourindependent directors and approval by a majority of our independent directorsin the case of non-cash charges.

Our Manager is required tocalculate the base management fee within fifteen business days after the end ofeach month and deliver that calculation to us promptly. We are obligated to paythe base management fee within twenty business days after the end of eachmonth. We may elect to have our Manager allocate the base management fee amongus and our subsidiaries, in which case the fee would be paid directly by eachentity that received an allocation.

**Reimbursementof Expenses*****.******  ***Becauseour Manager’s employees perform certain legal, accounting, due diligence tasksand other services that outside professionals or outside consultants otherwisewould perform, our Manager is paid or reimbursed for the documented cost ofperforming such tasks, provided that such costs and reimbursements are nogreater than those which would be paid to outside professionals or consultantson an arm’s-length basis.

We also pay all operating expenses, except thosespecifically required to be borne by our Manager under the managementagreement. The expenses required to be paid by us include, but are not limitedto, rent, issuance and transaction costs incident to the acquisition,disposition and financing of our investments, legal, tax, accounting, consultingand auditing fees and expenses, the compensation and expenses of our directors,the cost of directors’ and officers’ liability insurance, the costs associatedwith the establishment and maintenance of any credit facilities and otherindebtedness of ours (including commitment fees, accounting fees, legal feesand closing costs), expenses associated with other securities offerings ofours, expenses relating to making distributions to our stockholders, the costsof printing and mailing proxies and reports to our stockholders, costsassociated with any computer software or hardware, electronic equipment, orpurchased information technology services from third party vendors, costsincurred by employees of our Manager for travel on our behalf, the costs andexpenses incurred with respect to market information systems and publications,research publications and materials, and settlement, clearing, and custodialfees and expenses, expenses of our transfer agent, the costs of maintaining compliancewith all federal, state and local rules and regulations or any otherregulatory agency, all taxes and license fees and all insurance costs incurredby us or on our behalf. In addition, we will be required to pay our pro rataportion of rent, telephone, utilities, office furniture, equipment, machineryand other office, internal and overhead expenses of our Manager and itsaffiliates required for our operations. Except as noted above, our Manager isresponsible for all costs incident to the performance of its duties under themanagement agreement, including compensation of our Manager’s 

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employees and otherrelated expenses, except that we may elect to have our Manager allocateexpenses among us and our subsidiaries, in which case expenses would be paiddirectly by each entity that received an allocation.

**IncentiveCompensation.*****  ***In addition to the basemanagement fee, our Manager receives quarterly incentive compensation in anamount equal to the product of: (i) 25% of the dollar amount by which: (a) ourNet Income, before incentive compensation, per weighted-average share of ourcommon stock for such quarter, exceeds (b) an amount equal to (A) theweighted-average of the price per share of our common stock in our August 2004private placement and the prices per share of our common stock in our initialpublic offering and any subsequent offerings by us multiplied by (B) thegreater of (1) 2.00% and (2) 0.50% plus one-fourth of the Ten YearTreasury Rate for such quarter, multiplied by (ii) the weighted averagenumber of shares of our common stock outstanding in such quarter. The foregoingcalculation of incentive compensation will be adjusted to exclude specialone-time events pursuant to changes in GAAP, as well as non-cash charges, afterdiscussion between our Manager and our independent directors and approval by amajority of our independent directors in the case of non-cash charges. Theincentive compensation calculation and payment shall be made quarterly inarrears. For purposes of the foregoing: ‘‘Net Income’’ shall be determined bycalculating the net income available to stockholders before non-cash equitycompensation expense, in accordance with GAAP; and ‘‘Ten Year Treasury Rate’’means the average of weekly average yield to maturity for U.S. Treasurysecurities (adjusted to a constant maturity of ten years) as published weeklyby the Federal Reserve Board in publication H.15 or any successor publicationduring a fiscal quarter.

Our ability to achieve returns in excess of thethresholds noted above in order for our Manager to earn the incentivecompensation described in the preceding paragraph is dependent upon the leveland volatility of interest rates, our ability to react to changes in interestrates and to utilize successfully the operating strategies described herein,and other factors, many of which are not within our control.

Our Manager is required tocompute the quarterly incentive compensation within 30 days after the end ofeach fiscal quarter, and we are required to pay the quarterly incentivecompensation with respect to each fiscal quarter within five business daysfollowing the delivery to us of our Manager’s written statement setting forththe computation of the incentive fee for such quarter. We may elect to have ourManager allocate the incentive management fee among us and our subsidiaries, inwhich case the fee would be paid directly by each entity that received anallocation.

**The CollateralManagement Agreements**

An affiliate of ourManager has entered into separate management agreements with KKR Financial CLO2005-1, Ltd., or CLO 2005-1, KKR Financial CLO 2005-2, Ltd., or CLO 2005-2, andKKR Financial CLO 2006-1, Ltd., or CLO 2006-1, and is entitled to receive feesfor the services performed as the collateral manager under the managementagreements. As of December 31, 2006, the collateral manager haspermanently waived approximately $2.6 million of management fees payable to itfrom CLO 2005-1 which covered the period commencing in March 2005 andending in December 2006, has permanently waived approximately $1.7 millionof management fees payable to it from CLO 2005-2 which covered the periodcommencing November 2005 and ending in December 2006 and haspermanently waived approximately $1.4 million of management fees payable to itfrom CLO 2006-1 which covered the period commencing September 2006 andending in December 2006. The current waivers for CLO 2005-1, CLO 2005-2,and CLO 2006-1 expire in April 2007, May 2007, and May 2007,respectively. There are no assurances that the collateral manager will waivesuch management fees subsequent to those dates.

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**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 to OurOperation and Business Strategy—We operate in a highly competitive market forinvestment opportunities.”

**Staffing**

We do not have anyemployees. We are managed by KKR Financial Advisors LLC, our Manager, pursuantto the management agreement between our Manager and us. Our Manager is 100%owned by KKR Financial LLC and all of our executive officers are members, employees,or officers of KKR Financial LLC. As of February 20, 2007, KKR FinancialLLC had 53 full-time employees and two founding members.

**Tax Status**

We are taxed as a REIT forfederal income tax purposes. To qualify as a REIT, we must meet variousrequirements under the Code, including, among others, requirements relating tothe nature of our assets, the sources of our income, the timing and amount ofdistributions that we make and the composition of our stockholders. As a REIT,we generally are not subject to federal income tax on income that we distributeto our stockholders on a current basis. If we fail to qualify as a REIT in anytaxable year, we will be subject to federal income tax at regular corporaterates, and we may be precluded from qualifying as a REIT for the subsequentfour taxable years following the year during which we lost our qualification.Further, even to the extent that we qualify as a REIT, we will be subject totax at regular corporate rates on net income or capital gains not distributedto our stockholders, and we may be subject to other taxes, including payrolltaxes, and state and local income, franchise, property, sales and other taxes.Moreover, our domestic taxable REIT subsidiary, TRS Inc., is subject to federalincome tax at regular corporate rates and may be subject to other taxes,including payroll taxes, and state and local income, franchise, property, salesand other taxes. Any dividends received from us, with limited exceptions, willnot be eligible for taxation at the preferred capital gain rates that currentlyapply to dividends received by individuals, trusts and estates from taxablecorporations.

**Restrictionson Ownership of Our Capital Stock**

Due to limitations on theconcentration of ownership of a REIT imposed by the Code, our charter, amongother limitations, 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.

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**DistributionPolicy**

We generally need todistribute at least 90% of our taxable income each year (subject to certainadjustments) so that we can qualify as a REIT under the Code. Up to 20% of thevalue of a REIT’s assets may consist of investments in the securities of one ormore taxable REIT subsidiaries. A domestic taxable REIT subsidiary, such as TRS Inc.,may retain its taxable income, and its earnings are subject to the 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 TRS Holdings, Ltd., or TRS Ltd.,CLO 2005-1, CLO 2005-2, CLO 2006-1, KKR Financial CLO 2006-2,Ltd., or CLO 2006-2, and KKR Financial CDO 2005-1, Ltd., or CDO 2005-1,generally is deemed to distribute its earnings to the REIT on an annual basisfor 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.

**ITEM1A.**        RISK FACTORS

You should carefullyconsider the risks described below. In addition, the risks described below arenot the only ones facing us. We have only described the risks we consider to bematerial. However, there may be additional risks that are viewed by us as notmaterial or are not presently known to us.

If any of the risksdescribed below were to occur, our business, financial condition, liquidity andresults of operations could be materially and adversely affected. If this wereto occur, the price of our common stock could decline, and you could lose allor part of your investment.

**RisksRelated to Our Management and Our Relationship with Our Manager**

***We are highly dependent on our Manager and may notfind a suitable replacement if our Manager terminates the management agreement.***

We have no employees. OurManager, and its officers and employees, allocate a portion of their time tobusinesses and 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 as theManager and KKR expand their investment focus to include additional investmentvehicles, including vehicles which compete more directly with us, which timeallocations may 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 and investment strategies and ourrisk management practices. We are also subject to the risk that our Managerwill terminate the management agreement and that no suitable replacement willbe found. We believe that our success depends to a significant extent upon theexperience of our Manager’s executive officers, whose continued service is notguaranteed.

***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 seniormanagement of our Manager, or of a significant number of the investment professionalsor principals of KKR, could have a material adverse effect on our ability toachieve our investment objectives. 

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Inaddition, we can offer no assurance that our Manager will remain our Manager orthat we will continue to have access to KKR’s investment professionals orprincipals or its information and deal 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 REITor specialty finance company, and our investment focus differs from those ofmost 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 focus differsfrom that of other entities that are or have been managed by KKR investmentprofessionals. In particular, no entity managed by KKR has executed a businessstrategy that focuses primarily on investing in debt instruments. Our investorsare not acquiring an interest in any of KKR’s private equity funds and thereturns that are realized by our investors may be materially different than thereturns realized by investors in KKR’s private equity funds.

***Our board of directors has approved very broadInvestment Guidelines for our Manager and does not approve individualinvestment decisions made by our Manager except in limited circumstances.***

Our Manager is authorizedto follow very broad investment guidelines. If the Conversion Transactiondescribed below under “Risks Related to Proposed Conversion Transaction” isconsummated, these Investment Guidelines will be revised to provide evengreater latitude to our Manager with respect to certain matters relating toaffiliated transactions. Our directors periodically review and approve our InvestmentGuidelines. Our board of directors does not approve any individual investments,other than approving a limited set of transactions with affiliates that requirethe pre-approval of the affiliated transactions committee of our board ofdirectors. Furthermore, transactions entered into by our Manager may bedifficult or impossible to unwind. Our Manager has great latitude within thebroad parameters of the Investment Guidelines in determining the types ofassets it may decide are proper investments for us.

***The incentive fee provided for under the managementagreement may induce our Manager to make certain investments, includingspeculative 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. In addition, the compensation committee of our board ofdirectors may make grants of options and restricted 

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stock toour Manager in the future and the factors considered by the compensationcommittee in making these grants may include performance-related factors whichmay also induce our Manager to make investments that are riskier or morespeculative. This could result in increased risk to the value of our investmentportfolio.

***There are various potential conflicts of interest inour relationship with our Manager and its affiliates, including KKR, whichcould result in decisions that are not in the best interests of holders of ourshares.***

We are subject topotential conflicts of interest arising out of our relationship with ourManager and its affiliates. As of December 31, 2006, our Manager and itsaffiliates collectively owned approximately 12.1% of our shares on a fullydiluted basis and received their pro rata portion of the distributions we madeto our stockholders and will receive their pro rata portion of futuredistributions, if any. Saturnino S. Fanlo, our chief executive officer, andDavid A. Netjes, our chief operating officer, also serve in those capacitiesfor our Manager and as of December 31, 2006, beneficially owned approximately5.0% and 4.9% of our shares on a fully diluted basis, respectively. Inaddition, as of December 31, 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 investmentcommittee and is an executive at KKR, beneficially owned approximately 4.7% and4.4% of our shares on a fully diluted basis, respectively. Furthermore, ourManager is wholly-owned by KKR Financial LLC and KKR Financial LLC is owned byKKR and Messrs. Fanlo and Netjes. Our management agreement with our Manager wasnegotiated between related parties, and its terms, including fees payable, maynot be as favorable to us as if it had been negotiated with an unaffiliatedthird party. Pursuant to the management agreement, our Manager will not assumeany responsibility other than to render the services called for thereunder andwill not be responsible for any action of our board of directors in followingor declining to follow its advice or recommendations. Our Manager, its members,managers, officers and employees are not be liable to us, any subsidiary ofours, our directors, our stockholders or any subsidiary’s stockholders for actsperformed in accordance with and pursuant to the management agreement, exceptby reason of acts constituting bad faith, willful misconduct, gross negligence,or reckless disregard of their duties under the management agreement. We haveagreed to indemnify our Manager and its members, managers, officers andemployees and each person controlling our Manager with respect to all expenses,losses, damages, liabilities, demands, charges and claims arising from acts ofsuch indemnified party not constituting bad faith, willful misconduct, grossnegligence, or reckless disregard of duties, performed in good faith inaccordance with and pursuant to the management agreement.

***Affiliates of our Manager and KKR compete with us andthere may be conflicts arising from allocation of investment opportunities.***

Our management agreementwith our Manager does not prevent our Manager and its affiliates from engagingin additional management or investment opportunities. While the managementagreement generally restricts our Manager and its affiliates from raising,sponsoring or advising any new investment fund, company or other entity,including a REIT, that invests primarily in domestic mortgage-backedsecurities, this restriction will be of significantly lesser significance ifthe proposed Conversion Transaction is consummated; provided, further that forpurposes of the foregoing limitation, any portfolio company of any private equityfund controlled by KKR shall not be deemed to be an affiliate of our Manager.As a result, our Manager and its affiliates, including KKR, currently areengaged in and may in the future engage in management or investmentopportunities that have overlapping objectives with us. In particular,affiliates of our Manager currently manage a separate investment fund thatinvests in the same non-mortgage-backed securities investments that we investin, including other fixed income investments and KKR private equityinvestments. With respect to this entity and any other competing entitiesestablished in the future, our Manager and its affiliates will face conflictsin the allocation of investment opportunities. 

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Suchallocation is at the discretion of our Manager, and there is no guarantee thatthis allocation would be made in the best interests of our stockholders.

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

Subject to complying withour Investment Guidelines, it is a core element of our business strategy thatour Manager will at times cause us to invest in corporate leveraged loans,high-yield securities and equity securities of companies affiliated with KKR.To the extent KKR is the owner of all or a majority of the outstanding equitysecurities of such companies, KKR may have the ability to elect all of themembers of the board of directors of a company we invest in and thereby controlits policies and operations, including the appointment of management, future issuancesof shares or other securities, the payments of dividends, if any, on itsshares, the incurrence of debt by it, amendments to its certificate ofincorporation and bylaws and entering into extraordinary transactions, andKKR’s interests may not in all cases be aligned with the interests of theholders of the securities which we own. In addition, KKR may have an interestin pursuing acquisitions, divestitures and other transactions that, in theirjudgment, could enhance their equity investment, even though such transactionsmight involve 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 controllingstockholder it may 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. Our interests withrespect to the management, investment decisions, or operations of those companiesmay at times be in conflict with those of KKR. In addition, to the extent thataffiliates of our Manager or KKR invest in companies in which we have aninvestment, similar conflicts between our interests and theirs may arise.

***We compete with other investment entities affiliatedwith KKR for access to KKR’s investment professionals and principals.***

KKR and its affiliatesmanage several private equity funds, and we believe that KKR and its affiliateswill establish and manage other investment entities in the future. Certain ofthese investment entities have, and any newly created entities may have, aninvestment focus similar to our focus, and as a result we compete with thoseentities and will compete with any such newly created entities for access to thebenefits that our relationship with KKR provides to us. Since our formation, wehave entered into several private equity investments pursuant to which we areco-investing alongside KKR private equity funds. Our ability to continue toengage in these types of opportunities in the future depends, to a significantextent, on the contractual obligations that KKR has to the limited partners ofits private equity funds with respect to co-investment opportunities as well ason competing demands for these investment opportunities by other investmententities established by KKR and its affiliates. To the extent that we and otherKKR affiliated entities or related parties compete for investmentopportunities, there can be no assurances that we will get the best or any ofthose opportunities or that the performance of the investments allocated to us,even within the same asset classes, will perform as favorably, as thoseallocated to others.

***Termination by usof the management agreement with our Manager without cause is difficult andcostly.***

The management agreementprovides that it may only be terminated by us annually after December 31,2007 upon the affirmative vote of at least two-thirds of our independentdirectors, or by a vote of the holders of a majority of our outstanding sharesof common stock, based upon (i) unsatisfactory performance by our Manager thatis materially detrimental to us or (ii) a determination that the 

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managementfee payable to our Manager is not fair, subject to our Manager’s right toprevent such a termination under this clause (ii) by accepting a mutuallyacceptable reduction of management fees. Our Manager will be provided 180 days’prior notice of any such termination and will be paid a termination fee equalto four times the sum of the average annual base management fee and the averageannual incentive fee for the two 12-month periods immediately preceding thedate of termination, calculated as of the end of the most recently completedfiscal quarter prior to the date of termination. These provisions would resultin substantial cost to us if we terminate the management agreement, therebyadversely affecting our ability to terminate our Manager without cause.

***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 holders of our shares.***

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 affect on our operations. Conversely, we may pursue investmentswithout obtaining access to confidential information otherwise in thepossession of KKR or one of its affiliates, which information, if reviewed,might otherwise impact our judgment with respect to such investments.

***Our Manager’s liability is limited under themanagement agreement, and we have agreed to indemnify our Manager againstcertain liabilities.***

Pursuant to the managementagreement, our Manager does not assume any responsibility other than to renderthe services called for thereunder and is not be responsible for any action ofour board of directors in following or declining to follow its advice orrecommendations. Our Manager and its members, managers, officers and employees isnot liable to us, any subsidiary of ours, our directors, our stockholders orany subsidiary’s stockholders for acts performed in accordance with andpursuant to the management agreement, except by reason of acts constituting badfaith, willful misconduct, gross negligence, or reckless disregard of theirduties under the management agreement. We have agreed to indemnify our Managerand its members, managers, officers and employees and each person controllingour Manager with respect to all expenses, losses, damages, liabilities,demands, charges and claims arising from acts of such indemnified party notconstituting bad faith, willful misconduct, gross negligence, or recklessdisregard of duties, performed in good faith in accordance with and pursuant tothe management agreement.

**RisksRelated to Our Operation and Business Strategy**

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

We price our assets basedon our assumptions about future levels of credit spreads (the risk premium fortaking credit risk which is the difference between the risk free rate and theinterest rate paid on the investment) for term financing of those assets. Weexpect to obtain longer term financing for these assets at a spread over acertain benchmark, such as the yield on United States Treasury bonds, swaps, orLIBOR. If the spread that investors will pay over the benchmark widens and therates we charge on our 

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loans orthe income we generate from our other assets are not increased accordingly, wemay experience a material adverse reduction in the economic value of the assetsthat we have acquired.

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

We have a limitedoperating history and limited experience as a REIT. We are subject to all ofthe business risks and uncertainties associated with any business, includingthe risk that we will not achieve our investment objectives and that the valueof your investment could decline substantially. There can be no assurance thatwe will be able to generate sufficient revenue from operations to pay ouroperating expenses and make or sustain distributions to holders of our shares.

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

A number of entitiescompete with us to make the types of investments that we make. We compete with otherREITs, specialty finance companies, hedge funds, public and private funds, and commercialand investment banks. Many of our competitors are substantially larger and haveconsiderably greater financial, technical and marketing resources than we do.Several other REITs and other entities have recently raised, or are expected toraise, significant amounts of capital, and may have investment objectives thatoverlap with ours, which may create competition for investment opportunities.Some competitors may have a lower cost of funds and access to financing sourcesthat are not available to us. In addition, some of our competitors may havehigher risk tolerances or different risk assessments, which could allow them toconsider a wider variety of investments and establish more relationships thanus. We cannot assure you that the competitive pressures we face will not have amaterial adverse affect on our business, financial condition and results ofoperations. Also, as a result of this competition, we may not be able to takeadvantage of attractive investment opportunities from time to time, and we canoffer no assurance that we will be able to identify and make investments thatare consistent with our investment objectives.

***Failure to obtain adequate capital and financing wouldadversely affect our results and may, in turn, negatively affect the marketprice of our shares and our ability to make distributions to holders of ourshares.***

We depend upon theavailability of adequate financing and capital for our operations. As a REIT,we are 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 TRS Inc.,and any other domestic taxable REIT subsidiary, subject to the REITrequirements). We cannot assure you that any, or sufficient, financing orcapital will be available to us in the future on terms that are acceptable tous or at all. In the event that we cannot obtain sufficient financing onacceptable terms, there may be a negative impact on the market price of ourshares and our ability to make distributions to holders of our shares.

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

We leverage our portfolioinvestments through borrowings, generally through the use of warehousefacilities, bank credit facilities, repurchase agreements, asset-backed securedliquidity notes, mortgage loans on real estate, securitizations, including theissuance of collateralized debt obligations, or CDOs, loans to entities inwhich we hold, directly or indirectly, interests in pools of properties orloans, and other borrowings. The percentage of leverage varies depending on ourability to obtain credit facilities and the lender’s and rating agencies’estimate of the stability of the portfolio investments’ cash flow. Our returnon our investments and cash available for distribution to our stockholders maybe reduced to the extent that changes in market conditions cause the cost ofour financing to increase relative to the income that can be derived from theassets acquired. Our debt service payments reduce cash flow available fordistribution to holders of our shares. We may not be able to meet our debtservice obligations and, to the extent that we cannot, we risk the loss of someor all of our assets to foreclosure or sale to satisfy our debt obligations. We

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leveragecertain of our investments through repurchase agreements, total rate of returnswaps and asset-backed secured liquidity notes. A decrease in the value of theassets may lead to margin calls that we will have to satisfy. We may not havethe funds available to satisfy any such margin calls.

***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 tostructure our securitization transactions so that we must account for them assecured borrowings in accordance with Statement of Financial AccountingStandards (‘‘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 anygain or loss. To securitize our portfolio investments, we may create awholly-owned subsidiary and contribute a pool of portfolio investments to thesubsidiary. An inability to securitize our portfolio successfully could limitour ability to grow our business or fully execute our business strategy andcould decrease our earnings, if any. Moreover, the successful securitization ofour portfolio investments might expose us to losses as the residual portfolioinvestments in which we do not sell interests will tend to be those that areriskier and more likely to generate 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 toholders of our shares.***

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 holders of shares.

***We may enter intoderivative contracts that could expose us to contingent liabilities in thefuture.***

Part of our investmentstrategy involves entering into derivative contracts that will require us tofund cash payments in certain circumstances. These payments will be contingentliabilities and therefore may not appear on our balance sheet. Our ability tofund these contingent liabilities will depend on the liquidity of our assetsand access to capital at that time, and the need to fund these contingentliabilities could adversely impact our financial condition.

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

Weenter into interest rate swap agreements and other interest rate hedgingstrategies. Our hedging activity will vary in scope based on the level ofinterest rates, the type of portfolio investments held, and other changingmarket conditions. Interest rate hedging may fail to protect or could adverselyaffect us because, among other things:

·       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;

·       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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·       theduration of the hedge may be significantly different than the duration of therelated liability or asset;

·       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 holders of our shares. Therefore, while we mayenter into such transactions to seek to reduce interest rate risk,unanticipated changes in interest rates may result in poorer overall investmentperformance than if we had not engaged in any such hedging transactions. Inaddition, the degree of correlation between price movements of the instrumentsused in a hedging strategy and price movements in the portfolio positions beinghedged or liabilities being hedged may vary materially. Moreover, for a varietyof reasons, 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 with applicablestatutory, commodity and other regulatory requirements and, depending on theidentity of the counterparty, applicable international requirements. Thebusiness failure of a hedging counterparty with whom we enter into a hedgingtransaction will most likely result in a default. Default by a party with whomwe enter into a hedging transaction may result in the loss of unrealizedprofits and force us to cover our resale commitments, if any, at the thencurrent market price. Although generally we will seek to reserve the right toterminate our hedging positions, it may not always be possible to dispose of orclose out a hedging position without the consent of the hedging counterparty,and we may not be able to enter into an offsetting contract in order to coverour risk. We cannot assure you that a liquid secondary market will exist forhedging instruments purchased or sold, and we may be required to maintain aposition until exercise or expiration, which could result in losses.

***We make investments in non-U.S. dollar denominatedinvestments, which subject us to currency rate exposure and the uncertainty offoreign laws and markets.***

We purchase investmentsdenominated in foreign currencies. A change in foreign currency exchange ratesmay have an adverse impact on returns on any of these non-dollar denominatedinvestments. Although we may choose to hedge our foreign currency risk subjectto the REIT income qualification tests, we may not be able to do sosuccessfully and may incur losses on these investments as a result of exchangerate fluctuations. Investments in foreign countries also subject us to risks ofmultiple and conflicting tax laws and regulations and political and economicinstability abroad, which could adversely affect our receipt of interest incomeon these investments.

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**RisksRelated to Our Investments**

***We may not realizegains or income from our investments.***

We seek to generate bothcurrent income and capital appreciation. The assets in which we invest may notappreciate in value, however, and, in fact, may decline in value, and the debtsecurities 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 holders of ourshares.***

A substantial portion ofour assets are, and we believe are likely to continue to be, classified foraccounting purposes as ‘‘available-for-sale’’ so long as it is management’s intentnot to sell such assets. Changes in the market values of these assets will bedirectly charged or credited to stockholders’ equity. As a result, a decline invalues may reduce our book value. Moreover, if the decline in value of anavailable-for-sale security is considered by our Manager to be other thantemporary, such decline will reduce earnings.

A decline in the marketvalue of our assets may adversely affect us particularly in instances where wehave borrowed money based on the market value of these assets. If the marketvalue of these assets declines, the lender may require us to post additionalcollateral to support the loan. If we were unable to post the additionalcollateral, we would have to sell the assets at a time when we might nototherwise choose to do so. A reduction in credit available may reduce ourearnings and, in turn, cash available for distribution to holders of ourshares.

Further, credit facilityproviders may require us to maintain a certain amount of cash invested or toset aside unlevered assets sufficient to maintain a specified liquidityposition which would allow us to satisfy our collateral obligations. As aresult, we may not be able to leverage our assets as fully as we would choose, whichcould reduce our return on equity. In the event that we are unable to meetthese contractual obligations, our financial condition could deterioraterapidly.

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 ofloans and securities that have limited liquidity or are not publicly traded.The fair value of investments that have limited liquidity or are not publiclytraded may not be readily determinable. We value these investments quarterly atfair value as determined by our Manager. Because such valuations are inherentlyuncertain, may fluctuate over short periods of time and may be based onestimates, our determinations of fair value may differ materially from thevalues that would have been used if a ready market for these investmentsexisted. 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 holders of our shares.***

We invest in fixed-rateloans and securities. Under a normal yield curve, an investment in theseinstruments will decline in value if interest rates increase. We also invest infloating rate debt investments, 

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forwhich decreases in interest rates may have a negative effect on value. Declinesin market value may ultimately reduce earnings or result in losses to us, whichmay negatively affect cash available for distribution to holders of our shares.

In particular, asignificant risk associated with fixed-rate 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 loans and securitieswould decline and, with respect to mortgage-backed securities, the duration ofthe investments would increase. We could realize a loss if these investmentswere sold. At the same time, an increase in short-term interest rates wouldincrease the amount of interest owed on short-term borrowings we may enter intoin order to finance the purchase of these fixed-rate investments.

***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 holders of our shares.***

Our assets includeleveraged loans, high-yield securities and marketable and non-marketable commonand preferred equity securities, each of which involves a higher degree of riskthan senior secured loans. The leveraged loans and high-yield securities maynot be secured by mortgages or liens on assets. Even if secured, theseleveraged loans and high-yield securities may have higher loan-to-value ratiosthan senior secured loans. Furthermore, our right to payment and the securityinterest may be subordinated to the payment rights and security interests of asenior lender. Therefore, we may be limited in our ability to enforce ourrights to collect these loans and to recover any of the loan balance through a foreclosureof collateral.

Many of these leveragedloans and high-yield securities may have an interest-only payment schedule,with the principal amount remaining outstanding and at risk until the maturityof the loan. In this case, a borrower’s ability to repay its loan may bedependent upon a refinancing or a liquidity event that will enable therepayment of the loan.

In addition to the above,numerous other factors may adversely affect a company’s ability to repay itsloan, including the failure to meet its business plan, a downturn in itsindustry or negative economic conditions. A deterioration in a company’sfinancial condition and prospects may be accompanied by deterioration in thecollateral for the high-yield securities and leveraged loans. Losses on ourhigh-yield securities and leveraged loans could adversely affect our earnings,which could adversely affect cash available for distribution to holders of ourshares.

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

***Prepayments canadversely affect the yields on our investments.***

In the case of residentialmortgage loans, there are seldom any restrictions on borrowers’ abilities toprepay their loans. Homeowners tend to prepay mortgage loans faster wheninterest rates decline. Consequently, owners of the loans have to reinvest themoney received from the prepayments at the lower prevailing interest rates.Conversely, homeowners tend not to prepay mortgage loans when interest ratesincrease. Consequently, owners of the loans are unable to reinvest money thatwould have otherwise been received from prepayments at the higher prevailinginterest rates. This volatility in prepayment rates may adversely affect ourability to maintain targeted amounts of leverage on our mortgage-backedsecurities portfolio and may result in reduced earnings or losses for us andnegatively affect the cash available for distribution to holders of our shares.

The yield of our otherassets may be adversely 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, the yield on our portfolio will decline. In addition, we mayacquire assets at a discount or premium and if the asset does not repay whenexpected, our anticipated yield may be impacted. Under certain interest rateand prepayment scenarios we may fail to recover fully our cost of acquisitionof 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 estateloans are secured by multifamily or commercial property and are subject torisks of delinquency and foreclosure, and risks of loss that are greater thansimilar risks associated with loans made on the security of single-familyresidential property. The ability of a borrower to repay a loan secured by anincome-producing property typically is dependent primarily upon the successfuloperation of such property rather than upon the existence of independent incomeor assets of the borrower. If the net operating income of the property isreduced, the borrower’s ability to repay the loan may be impaired. Netoperating income of an income-producing property can be affected by, among otherthings: tenant mix, success of tenant businesses, property managementdecisions, property location and condition, competition from comparable typesof properties, changes in laws that increase operating expense or limit rentsthat may be charged, any need to address environmental contamination at theproperty, the occurrence of any uninsured casualty at the property, changes innational, regional or local economic conditions and/or specific industrysegments, declines in regional or local real estate values, declines inregional or local rental or occupancy rates, increases in interest rates, realestate tax rates and other operating expenses, changes in governmental rules,regulations and fiscal policies, including environmental legislation, acts ofGod, terrorism, social unrest and civil disturbances.

Residential mortgage loansare secured by single-family residential property and are subject to risks ofdelinquency, foreclosure and risks of loss. The ability of a borrower to repaya loan secured by a residential property is dependent upon the income or assetsof the borrower. A number of factors, including a general economic downturn,acts of God, terrorism, social unrest and civil disturbances, may impairborrowers’ abilities to repay their loans. Asset-backed securities are bonds ornotes backed by loans and/or other financial assets. The ability of borrowersto repay these loans or other financial assets is dependent upon the income orassets of these borrowers.

In the event of anydefault under a mortgage loan held directly by us, we will bear a risk of lossof principal to the extent of any deficiency between the value of thecollateral and the principal and accrued interest of the mortgage loan, whichcould have a material adverse effect on our cash flow from operations. In theevent of the bankruptcy of a mortgage loan borrower, the mortgage loan to suchborrower will be deemed to be secured only to the extent of the value of theunderlying collateral at the time of bankruptcy (as determined by the bankruptcycourt), and the lien securing the mortgage loan will be subject to theavoidance powers of the bankruptcy trustee or debtor-in-possession to theextent the lien is unenforceable under state law.

Foreclosure of a mortgageloan can be an expensive and lengthy process that could have a substantialnegative affect on our anticipated return on the foreclosed mortgage loan.Residential mortgage-backed securities, or RMBS, evidence interests in or aresecured by pools of residential mortgage loans and commercial mortgage-backedsecurities, or CMBS, evidence interests in or are secured by a singlecommercial mortgage loan or a pool of commercial real estate loans.Accordingly, the mortgage-backed securities we invest in are subject to all ofthe risks of the underlying mortgage 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.

***A significant portion, of our investment portfolio isinvested in non-agency RMBS and non-conforming residential mortgage loans.***

A significant portion ofour investment portfolio consists of non-agency RMBS and non-conformingresidential mortgage loans. Agency backed securities include RMBS whichrepresent the entire ownership interest in pools of residential mortgage loanssecured by residential real property and are guaranteed as to principal andinterest by federally chartered entities such as the FederalNational Mortgage Association, better known as “Fannie Mae,” the Federal HomeLoan Mortgage Corporation, better known as “Freddie Mac,” and, in the case ofthe Government National Mortgage Association, better known as “Ginnie Mae,” bythe U.S. government. Non-agency RMBS are not guaranteed by FannieMae, Freddie Mac, Ginnie Mae, or the U.S. government; rather their ratings areassigned by nationally recognized rating agencies such as Moody’s InvestorsService, or Moody’s, and Standard & Poor’s Ratings Service, or Standard& Poor’s. Non-agency RMBS have a higher risk of loss than do agency RMBS.We may realize 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, RMBS, commercial real estate loans, and CMBS may have materialgeographic concentrations.***

We have materialgeographic concentrations related to investments in residential mortgage loansand RMBS. We have material geographic concentrations related to investments incommercial real estate loans and CMBS. The risk of foreclosure and losses arelikely to be 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 insubordinated CMBS are generally in the ‘‘second loss’’ position and thereforesubject 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 ofdefault and the exhaustion of any equity support, reserve fund, letter ofcredit and any classes of securities junior to those in which we invest, wewill not be able to recover all of our investment in the securities wepurchase. In addition, if the underlying mortgage portfolio has been overvaluedby the originator, 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 seniorsecurities, which may result in significant losses to us. The prices of lowercredit quality securities are generally less sensitive to interest rate changesthan more 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-backedsecurities to make principal and interest payments may be impaired. In suchevent, existing credit support in the securitization structure may beinsufficient to protect us against loss of our principal on these securities.

***Our rights undercorporate leveraged loans we invest in may be more restricted than investmentsin other loans.***

We may hold interests incorporate leveraged loans originated by banks and other financial institutions.We may acquire interests in corporate leveraged loans either directly (by wayof sale or assignment) or indirectly (by way of participation). The purchaserof an assignment typically succeeds to all the rights and obligations of theassigning institution and becomes a lender under the credit agreement withrespect to the debt obligation; however, its rights can be more restricted thanthose of the assigning institution. Participation interests in a portion of adebt obligation typically result in a contractual relationship only with theinstitution participating out the interest, not with the borrower. Inpurchasing participations, we generally will have no right to enforcecompliance by the borrower with the terms of the credit agreement, nor anyrights of set-off against the borrower, and we may not directly benefit fromthe collateral supporting the debt obligation in which it has purchased theparticipation. As a result, we will assume the credit risk of both the borrowerand the institution selling the participation.

***The high yieldbonds that we invest in have greater credit and liquidity risk than more highlyrated bonds.***

We invest in high yieldbonds which are rated below investment-grade by one or more nationallyrecognized statistical rating organizations or are unrated but of comparablylow credit quality, and have greater credit and liquidity risk than more highlyrated bonds. High yield bonds may be unsecured, and may be subordinate to otherobligations of the obligor. The lower rating, or lack of a rating, on highyield bonds reflects a greater possibility that adverse changes in thefinancial condition of the obligor or in general economic conditions or bothmay impair the ability of the obligor to make payment of principal and interest.Many issuers of high yield bonds are highly leveraged, and their relativelyhigh debt-to-equity ratios create increased risks that their operations mightnot generate sufficient cash flow to service their debt obligations. Overalldeclines in the below investment-grade bond and other markets may adverselyaffect such issuers by inhibiting their ability to refinance their debt atmaturity. High yield bonds are often less liquid than higher rated bonds.

High yield bonds are oftenissued in connection with leveraged acquisitions or recapitalizations in whichthe issuers incur a substantially higher amount of indebtedness than the levelat which they had previously operated. High yield bonds have historicallyexperienced greater default rates than has been the case for investment-gradebonds.

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***Asset-backedsecurities are subject to credit risks that may arise due to defaults by theborrowers in the underlying collateral or the issuer’s or servicer’s failure toperform and other risks.***

We invest in investment grade and non-investment gradeasset-backed securities, or ABS. Investments in ABS bear various risks,including credit risk, interest rate risk, market risk, liquidity risk,operations risk, structural risk and legal risk. Credit risk arises from lossesdue to defaults by the borrowers in the underlying collateral and the issuer’sor servicer’s failure to perform. These two elements may be related, as, forexample, in the case of a servicer that does not provide adequate credit-reviewscrutiny to the serviced portfolio, leading to higher incidence of defaults.Interest rate risk arises for the issuer from the relationship between thepricing terms on the underlying collateral and the terms of the rate paid toholders of the ABS and from the need to mark to market the excess servicing orspread account proceeds carried on the balance sheet. For the holder of theABS, interest rate risk depends on the expected life of the ABS which maydepend on prepayments on the underlying assets or the occurrence of wind-downor termination events. Market risk arises from the cash flow characteristics ofthe security, which for most ABS tend to be predictable. The greatestvariability in cash flows comes from credit performance, including the presenceof wind-down or acceleration features designed to protect the purchaser in theevent that credit losses in the portfolio rise well above expected levels.

Liquidity risk may arisefrom an increase in perceived credit risk. Liquidity can also become a majorconcern for asset-backed commercial paper programs. For example, concerns aboutcredit quality may lead buyers to avoid the commercial paper issued by therelevant special-purpose entity. For these cases, the securitizationtransaction may include a ‘‘liquidity facility,’’ which requires the facilityprovider to advance funds to the relevant special-purpose entity shouldliquidity problems arise. To the extent that the bank originating the loans isalso the provider of the liquidity facility, and that the bank is likely toexperience similar market concerns if the loans it originates deteriorate, theultimate practical value of the liquidity facility to the transaction may bequestionable. Other risks arise through the potential for misrepresentation ofloan quality or terms by the originating institution, misrepresentation of thenature and current value of the assets by the servicer and inadequate controlsover disbursements and receipts by the servicer.

***Collateralized debtobligations, or CDO, are subject to the risk that the collateral underlying theCDOs are insufficient to make payments on the CDO securities.***

We invest in investmentgrade and non-investment grade CDOs. CDO debt securities rely on distributionsof the collateral underlying the CDO. Interest payments on CDO debt (other thanthe most senior tranche or tranches of a given issue) are generally subject todeferral without causing an event of default or permitting exercise of remediesby the holders thereof. If distributions on the collateral of the CDO orproceeds of such collateral are insufficient to make payments on the CDO debtsecurities we hold, no other assets will be available for payment of thedeficiency. In addition, CDO securities are generally privately placed andoffer less liquidity than other investment-grade or high-yield corporate debt.

***Total return swapsare subject to risks related to changes in interest rates, credit spreads,credit quality and expected recovery rates of the underlying credit instrumentas well as renewal risks.***

We enter into total rateof return swaps, or TRORS, to finance certain of our investments. TRORS aresubject to risks related to changes in interest rates, credit spreads, creditquality and expected recovery rates of the underlying credit instrument as wellas renewal risks. A TRORS agreement is a two-party contract under which anagreement is made to exchange returns from predetermined investments orinstruments. TRORS allow investors to gain exposure to an underlying creditinstrument without actually owning the credit instrument. In these swaps, thetotal return, which consists of interest, fees and gains/losses on anunderlying credit instrument, is paid to an investor in exchange for a floatingrate payment. The investor pays a fraction of the value of the total amount ofthe credit instrument that is 

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referencedin the swap as collateral posted with the swap counterparty. The TRORS,therefore, is a leveraged investment in the underlying credit instrument. Thegross returns to be exchanged or ‘‘swapped’’ between the parties are calculatedbased on a ‘‘notional amount,’’ which is valued monthly to determine eachparty’s obligation under the contract. We recognize all cash flows received(paid) or receivable (payable) from swap transactions on a net basis asrealized or unrealized gains or losses in the consolidated statement of operations.We are charged a finance cost by counterparties with respect to each agreement.The finance cost is reported as part of the realized or unrealized gains orlosses. Because swap maturities may not correspond with the maturities of thecredit instruments underlying the swap, we may wish to renew many of the swapsas they mature. However, there is a limited number of providers of such swaps,and there is no assurance the initial swap providers will choose to renew theswaps, and, if they do not renew, that we would be able to obtain suitablereplacement providers.

***Credit default swaps,or CDS, are subject to risks related to changes, credit spreads, credit qualityand expected recovery rates of the underlying credit instrument.***

CDS are subject to risksrelated to changes in credit spreads, credit quality and expected recoveryrates of the underlying credit instrument. A CDS is a contract in which thecontract buyer pays, in the case of a short position, or receives, in the caseof a long position, a periodic premium until the contract expires or a creditevent occurs. In return for this premium, the contract seller receives, in thecase of a short position, or makes a payment, in the case of a long position,to the buyer if there is a credit default or other specified credit event withrespect to the issuer of the underlying credit instrument referenced in theCDS.

***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 typically have no ability to affect these managementdecisions and we may have only limited ability to dispose of our investments.

***Due diligence conducted by our Manager may not revealall of the risks of the businesses in which we invest.***

Before making aninvestment in a business entity, our Manager assesses the strength and skillsof the entity’s management and other factors that it believes will determinethe success of the investment. In making the assessment and otherwise conductingdue diligence, 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. Inaddition, we may pursue investments without obtaining access to confidentialinformation otherwise in the possession of KKR or one of its affiliates, whichinformation, if reviewed, might otherwise impact our judgment with respect tosuch investments.

***A prolongedeconomic slowdown, a recession or declining real estate values could impair ourinvestments and harm our operating 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 our 

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mortgageloans, and the mortgage loans we own that back the mortgage-backed securities,in our investment portfolio. Unfavorable economic conditions also couldincrease our financing costs, limit our access to the capital markets or resultin a decision by lenders not to extend credit to us. These events could preventus from increasing investments and harm our operating results.

***Many of ourinvestments are illiquid and we may not be able to vary our portfolio inresponse to changes in economic and other conditions.***

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.

**Risks Related toour Organization and Structure**

***Our ability to makefuture distributions may be affected by, and the amount of such distributionsmay be reduced by, among other factors, a change in the return on ourinvestments, our operating expense levels and certain restrictions imposed byMaryland law.***

As a REIT, we mustdistribute annually at least 90% of our 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 levels,certain restrictions imposed by Maryland law and, as discussed below, restrictionsin our credit facility. Some of the factors are beyond our control and a changein any such factor could affect our ability to make future distributions to ourstockholders or reduce the amount of such distributions. No assurance can begiven as to our ability to make distributions to our stockholders.

***The terms of ourindebtedness may restrict our ability to make future distributions and imposelimitations on our current and future operations.***

Our credit facility contains, and any futureindebtedness may also contain, a number of restrictive covenants that imposeoperating restrictions on us, including restrictions on our ability to makedistributions to holders of our shares. The credit facility includes covenantsrestricting our ability to incur or guarantee additional debt, create or incurliens, make loans, acquisitions or investments, pay dividends, and engage intransactions with affiliates. In addition, the facility also includes financialcovenants, including net worth, net income and leverage requirements.

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 to exceedour calculation of taxable income for REIT compliance purposes, as it iscomputed 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 

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million; certain eventsrelating to benefit plans subject to ERISA; the failure of our Manager tocontinue as our manager and remain affiliated with KKR; our failure to maintainour status as a REIT; and any change in control (such defaults subject incertain cases to grace periods). As a result, these limitations, andlimitations imposed by any future financing agreements, may adversely affectour ability to make future distributions to our stockholders or may reduce theamount of such distributions, which may prevent us from qualifying as a REITfor federal income tax purposes. No assurance can be given as to our ability tomake 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.

***Our InvestmentCompany Act exemption limits our investment discretion and loss of theexemption would adversely affect us and negatively affect the market price ofshares of our common stock and the ability to make distributions to ourstockholders.***

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, RMBSand CMBS that represent the entire ownership in a pool of mortgage loans andother 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 qualifyingreal estate assets is more limiting. For example, our ability to invest inprivately issued mortgage-backed securities for which we do not own all of thesecurities issued and with respect to which we do not obtain the right toforeclose on the related mortgage loans is limited because these securities donot constitute qualifying investments for the 55% test, even if they aretreated more favorably under the REIT tax rules. Maintaining our exemption fromregulation as an investment company under the Investment Company Act limits ourability to invest in assets that otherwise would meet our investmentstrategies.

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 in mortgage loans or other qualifying real estate assets, we mighthave to sell equity securities in order to qualify for exemption under theInvestment Company Act. The sale could occur under adverse market conditions.In addition, our Manager may terminate its management agreement with us if wefail to qualify for this exemption.

***Rapid changes inthe values of our mortgage-backed securities and other real estate relatedinvestments may make it more difficult for us to maintain our REIT status orexemption from the Investment Company Act.***

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 

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difficultymay be exacerbated by the illiquid nature of many of our non-real estateassets. We may have to make investment decisions that we otherwise would notmake absent the REIT and Investment Company Act considerations.

***Maryland takeoverstatutes may prevent or make difficult a change of control of our company thatcould be in the interests of our 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 “business combination”provisions of the MGCL that, subject to limitations, prohibit certain businesscombinations between us and an “interested stockholder” (defined generally asany person who beneficially owns 10% or more of the voting power of our sharesor an affiliate or associate of ours who, at any time within the two-yearperiod prior to the date in question, was the beneficial owner of 10% or moreof our then outstanding voting shares, or an affiliate thereof) for five yearsafter the most recent date on which the stockholder becomes an interestedstockholder, and thereafter imposes special appraisal rights and specialstockholder voting requirements on these combinations. We have, by resolution,however, exempted business combinations between us and any person, providedthat such business combination is first approved by our board of directors,from the provisions of the Maryland Business Combination Act. Consequently, thefive-year prohibition and the supermajority vote requirements will not apply tobusiness combinations between us and any person described above if approved byour board of directors. We have determined to opt out of the so-called “controlshare” provisions of the MGCL that provide that “control shares” of a Marylandcorporation (defined as shares which, when aggregated with other sharescontrolled by the stockholder, entitle the stockholder to exercise one of threeincreasing ranges of voting power in electing directors) acquired in a “controlshare acquisition” (defined as the direct or indirect acquisition of ownershipor control of “control shares”) have no voting rights except to the extentapproved by our stockholders by the affirmative vote of at least two-thirds ofall the votes entitled to be cast on the matter, excluding all interestedshares. We may in the future, however, elect to become subject to the controlshare provisions of the MGCL. The “unsolicited takeover” provisions of the MGCLpermit our board of directors, without stockholder approval and regardless ofwhat is currently provided in our charter or bylaws, to implement takeoverdefenses, some of which (for example, a classified board) we do not yet have.These provisions may have the effect of inhibiting a third party from making anacquisition proposal for us or of delaying, deferring or preventing a change incontrol of our company under the circumstances that otherwise could provide theholders of our common stock with the opportunity to realize a premium over thethen-current market price. We have no present plans to classify our board.

***Our charter andbylaws contain provisions that may inhibit potential acquisition bids that ourstockholders may consider favorable, and the market price of our common stockmay 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 

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number of shares,whichever is more restrictive, of any class or series of our outstandingcapital 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 therights of our stockholders to take action against our directors and officersare limited, which could limit their recourse in the event of actions not intheir 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 charter authorizes us to obligate ourcompany to indemnify our present and former directors and officers for actionstaken by them in those capacities to the maximum extent permitted by Marylandlaw. Our bylaws require us to indemnify each present or former director orofficer, to the maximum extent permitted by Maryland law, in the defense of anyproceeding to which he or she is made, or threatened to be made, a party byreason of his or her service to us. In addition, we may be obligated to fundthe defense costs incurred by our directors and officers.

**TaxRisks**

***Complying with theREIT requirements may cause us to forgo otherwise attractive opportunities orengage in marginal investment opportunities.***

To qualify as a REIT for federal income tax purposes,we must continually satisfy tests concerning, among other things, the sourcesof our income, the nature and diversification of our assets, the amounts wedistribute to our stockholders and the ownership of our stock. In order to meetthese tests, we may be required to forgo attractive business or investmentopportunities or engage in marginal investment 

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opportunities. Thus,compliance with the REIT requirements may hinder our ability to operate solelyon the basis of maximizing profits.

As discussed below under“Risks Related to Proposed Conversion Transaction”, our board of directors hasapproved a conversion transaction that, if consummated, would result in ourbecoming a subsidiary of KKR Financial Holdings LLC, a recently formed Delawarelimited liability company. KKR Financial Holdings LLC will not be a REIT, butis intended to be a pass-through entity for U.S. federal income tax purposes.However, we intend to continue to operate in a manner that is intended to causeus to qualify as a REIT for U.S. federal income tax purposes if the conversiontransaction is consummated and we will therefore remain subject to many of thetax risks described in this section.

***The prohibitedtransactions tax will limit our ability to engage in transactions, includingcertain methods of securitizing mortgage loans, that would be treated as salesfor 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 mightotherwise be 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 domestic taxable REIT subsidiaries,the income associated with such activities may be subject to full corporateincome tax.

***We may be subjectto the prohibited transactions tax on the loans we sold or will sell to our CLOissuers if the Internal Revenue Service challenges our characterization ofthose transactions.***

We have sold certain loansto certain of our CLO issuers, including CLO 2005-1, CLO 2005-2 and CLO 2006-1.We believe that such loans were not held by us primarily for sale to customersin the ordinary course of our trade or business, and we do not believe that theprohibited transactions tax applies to the sales of such loans. There can be nocomplete assurance, however, that the Internal Revenue Service, or IRS, willnot successfully assert a contrary position, in which case we would be subjectto the prohibited transactions tax on the gain from the sale of such loans,which would reduce our distributions to our stockholders.

***Our excessinclusion income will likely increase the tax liability of our tax-exemptshareholders, foreign shareholders, and shareholders with net operating lossesand may subject us to an entity-level tax.***

In general, dividend income that a tax-exempt entityreceives from us should not constitute unrelated business taxable income asdefined in Section 512 of the Code. If we realize excess inclusion incomeand allocate it to our shareholders, however, then this income would be fullytaxable as unrelated business taxable income to a tax-exempt entity underSection 512 of the Code. A foreign shareholder would generally be subjectto U.S. federal income tax withholding on this income without reductionpursuant to any otherwise applicable income tax treaty. U.S. shareholders wouldnot be able to offset such income with their net operating losses.

Although the law is not entirely clear, the InternalRevenue Service, or IRS, has taken the position that we are subject to tax atthe highest corporate rate on our excess inclusion income allocated to 

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“disqualifiedorganizations” (generally tax-exempt investors, such as certain state pensionplans and charitable remainder trusts, that are not subject to the tax onunrelated business taxable income) that own our stock in record name. To theextent that our stock owned by “disqualified organizations” is held in streetname by a broker/dealer or other nominee, the broker/dealer or nominee would beliable for a tax at the highest corporate rate on the portion of our excessinclusion income allocable to the stock held on behalf of the “disqualifiedorganizations.” A regulated investment company or other pass-through entityowning our stock may also be subject to tax at the highest corporate tax rateon any excess inclusion income allocated to their record name owners that are“disqualified organizations.”

Excess inclusion incomecould result if a REIT held a residual interest in a real estate mortgageinvestment conduit, or REMIC. In addition, excess inclusion income also may begenerated if we or a portion of our assets are treated as a “taxable mortgagepool” for U.S. federal income tax purposes as a result of certain financing orsecuritization activities. We have not made investments or entered intofinancing and securitization transactions, and do not currently intend to makesuch investments or enter into such transactions in the future, that could giverise to our being considered to own an interest in one or more taxable mortgagepools. We may, however, make such investments or enter into such transactionsin the future. In addition, we own a small number of residual interests inREMICs. Accordingly, we expect that a portion of our dividends will constituteexcess inclusion income, which will likely increase the tax liability oftax-exempt shareholders, foreign shareholders, shareholders with net operatinglosses, regulated investment companies and other pass-through entities whoserecord name owners are disqualified organizations, and brokers/dealers andother nominees who hold stock on behalf of disqualified organizations. Moreover,we will be subject to an entity-level tax to the extent our stock is owned inrecord name by disqualified organizations.

***Failure to qualifyas a REIT would subject us to U.S. federal income tax, which would reduce thecash available for distribution to our stockholders.***

We operate in a manner that is intended to cause us toqualify as a REIT for U.S. federal income tax purposes. The U.S. federal incometax laws governing REITs are extremely complex, however, and interpretations ofthe U.S. federal income tax laws governing qualification as a REIT are limited.Qualifying as a REIT requires us to meet various tests regarding the nature ofour assets and our income, the ownership of our outstanding stock, and theamount of our distributions on an ongoing basis. While we have operated andintend to continue to operate so that we will qualify as a REIT, given thehighly complex nature of the rules governing REITs, the ongoing importanceof factual determinations and the possibility of future changes in ourcircumstances, no assurance can be given that we will so qualify for anyparticular 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 makerequired distributions would subject us to tax, which would reduce the cashavailable for distribution to our stockholders.***

In order to qualifyas a REIT, an entity must distribute to its stockholders, each calendar year,at least 90% of its taxable income, determined without regard to the deductionfor dividends paid and excluding net capital gain. To the extent that a REITsatisfies the 90% distribution requirement, but distributes less than 100% ofits taxable income, it will be subject to federal corporate income tax on itsundistributed 

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income.In addition, a REIT will incur a 4% nondeductible excise tax on the amount, ifany, by which its distributions 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 continue to payout our REIT taxable income to our stockholders in a manner intended to satisfythe 90% distribution requirement and to avoid both corporate income tax and the4% nondeductible excise tax. There is, however, no requirement that domestictaxable REIT subsidiaries distribute their after-tax net income to their parentREIT or their stockholders, and our domestic taxable REIT subsidiary maydetermine not to make any distributions to us. 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 qualify as a REIT, no more than 50%in value of our outstanding capital stock may be owned, directly or indirectly,by five or fewer individuals during the last half of any calendar year (otherthan our first REIT taxable year). “Individuals” for this purpose includenatural persons, private foundations, some employee benefit plans and trusts,and some charitable trusts. In order to preserve our REIT status, our chartergenerally prohibits any person from directly or indirectly owning more than9.8% in value or in number of shares, whichever is more restrictive, of anyclass or series of the outstanding shares of 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 

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deductibilityof interest 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, including intercompany debt and allocationsof expenses. We can not assure you that we will be able to comply with the 20%value limitation on ownership of taxable REIT subsidiary stock and securitieson an ongoing basis so as to maintain REIT status or to avoid application ofthe 100% excise tax imposed on certain non-arm’s length transactions. TRS Inc.,as a domestic taxable REIT subsidiary, pays federal, state and local income taxon its taxable income, and its after-tax net income is available fordistribution to us, but is not required to be distributed to us.

***Our stockholders may receive lower distributionsbecause TRS Inc. will likely retain its earnings.***

As a REIT, we mustdistribute annually at least 90% of our taxable income to our stockholders,determined without regard to the deduction for dividends paid and excluding netcapital gain. The earnings of a domestic taxable REIT subsidiary are subject tothe distribution requirement only to the extent they are included in the parentREIT’s income. The earnings of TRS Inc., and any other domestic taxableREIT subsidiary will be included in our income only to the extent they makedistributions to us. There is no requirement that TRS Inc. distribute itsearnings to us. In addition, we anticipate that TRS Inc., will likely, butis not required to, retain its after-tax earnings, subject to our complying withthe rule that no more than 20% of the value of our assets may consist ofstock or securities of one or more taxable REIT subsidiaries. We are, however,required to include in income, on a current basis, the earnings of our foreigntaxable REIT subsidiaries, including our CDO and CLO issuers that have electedto be treated as taxable REIT subsidiaries for federal income tax purposes.Because we anticipate that TRS Inc. will retain its after-tax earnings,our stockholders may receive lower distributions from us.

***We may lose ourREIT status if the IRS successfully challenges our characterization of ourincome from our foreign taxable REIT subsidiaries.***

We intend to treat certainincome inclusions received with respect to our equity investments in ourforeign taxable REIT subsidiaries, including our CDO and CLO issuers that aretreated as corporations for federal income tax purposes, as qualifying incomefor purposes of the 95% gross income test but not the 75% gross income test.Because there is no clear precedent with respect to the qualification of suchincome for purposes of the REIT gross income tests, no assurance can be giventhat the IRS will not assert a contrary position. In the event that such incomewas 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 foreigntaxable REIT subsidiaries, including our CDO and CLO issuers that are treatedas corporations for federal income tax purposes, are subject to federal incometax at the entity level, it would greatly reduce the amounts those entitieswould have available to distribute to us and that we would have available topay their creditors.***

There is a specificexemption from federal income tax for non-U.S. corporations that restrict theiractivities in the United States to trading stock and securities (or anyactivity closely related thereto) for their own account whether such trading(or such other activity) is conducted by the corporation or its employeesthrough a resident broker, commission agent, custodian or other agent. Weintend that our foreign taxable REIT subsidiaries, including our CDO and CLOissuers that are treated as corporations for federal income tax purposes, willrely on that exemption or otherwise operate in a manner so that they will notbe subject to federal income tax on their net income at the entity level. Ifthe IRS were to succeed in challenging that tax treatment, it could greatlyreduce the amount that our foreign taxable REIT subsidiaries would haveavailable to distribute to us and to pay to their creditors.

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***The taxation of corporate dividends may adverselyaffect the value of our common stock.***

Legislation enacted in2003 and 2006, among other things, generally reduced to 15% the maximummarginal rate of tax payable by domestic noncorporate taxpayers on dividendsreceived from a regular C corporation for tax years 2003 through 2010.This reduced tax rate does not apply, however, to dividends paid to domesticnoncorporate taxpayers by a REIT on its stock, except for certain limitedamounts. 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 investors to view the stock of regular C corporations as moreattractive relative to the stock of a REIT than was the case prior to theenactment of the legislation, because the dividends from regular C corporationsare now generally taxed at a lower rate while dividends from REITs aregenerally taxed at the same rate as the domestic noncorporate taxpayer’sordinary income. The more favorable tax rates applicable to regular corporatedividends could cause domestic noncorporate investors to perceive investmentsin REITs to be relatively less attractive than investments in the stocks ofnon-REIT corporations that pay dividends, which could adversely affect thevalue of the stock of REITs, including our common stock.

***Complying with REIT requirements may limit our abilityto 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.

**Risks Related toProposed Conversion Transaction**

On January 17, 2007, our board of directors approved theConversion Transaction that would result in the conversion of our shares ofcommon stock into shares representing limited liability company interests inKKR Financial Holdings LLC, a recently formed Delaware limited liabilitycompany. If consummated, the Conversion Transaction would be effected pursuantto the Agreement and Plan of Merger entered into on February 9, 2007 among us,KKR Financial Holdings LLC and KKR Financial Merger Corp., a Marylandcorporation. Pursuant to the Conversion Transaction, KKR Financial Holdings LLCwould not be a REIT, but is intended to be a pass-through entity for U.S.federal income tax purposes. If the Conversion Transaction is consummated, wewould become a subsidiary of KKR Financial Holdings LLC and would intend tocontinue to operate in a manner intended to cause us to qualify as a REIT forU.S. federal income tax purposes and each of our stockholders would receive oneshare representing a limited 

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liability company interestin KKR Financial Holdings LLC in exchange for each share of common stock ownedby that stockholder.

On February 9, 2007, KKR Financial Holdings LLC filedwith the SEC a registration statement on Form S-4, including a preliminaryproxy statement/prospectus, relating to the Conversion Transaction. We expectthat the conversion transaction, which is subject to approval by our stockholders,will be completed by June 30, 2007. There can be no assurance that the ConversionTransaction will be consummated on the terms described herein or in theregistration statement or at all. In addition, our board of directors may electnot to pursue the Conversion Transaction in its sole discretion.

If the Conversion Transaction occurs, KKR FinancialHoldings LLC and its shareholders will be subject to many of the same risks towhich we and our stockholders are subject as described above. Moreover, inaddition to the risks described above, you should carefully consider theadditional risks related to the Conversion Transaction and KKR FinancialHoldings LLC, some of which are summarized below. For a more completedescription of some of those risks and other important information, you shouldreview the registration statement on Form S-4 that was filed by KKR FinancialHoldings LLC with the SEC and any amendments thereto, which may be obtainedfree of charge on the SEC’s website at www.sec.gov.

Therecan be no assurance that the Conversion Transaction will occur on the proposedterms or at all. In addition, our board of directors may elect not to pursuethe Conversion Transaction in its sole discretion. If any of the risksdescribed below were to occur, the business, financial condition, liquidity andresults of operations of KKR Financial Holdings LLC could be materially andadversely affected. These risks of the Conversion Transaction include thefollowing:

**·****      *After the Conversion Transaction KKR Financial Holdings LLC intendsover time to allocate significantly more capital to non-real estate investments,which may result in a riskier investment portfolio and increased volatility inits earnings, and as a result may adversely affect the market price of itsshares.***

**·****      *KKR Financial Holdings LLC will not be able to immediately reallocateits capital, which may adversely affect the market price of its shares.***

**·****      *Under the proposed limited liability company structure of the ConversionTransaction, the Manager may receive an increased incentive fee since it willbe allocating more capital to investments with a higher return on equity, whichinvestments may be riskier and more volatile than other investments.***

**·****      *The Conversion Transaction may not be completed, which may harm themarket price of KKR Financial Corp.’s common stock.***

**·****      *Because KKR Financial Holdings LLC, the limited liability company intowhich we intend to convert, is not taxed as a REIT, it will not be subject tothe same distribution requirements to which we are subject and therefore maydistribute a lower percentage of its taxable income to the holders of itsshares.***

**·****      *Following completion of the Conversion Transaction, KKR FinancialHoldings LLC may be able to engage in more transactions with companies that arecontrolled by or affiliated with KKR, which may result in or create theappearance of conflicts of interest.***

**·****      *The current market price of our common stock may not be indicative ofthe market price of shares of KKR Financial Holdings LLC following the ConversionTransaction.***

**·****      *Substantial sales of shares of KKR Financial Holdings LLC could occurin connection with the Conversion Transaction, which could cause its shareprice to decline.***

**·****      *Certain of KKR Financial LLC’s directors, officers and the Manager haveinterests in the proposed merger that will be part of the Conversion Transactionthat are different from, and in addition to, the interests of other KKRFinancial Corp. stockholders.***

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**·****      *Certain provisions of the limited liability company agreement of KKRFinancial Holdings LLC will make it difficult for third parties to acquirecontrol of KKR Financial Holdings LLC and could deprive its shareholders of theopportunity to obtain a takeover premium for their shares.***

**·****      *Future sales of KKR Financial Holdings LLC’s shares may affect themarket price of its shares***

**·****      *KKR Financial Holdings LLC may issue additional debt and equitysecurities which are senior to its shares as to distributions and inliquidation, which could materially adversely affect the market price of itshares.***

**·****      *KKR Financial Holdings LLC’s earnings and cash distributions may affectthe market price of its shares.***

**·****      *The market price, trading volume and marketability of KKR FinancialHoldings LLC’s shares may, from time to time, be significantly affected bynumerous factors beyond its control, which may adversely affect the marketprice of its shares and its ability to raise capital through future equityfinancings.***

**·****      *Broad market fluctuations could negatively impact the market price ofshares.***

**·****      *An increase in market interest rates may have an adverse effect on themarket price of shares.***

**·****      *The board of directors of KKR Financial Holdings LLC will have theauthority to change many of the terms of the shares of KKR Financial HoldingsLLC in ways with which its shareholders may disagree without approval ofholders of its shares.***

**·****      *While KKR Financial Holdings LLC intends to make regular cashdistributions to holders of shares of KKR Financial Holdings LLC, the board ofdirectors of KKR Financial Holdings LLC will have full authority and discretionover the distributions and it may decide to reduce or eliminate distributionsat any time, which may adversely affect the market price for its shares.***

**·****      *Maintenance of KKR Financial Holdings LLC’s Investment Company Actexemption imposes limits on its operations, which may adversely affect itsresults of operations.***

**·****      *If KKR Financial Holdings LLC fails to satisfy the ‘‘qualifying incomeexception,’’ all of its income will be subject to an entity-level tax, whichcould result in a material reduction in cash flow and after-tax return forholders of its shares and thus could result in a substantial reduction in thevalue of those shares.***

**·****      *Complying with certain tax-related requirements may cause KKR FinancialHoldings LLC and KKR Financial Corp. to forego otherwise attractive business orinvestment opportunities.***

**·****      *The REIT tax rules may limit KKR Financial Holdings LLC’s ability toliquidate mortgage assets and/or transfer non-mortgage assets from KKRFinancial Corp. to KKR Financial Holdings LLC.***

**·****      *KKR Financial Holdings LLC could incur a significant tax liability ifthe IRS successfully asserts that the ‘‘anti-stapling’’ rules apply to KKRFinancial Holdings LLC’s investments in KKR Financial Corp. and certain of itsforeign CDO and CLO issuers, which could result in a reduction in cash flow andafter-tax return for holders of shares and thus could result in a reduction ofthe value of those shares.***

**·****      *The merger that is part of the conversion transaction may berecharacterized as a taxable exchange.***

**·****      *Shareholders of KKR Financial LLC will be subject to U.S. federalincome tax on their share of KKR Financial Holdings LLC’s taxable income,regardless of whether or when they receive any cash distributions from KKRFinancial Holdings LLC.***

**·****      *The ability of shareholders of KKR Financial Holdings LLC to deductcertain expenses of KKR Financial Holdings LLC may be limited.***

**·****      *Shareholders of KKR Financial Holdings LLC may recognize a greatertaxable gain (or a smaller tax loss) on a disposition of shares of KKRFinancial Holdings LLC than expected because of the treatment of debt under thepartnership tax accounting rules.***

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**·****      *Tax-exempt holders of shares of KKR Financial Holdings LLC will likelyrecognize significant amounts of ‘‘unrelated business taxable income.’’***

**·****      *There can be no assurance that the IRS will not assert successfullythat some portion of KKR Financial Holdings LLC’s income is properly treated aseffectively connected income with respect to non-U.S. holders.***

**·****      *Dividends paid by, or certain income inclusions derived with respect toKKR Financial Holdings LLC’s ownership of, foreign corporate subsidiaries andKKR Financial Corp. will not qualify for the reduced tax rates generallyapplicable to corporate dividends paid to taxpayers taxed at individual rates.***

**·****      *Although KKR Financial Holdings LLC anticipates that its foreigncorporate subsidiaries will not be subject to U.S. federal income tax on a netbasis, no assurance can be given that such subsidiaries will not be subject toU.S. federal income tax on a net basis in any given taxable year.***

**·****      *KKR Financial Holdings LLC’s structure involves complex provisions ofU.S. federal income tax law for which no clear precedent or authority may beavailable, and which is subject to potential change, possibly on a retroactivebasis. Any such change could result in adverse consequences to the holders ofshares of KKR Financial Holdings LLC.***

**·****      *Ownership limitations in KKR Financial Holdings LLC’s limited liabilitycompany agreement that apply so long as KKR Financial Holdings LLC owns aninterest in a REIT, such as KKR Financial Corp., may restrict a change ofcontrol in which shareholders of KKR Financial Holdings LLC might receive apremium for their shares.***

**·****      *The failure of KKR Financial Corp. to qualify as a REIT would generallycause it to be subject to U.S. federal income tax on its taxable income, whichcould result in a material reduction in cash flow and after-tax return forholders of shares of KKR Financial Holdings LLC and thus could result in areduction of the value of those shares.***

**·****      *The IRS Schedule K-1 provided by KKR Financial Holdings LLC will besignificantly more complicated than the IRS Forms 1099 provided in prior yearsby KKR Financial Corp. and shareholders of KKR Financial LLC may be required torequest an extension of the time to file their tax returns.***

**Item1B.**               UNRESOLVED STAFFCOMMENTS

None.

**Item2.**                        PROPERTIES

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

**Item3.**                        LEGALPROCEEDINGS

At December 31, 2006,there were no material pending legal proceedings to which we were a party or towhich any of our property was subject.

**Item4.**                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submittedto a vote of our stockholders during the fourth quarter of 2006.

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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 New York Stock Exchange (“NYSE”) under the symbol“KFN.”  On February 20, 2007, theclosing price of our common stock, as reported on the NYSE, was $29.94. Thefollowing table sets forth the high and low sale prices for our common stockfor the period indicated 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 |   |
| March 31,  2006                |       | 24.25                |       | 22.10 |   |
| June 30,  2006                 |       | 23.50                |       | 20.51 |   |
| September 30,  2006            |       | 25.24                |       | 20.96 |   |
| December 31, 2006              |       | 27.43                |       | 24.02 |   |
|                                     |            |                      |            |  |  |  |  |

 

As of February 20,2007, we had 80,464,713 issued and outstanding shares of common stock that wereheld by 21 holders of record. The 21 holders of record include Cede &Co., which holds shares as nominee for The Depository Trust Company, whichitself holds shares on behalf of the beneficial owners of our common stock.

**Distributions**

We generally need to distribute at least 90% of ourtaxable income each year (subject to certain adjustments) so that we canqualify as a real estate investment trust (“REIT”) under the Internal RevenueCode of 1986, as amended. Up to 20% of the value of a REIT’s assets may consistof investments 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, our foreign taxable REITsubsidiaries generally are deemed to distribute their earnings to the REIT onan annual basis for federal income tax purposes, and their earnings are subjectto the 90% distribution requirement, regardless of whether they actuallydistribute their earnings.

Our credit facility contains provisions that limitand, upon the occurrence of certain defaults, prohibit distributions to ourstockholders.  For example, the creditfacility limits the amount of distributions we make to 100% of our taxableincome (which, as defined, is expected to exceed our calculation of taxableincome for REIT compliance purposes, as it is computed without giving effect tonet operating loss carryforwards and non-recurring items, including, but notlimited to, stock-based compensation expense and bad debt write-offs).  See Item 1A “Risk Factors—Risks Related toOur Organization and Structure—The terms of our indebtedness may restrict ourability to make future distributions and impose limitations on our current andfuture operations” appearing above in this Annual Report on Form 10-K.  As a result, these limitations, andlimitations imposed by any future financing agreements, may adversely affect ourability to make future distributions to our stockholders or may reduce the amountof such distributions, which may prevent us from qualifying as a REIT forfederal income tax purposes.  Noassurance can be given as to our ability to make distributions to ourstockholders.

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Subject to the distributionrequirements referred to above, we intend, to the extent practicable, to investsubstantially all of the proceeds from repayments, sales and refinancings ofour assets in real estate-related assets and other assets. We may, however,under certain circumstances, make a distribution of capital or of assets. Suchdistributions, if any, will be made at the discretion of our board ofdirectors. Distributions will be made in cash to the extent that cash isavailable 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 and 2006 fiscalyears:

| ** **             | **Record Date** | ** **              | ** ** | ** ** | **Payment  Date** | ** ** | ** ** | ** ** | **Cash Distribution  Declared per Common 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      |
| May 17, 2006      |                 | May 31,  2006      |       | $0.45      |
| August 16, 2006   |                 | August 30,  2006   |       | $0.49      |
| November 16, 2006 |                 | November 30,  2006 |       | $0.52      |
| February 15, 2007 |                 | February 28,  2007 |       | $0.54      |

 

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**Total ReturnComparison**

Thefollowing graph presents a total return comparison from a $100 investment inour common stock on June 24, 2005 (the date our common stock was listed on theNYSE) to the Bloomberg Mortgage REIT Index and the S&P 500 FinancialsIndex.  We obtained this information fromsources that we believe to be reliable, but we do not guarantee its accuracy orcompleteness.  The graph assumes that thevalue of the investment in our common stock and each index was $100 on June 24,2005, and that all dividends were reinvested. The total return performance shown on the graph is not necessarilyindicative of future total return performance.

**Total ReturnComparison from June 24, 2005 through December 31, 2006**

**Share PricePerformance Graph**

| ** **              | ** ** | **6/24/2005** | ** ** | **12/31/2005** | ** ** | **12/31/2006** | ** ** |
|-------------------------|------------|---------------|------------|----------------|------------|----------------|------------|
| KKR Financial  Corp.    |       |          | 100        |           |       |           | 101        |   |   |   | 122 |   |   |
| S&P 500 Index       |       |          | 100        |           |       |           | 106        |   |   |   | 122 |   |   |
| BBG REIT Mortgage Index |       |          | 100        |           |       |           | 85         |   |   |   | 102 |   |   |

 

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**Item 6.**                        SELECTEDCONSOLIDATED FINANCIAL DATA

The following selectedfinancial data is derived from our audited consolidated financial statements asof December 31, 2006 and 2005 and for the years ended December 31,2006 and 2005 and for the period from August 12, 2004 (inception) through December 31,2004. You should read the selected financial data together with the moredetailed information contained in the consolidated financial statements andassociated notes and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included elsewhere in this Annual Reporton Form 10-K.

| ** **                                                                                           | ** ** | **Year Ended  December 31, 2006**                   | ** ** | **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                                                                             |       |                                                               | $          | 950,037                                          |       |                                                                                                       |       | $ | 399,929 |   |   |   | $ | 8,122 |   |   |
| Interest expense                                                                                     |       |                                                               | (741,680   | )                                                |       |                                                                                                       | (279,718   | ) |   |   | (975 | ) |   |
| Provision for  loan losses                                                                           |       |                                                               | —     |                                             |       |                                                                                                       | (1,500     | ) |   |   | — |   |   |
| Net investment income                                                                                |       |                                                               | 208,357    |                                             |       |                                                                                                       | 118,711    |   |   |   | 7,147 |   |   |
| **Other  income (loss):**                                                                            | ** ** |                                                               | ** ** | ** **                                       |       |                                                                                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Total other income (loss)                                                                            |       |                                                               | 20,755     |                                             |       |                                                                                                       | 7,560      |   |   |   | (488 | ) |   |
| **Non-investment  expenses:**                                                                        | ** ** |                                                               | ** ** | ** **                                       |       |                                                                                                       | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Related party  management compensation                                                               |       |                                                               | 65,298     |                                             |       |                                                                                                       | 50,791     |   |   |   | 11,222 |   |   |
| Professional  services                                                                               |       |                                                               | 4,904      |                                             |       |                                                                                                       | 4,121      |   |   |   | 901 |   |   |
| Loan servicing  expense                                                                              |       |                                                               | 14,750     |                                             |       |                                                                                                       | 5,143      |   |   |   | — |   |   |
| Insurance  expenses                                                                                  |       |                                                               | 909        |                                             |       |                                                                                                       | 975        |   |   |   | 335 |   |   |
| Directors  expenses                                                                                  |       |                                                               | 1,486      |                                             |       |                                                                                                       | 1,071      |   |   |   | 341 |   |   |
| Other general and  administrative expenses                                                           |       |                                                               | 11,191     |                                             |       |                                                                                                       | 5,945      |   |   |   | 797 |   |   |
| Total non-investment expenses                                                                        |       |                                                               | 98,538     |                                             |       |                                                                                                       | 68,046     |   |   |   | 13,596 |   |   |
| Income (loss)  before equity in income of unconsolidated affiliate and income tax expense  (benefit) | ** ** |                                                               | 130,574    |                                             |       |                                                                                                       | 58,225     |   |   |   | (6,937 | ) |   |
| Equity in income  of unconsolidated affiliate                                                        | ** ** |                                                               | 5,722      |                                             |       |                                                                                                       | —     |   |   |   | — |   |   |
| Net income (loss)  before income tax expense (benefit)                                               | ** ** |                                                               | 136,296    |                                             |       |                                                                                                       | 58,225     |   |   |   | (6,937 | ) |   |
| Income tax  expense (benefit)                                                                        | ** ** |                                                               | 964        |                                             |       |                                                                                                       | 3,144      |   |   |   | (228 | ) |   |
| Net income (loss)                                                                                    | ** ** |                                                               | $          | 135,332                                          |       |                                                                                                       |       | $ | 55,081 |   |   |   | $ | (6,709 | ) |   |
| **Net  income (loss) per common share:**                                                             | ** ** |                                                               |       |                                             |       |                                                                                                       |       | ** ** |   |   | ** ** | ** ** |   |
| Basic                                                                                                | ** ** |                                                               | $          | 1.73                                             |       |                                                                                                       |       | $ | 0.93 |   |   |   | $ | (0.17 | ) |   |
| Diluted                                                                                              | ** ** |                                                               | $          | 1.71                                             |       |                                                                                                       |       | $ | 0.92 |   |   |   | $ | (0.17 | ) |   |
| Weighted-average  number of common shares outstanding:                                          | ** ** |                                                               |       |                                             |       |                                                                                                       |       |   |   |   |   |   |   |
| Basic                                                                                                | ** ** |                                                               | 78,166     |                                             |       |                                                                                                       | 58,998     |   |   |   | 39,796 |   |   |
| Diluted                                                                                              | ** ** |                                                               | 78,948     |                                             |       |                                                                                                       | 60,087     |   |   |   | 39,796 |   |   |
| Distributions declared  per common share                                                             | ** ** |                                                               | $          | 1.86                                             |       |                                                                                                       |       | $ | 0.97 |   |   |   | $ | — |   |   |

 

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| ** **                                                                                                                           | ** ** | **As of December 31, 2006**                    | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Balance Sheet  Data:**                                                                                                | ** ** |                                                               | ** ** | ** **                                      |       |   | ** ** | ** ** |   |
| Cash and cash  equivalents                                                                                                           |       |                                                               | $          | 5,125                                           | ** ** |   |   | $ | 16,110 | ** ** |   |
| Restricted cash  and cash equivalents                                                                                                |       |                                                               | 138,065    | ** **                                      |       |   | 80,223 | ** ** |   |
| Securities  available-for-sale, $8,336,435 and $5,910,399 pledged as collateral as of  December 31, 2006 and 2005, respectively |       |                                                               | 8,500,636  | ** **                                      |       |   | 6,149,506 | ** ** |   |
| Loans, net of  allowance for loan losses of $1,500 as of December 31, 2006 and 2005                                             |       |                                                               | 8,442,021  | ** **                                      |       |   | 8,846,341 | ** ** |   |
| Total assets                                                                                                                         |       |                                                               | 17,565,177 | ** **                                      |       |   | 15,290,540 | ** ** |   |
| Total borrowings                                                                                                                     |       |                                                               | 15,749,301 | ** **                                      |       |   | 13,363,838 | ** ** |   |
| Total liabilities                                                                                                                    |       |                                                               | 15,841,746 | ** **                                      |       |   | 13,635,394 | ** ** |   |
| Total  stockholders’ equity                                                                                                     |       |                                                               | 1,723,431  | ** **                                      |       |   | 1,655,146 | ** ** |   |
| Book value per common  share                                                                                                         |       |                                                               | $          | 21.42                                           | ** ** |   |   | $ | 20.59 | ** ** |   |

 

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

*Except where otherwise expressly stated or the contextsuggests 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 with objective of generatingcompetitive risk-adjusted returns subject to maintaining our status as a realestate investment trust (“REIT”) under the Internal Revenue Code of 1986, asamended (the “Code”), and our exemption from regulation under the InvestmentCompany Act of 1940, as amended (the “Investment Company Act”). Our objectiveis to provide competitive returns to our investors through a combination of distributionsand capital appreciation. As part of our multi-asset class strategy, weseek to invest opportunistically in those asset classes that can generatecompetitive leveraged risk-adjusted returns. Investing in multiple assetclasses does not, however, reduce or eliminate many of the risks associatedwith our investment portfolio such as geographic concentration risk, assetclass concentration risk, market risk and credit risk. We currently makeinvestments in the following asset classes: (i) residential mortgage loansand mortgage-backed securities; (ii) corporate loans and debtsecurities; (iii) commercial real estate loans and debt securities; (iv) asset-backedsecurities; and (v) marketable and non-marketable equity securities. Wealso make opportunistic investments in other asset classes from time to time.Our investment 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 on its derivatives that are not accounted foras hedges, (ii) realized gains 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. We are taxed as a REIT and are required tocomply with the provisions of the Code with respect thereto.

We completed our initial private placement of sharesof our common stock on August 12, 2004 and our initial public offering ofour common stock on June 29, 2005. Our stock is listed on the New YorkStock Exchange under the symbol “KFN” and began trading on June 24, 2005.On June 23, 2005 we effected a reverse stock split of our common stock ata ratio 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.

Our board of directors hasapproved a restructuring transaction (the “Conversion Transaction”) whereby KKRFinancial Corp., currently a publicly traded Maryland corporation, would becomea subsidiary of a recently formed Delaware limited liability company that wouldbe publicly traded. The Delaware limited liability company, named KKR FinancialHoldings LLC, will not be taxed as a REIT, but is intended to be a pass-throughentity for U.S. federal income tax purposes. The Conversion Transaction wouldresult in each share of currently issued and outstanding KKR Financial Corp. commonstock being converted into an equal number of limited liability company sharesin KKR Financial Holdings LLC. The Conversion Transaction is subject toshareholder approval and if approved, we expect that it will be completed by June 30,2007.

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***Cash Distributions to Stockholders***

During 2006, we paidaggregate cash distributions totaling $149.6 million and declared aggregatedistributions totaling $160.9 million, including a distribution for the fourthquarter that was declared on February 1, 2007.

***Investment Portfolio***

As of December 31,2006, our investment portfolio totaled $17.1 billion, representing an increaseof 14% from $15.0 billion as of December 31, 2005. As of December 31,2006, our investment portfolio primarily consisted of residential mortgageloans and securities totaling $12.6 billion, corporate loans and securitiestotaling $4.1 billion, commercial real estate loans and securities totaling $140.7million, and marketable equity securities consisting of preferred and commonstock totaling $69.0 million. In addition, our investment portfolio includedinvestments in non-marketable equity securities totaling $166.3 million as of December 31,2006.

***Funding Activities***

We have expanded our sourcesof funding during 2006. During 2006, our securitization transactions consistedof closing our third $1.0 billion collateralized loan obligation transactionthrough which we issued $727.5 million of senior secured notes at par toinvestors and closing our second $5.0 billion commercial paper conduitfacility. Additionally, we entered into a three year $800.0 million seniorsecured revolving credit facility that replaced our $275.0 million 364-daycredit facility. We also issued approximately $250.0 million of trustpreferred securities through five separate trusts formed during the year.

**Critical AccountingPolicies**

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 auditcommittee.

***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 that are nothighly rated (i.e., subordinate tranches of residential mortgage-backedsecurities), unamortized premiums and discounts are recognized over the contractuallife, adjusted for estimated prepayments and estimated credit losses of thesecurities using the effective interest method. Actual prepayment and creditloss experience is reviewed quarterly and effective yields are recalculatedwhen differences arise between prepayments and credit losses originallyanticipated compared to amounts actually received plus anticipated futureprepayments.

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 for actual prepayments, of the loans using theeffective interest method. For residential mortgage loans, 

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unamortized premiums anddiscounts are recognized over the contractual life, adjusted for estimatedprepayments using the effective interest method.

As of December 31,2006, unamortized purchase premiums and unaccreted purchase discounts on ourinvestment portfolio totaled $27.9 million and $45.2 million,respectively.

***Share-Based Compensation***

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 record compensation costs for restricted common stockand common stock options that we issued to our Manager at estimated fair valueas of the grant date and we remeasure the amount on subsequent reporting datesto the extent that the restricted common stock and/or common stock options havenot vested. Unvested restricted common stock is valued using observablesecondary market prices. Unvested common stock options are valued using theBlack-Scholes model and assumptions based on observable market data forcomparable 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, 2006, share-based compensation totaled $29.2million. As of December 31, 2006, 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, 2006,a $1 increase in the price of our common stock would have increased our futureshare-based compensation expense by approximately $1.6 million and this futureshare-based compensation expense would be recognized over the remaining vestingperiods of our outstanding restricted common stock and common stock options. Asof December 31, 2006, future unamortized share-based compensation totaled$16.7 million, of which $13.4 million, $3.2 million, and $0.1 millionwill be recognized in 2007, 2008, and 2009, respectively.

***Classifications of Investment Securities***

Our investments in securitiesare classified as “available-for-sale” and are recorded and reported on ourconsolidated balance sheet at estimated fair value with unrealized gains andlosses 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***

We recognize all derivatives on our consolidatedbalance sheet at estimated fair value. On the date we enter into a derivativecontract, we designate and document each derivative contract as one of thefollowing at the time the contract is executed: (i) a hedge of arecognized asset or liability (“fair value” hedge); (ii) a hedge of aforecasted transaction or of the variability of cash flows to be received orpaid related to a recognized asset or liability (“cash flow” hedge);(iii) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, we record changes in the estimated fair valueof the derivative and, to the extent that it is effective, changes in the fairvalue of the hedged asset or liability attributable to the hedged risk, in thecurrent period earnings in the same financial statement category as the hedgeditem. For a cash flow hedge, we record changes in the estimated fair value ofthe derivative to the extent that it is effective in other comprehensiveincome. We subsequently reclassify these changes in estimated fair value to netincome in the same period(s) that the hedged transaction affects earningsin the same financial statement category as the hedged item. For free-standingderivatives, we report changes in the fair values in current period noninterestincome.

We formally document at inception our hedge relationships,including identification of the hedging instruments and the hedged items, ourrisk management objectives, strategy for undertaking the hedge transaction andour evaluation of effectiveness of its hedged transactions. Periodically, asrequired by SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, as amended andinterpreted (“SFAS No. 133”) , we also formally assesses whether thederivative it designated in each hedging relationship is expected to be and hasbeen highly effective in offsetting changes in estimated fair values or cashflows of the hedged item using either the dollar offset or the regressionanalysis method. If we determine that a derivative is not highly effective as ahedge, we discontinue hedge accounting.

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 the changesin the estimated fair values of our derivative contracts would affect periodicearnings immediately potentially resulting in the increased volatility of ourearnings. The qualification requirements for hedge accounting are complex andas a result we must evaluate, designate, and thoroughly document each hedgetransaction at inception and perform ineffectiveness analysis and preparerelated documentation at inception and on a recurring basis thereafter. During2005, we purchased an interest rate corridor with a maturity date ofJanuary 25, 2009 for a cost of $10.0 million. The purchase price of thecorridor is being amortized over the life of the corridor and will result in anincrease in interest expense of $3.7 million, $4.1 million and $0.3 million in2007, 2008, and 2009, respectively, exclusive of any payments we receive inconnection with corridor. As of December 31, 2006, the estimated fairvalue of our derivatives totaled $60.7 million.

***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, 2006, we had aggregate unrealized losseson our securities classified as available-for-sale of 

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approximately$42.6 million, which if not recovered may result in the recognition offuture losses. As of December 31, 2006, $37.7 million of the aggregateunrealized losses were associated with investments rated Aaa by Moody’sInvestor Services, or Moody’s, and AAA by Standard and Poor’s Ratings Service,or Standard & Poor’s. As of December 31, 2006, no impairments weredetermined to be other-than-temporary.

***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. Loans are generallyevaluated for impairment individually, but loans purchased on a pooled basiswith relatively smaller balances and substantially similar characteristics maybe evaluated collectively for impairment. Our allowance for loan lossesconsists of an allocated component and an unallocated component. The allocatedcomponent of our allowance for loan losses reflects our estimate of losses onindividual loans and our unallocated component reflects our estimate of losseson pools or groups of similar loans.

Our investments in commercial real estate mortgageloans and corporate loans are not homogeneous and we individually review eachof the loans for impairment and use relevant information in our analysis,including current estimated fair values, current valuation multiples, estimatedfair values and quality of collateral, projected operating cash flow andprojected liquidation cash flows. We consider a loan to be impaired when, basedon current information and events, we believe it is probable that we will beunable to collect all amounts due to us based on the contractual terms of theloan. When a loan is impaired, the allowance for loan losses is increased bythe amount of the excess of the amortized cost basis of the loan over itsestimated fair value. Increases in the allowance for loan losses are recognizedin our results of operations as a provision for loan losses. When we make adetermination that some or all of a loan is uncollectible, we charge-off orwrite-down the loan and the allowance for loan losses is reduced. As ofDecember 31, 2006 we have not recorded an allowance for loan losses forour commercial real estate and corporate loans and no losses have been realizedon these loan portfolios since inception.

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, estimated fair values and quality of collateral, delinquencytrends and credit losses realized to-date on underlying loans. Two criticalassumptions used in estimating the loan loss reserves for the residentialmortgage loan portfolio are an assumed rate of default, which is the expectedrate at which loans go into foreclosure over their life, and an assumed rate ofloss severity, which represents the expected rate of realized loss upondisposition of the properties that have gone into foreclosure.

As of December 31, 2006, our allowance for loanlosses totaled $1.5 million which we have determined as being adequate forestimated losses inherent in our loan investments as of that date.

**Recent AccountingPronouncements**

In February 2006, the Financial AccountingStandards Board, or FASB, issued SFAS No. 155, *Accountingfor Certain Hybrid Financial Instruments* (“SFAS No. 155”). Keyprovisions of SFAS No. 155 include: (1) a broad fair valuemeasurement option for certain hybrid financial instruments that contain anembedded derivative that would otherwise require bifurcation; (2) clarificationthat only the simplest separations of interest payments and principal paymentsqualify for the exception afforded to interest-only strips and principal-onlystrips from derivative accounting under paragraph 14 of SFAS No. 133*,**Accounting for DerivativeInstruments and Hedging Activities,* thereby narrowing suchexception; (3) a 

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requirement thatbeneficial interests in securitized financial assets be analyzed to determinewhether they are freestanding derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation; (4) clarificationthat concentrations of credit risk in the form of subordination are notembedded derivatives; and (5) elimination of the prohibition on a qualifyingspecial purpose entity, or QSPE, holding passive derivative financialinstruments that pertain to beneficial interests that are or contain aderivative financial instrument. In general, these changes will reduce theoperational complexity associated with bifurcating embedded derivatives, andincrease the number of beneficial interests in securitization transactions, includinginterest-only strips and principal-only strips, required to be accounted for inaccordance with SFAS No. 133. SFAS No. 155 is required to be adoptedby us in the first quarter of 2007. We do not expect that the adoption of SFAS No. 155will have a material effect on our consolidated financial statements.

In June 2006, FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109* (“FIN 48”). FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement No. 109,*Accounting for Income Taxes*. FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. We are required to adopt FIN 48 in the first quarter of2007. We do not expect that the adoption of FIN 48 will have a material effecton our consolidated financial statements.

In September 2006, FASB issued SFAS No. 157,*Fair Value Measurements* (“SFASNo. 157”). This statement defines fair value, establishes a framework formeasuring fair value in GAAP and expands disclosures about fair valuemeasurements. SFAS No. 157 does not require any new fair valuemeasurements. We are required to adopt SFAS No. 157 in the first quarterof 2008 and we do not expect the adoption of SFAS No. 157 to have amaterial impact on our consolidated financial statements.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB No. 108”). SAB No. 108 requiresa dual evaluation approach—evaluation of an error from both a balance sheetperspective and results of operations perspective—when quantifying andevaluating the materiality of a misstatement. The guidance in SAB No. 108must be applied to annual financial statements for fiscal years ending after November 15,2006. We do not expect the adoption of SAB No. 108 to have a materialimpact on our consolidated financial statements.

In February 2007, FASBissued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*—*Including anamendment of FASB Statement No. 115* (“SFAS No. 159”). Thisstatement permits entities to choose to measure many financial instruments andcertain other items at fair value. We are required to adopt SFAS No. 159in the first quarter of 2008 and are currently evaluating the impact that SFASNo. 159 will have on our consolidated financial statements.

**Results ofOperations**

**Year ended December 31,2006 compared to year ended December 31, 2005**

*Summary*

Our net income for theyear ended December 31, 2006 totaled $135.3 million (or $1.71 per dilutedshare) as compared to a net income of $55.1 million (or $0.92 per dilutedshare) for the year ended December 31, 2005. During the year ended December 31,2006, our investment portfolio increased by 14% from $15.0 billion as of December 31,2005 to $17.1 billion as of December 31, 2006.

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*Net InvestmentIncome*

The following tablepresents the components of our net investment income for the years ended December 31,2006 and 2005:

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

| ** **                                                            | ** ** | **For the year ended  December 31, 2006** | ** ** | **For the year ended  December 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| Investment Income:                                                    |       |                                                               |       |                                                               |       |   |   |   |   |
| Residential mortgage loans and securities interest  income            |       |                                                               | $          | 636,711                                                            |       |   |   | $ | 281,985 |   |   |
| Corporate loans and securities interest income                        |       |                                                               | 274,637    |                                                               |       |   | 95,852 |   |   |
| Commercial real estate loans and securities interest  income          |       |                                                               | 26,337     |                                                               |       |   | 19,284 |   |   |
| Other interest income                                                 |       |                                                               | 8,387      |                                                               |       |   | 3,335 |   |   |
| Common and preferred stock dividend income                            |       |                                                               | 3,656      |                                                               |       |   | 3,421 |   |   |
| Net premium/discount (amortization) accretion                         |       |                                                               | 309        |                                                               |       |   | (3,948 | ) |   |
| Total investment income                                               |       |                                                               | 950,037    |                                                               |       |   | 399,929 |   |   |
| Interest Expense:                                                     |       |                                                               |       |                                                               |       |   |   |   |   |
| Repurchase agreements interest expense                                |       |                                                               | 348,551    |                                                               |       |   | 237,985 |   |   |
| Collateralized loan obligation senior secured notes  interest expense |       |                                                               | 95,128     |                                                               |       |   | 28,269 |   |   |
| Asset-backed secured liquidity notes interest  expense                |       |                                                               | 312,462    |                                                               |       |   | 8,065 |   |   |
| Secured revolving credit facility interest expense                    |       |                                                               | 8,395      |                                                               |       |   | 245 |   |   |
| Demand loan interest expense                                          |       |                                                               | 2,307      |                                                               |       |   | 1,430 |   |   |
| Junior subordinated notes interest expense                            |       |                                                               | 9,459      |                                                               |       |   | — |   |   |
| Other interest expense                                                |       |                                                               | 3,601      |                                                               |       |   | 803 |   |   |
| Interest rate swaps interest (income) expense, net                    |       |                                                               | (38,223    | )                                                                  |       |   | 2,921 |   |   |
| Total interest expense                                                |       |                                                               | (741,680   | )                                                                  |       |   | (279,718 | ) |   |
| Provision for loan losses                                             |       |                                                               | —     |                                                               |       |   | (1,500 | ) |   |
| Net investment income                                                 |       |                                                               | $          | 208,357                                                            |       |   |   | $ | 118,711 |   |   |

 

As presented in the tableabove, our net investment income increased by $89.6 million in 2006 compared to2005. The change from 2005 to 2006 is primarily attributable to the increase inour investment portfolio during 2006. As of December 31, 2006, we held$16.9 billion in investments in loans and securities available-for-saleand had borrowings outstanding totaling $15.7 billion. In comparison, as of December 31,2005 investments in loans and securities available-for-sale totaled $15.0billion and borrowings outstanding totaled $13.4 billion.

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*Other Income*

The following tablepresents the components of other income for the years ended December 31,2006 and 2005:

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

| ** **                                                              | ** ** | **For the year ended  December 31, 2006** | ** ** | **For the year ended  December 31, 2005** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| Net realized and  unrealized gain on derivatives and foreign exchange:  |       |                                                               |       |                                                               |       |   |   |   |   |
| Interest rate swaptions                                                 |       |                                                               | $          | (92                                                                | )          |   |   | $ | (424 | ) |   |
| Interest rate swaps                                                     |       |                                                               | (58        | )                                                                  |       |   | 758 |   |   |
| Credit default swaps                                                    |       |                                                               | (896       | )                                                                  |       |   | (259 | ) |   |
| Total rate of return swaps                                              |       |                                                               | 4,237      |                                                               |       |   | 755 |   |   |
| Foreign exchange contracts                                              |       |                                                               | —     |                                                               |       |   | 2,211 |   |   |
| Foreign exchange translation                                            |       |                                                               | 1,257      |                                                               |       |   | (2,928 | ) |   |
| Total realized and unrealized gain on derivatives  and foreign exchange |       |                                                               | 4,448      |                                                               |       |   | 113 |   |   |
| Net realized gain  on investments                                       |       |                                                               | 10,585     |                                                               |       |   | 4,117 |   |   |
| Fee and other  income                                                   |       |                                                               | 5,722      |                                                               |       |   | 3,330 |   |   |
| Total other income                                                      |       |                                                               | $          | 20,755                                                             |       |   |   | $ | 7,560 |   |   |

 

As presented in the table above, other income totaled$20.8 million for the year ended December 31, 2006 as compared to$7.6 million for the year ended December 31, 2005. This increase in totalother income from the prior year is primarily attributable to increasedinvestment activity during 2006, including the use of total rate of returnswaps and gains from the sales of certain investments, including the sale of asignificant portion of our commercial real estate portfolio during 2006.

We use total rate of return swaps to finance certaininvestments whereby we receive the sum of all interest, fees and any positiveeconomic change in market value amounts from a reference asset with a specifiednotional amount and pay interest on such notional plus any negative change in marketvalue amounts from such asset. These agreements are recorded as derivatives andclassified by us as free-standing derivatives whereby any changes in the fairvalue to the agreements is recorded in other income. As of December 31,2006, we had seven total rate of return contracts with an aggregate notionalamount of $222.6 million as compared to December 31, 2005 where we had twototal rate of return contracts with an aggregate notional amount of $131.7million.

During 2006 we sold asubstantial majority of our commercial real estate portfolio, consisting of $209.5million in loans for a gain of $2.2 million.

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*Non-InvestmentExpenses*

The following tablepresents the components of non-investment expenses for the years endedDecember 31, 2006 and 2005:

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

| ** **                              | ** ** | **For the year ended  December 31, 2006** | ** ** | **For the year ended  December 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| Related party  management compensation: |       |                                                               |       |                                                               |       |   |   |   |   |
| Base management fees                    |       |                                                               | $          | 28,835                                                             |       |   |   | $ | 20,982 |   |   |
| Incentive fees                          |       |                                                               | 7,844      |                                                               |       |   | — |   |   |
| Share-based compensation                |       |                                                               | 28,619     |                                                               |       |   | 29,809 |   |   |
| Related party management compensation   |       |                                                               | 65,298     |                                                               |       |   | 50,791 |   |   |
| Professional  services                  |       |                                                               | 4,904      |                                                               |       |   | 4,121 |   |   |
| Loan servicing  expense                 |       |                                                               | 14,750     |                                                               |       |   | 5,143 |   |   |
| Insurance expense                       |       |                                                               | 909        |                                                               |       |   | 975 |   |   |
| Directors  expenses                     |       |                                                               | 1,486      |                                                               |       |   | 1,071 |   |   |
| General and administrative  expenses    |       |                                                               | 11,191     |                                                               |       |   | 5,945 |   |   |
| Total non-investment  expenses          |       |                                                               | $          | 98,538                                                             |       |   |   | $ | 68,046 |   |   |

 

As presented in the tableabove, our non-investment expenses increased by $30.5 million for the yearended December 31, 2006 compared to the year ended December 31, 2005.The increase in non-investment expenses from prior period is primarilyattributable to our growth in 2006. The significant components ofnon-investment expense are described below.

Management compensation torelated parties consists of base management fees and, for 2006, incentive fees payableto our Manager pursuant to the Management Agreement, and share-basedcompensation related to restricted common stock and common stock optionsgranted to our Manager. The base management fee payable was calculated inaccordance with the Management Agreement and is based on an annual rate of1.75% times our “equity” as defined in the Management Agreement. Our Manager isalso entitled to a quarterly incentive fee provided that our quarterly “netincome,” as defined in the Management Agreement, before the payment of theincentive fee exceeds a defined return hurdle. We did not exceed the applicablehurdle during any quarter in the year ended December 31, 2005.

General and administrative expenses consist ofexpenses incurred by our Manager on our behalf that are reimbursable to ourManager pursuant to the Management Agreement. Professional services expensesconsist of legal, accounting and other professional services. Loan servicingexpense consists of fixed servicing fees paid to third-party servicers relatedto our residential mortgage investments.

*Equity in Income ofUnconsolidated Affiliate*

Equity in income of unconsolidated affiliate totaled$5.7 million for the year ended December 31, 2006 and represents of ourproportionate share of the net income in an unconsolidated affiliate consistingof a 49.9% limited partnership interest in KKR Financial Holdings I, L.P.(“KFH”). KFH was formed during the third quarter of 2006 and is the primarybeneficiary of four special purpose entities formed during the third quarter of2006 to complete secured borrowing transactions, in the form of collateralizedloan obligation (“CLO”) warehouses structured as repurchase agreements, tofinance certain investments in corporate loans and securities.

As of December 31,2006, KFH had $1.1 billion in assets consisting of $746.3 million of corporateloans, $294.5 million of corporate securities, $12.5 million of restrictedcash, $12.1 million of interest 

49

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receivable,and $6.6 million of other receivables. As of December 31, 2006, KFH hadliabilities totaling $863.9 million consisting of $851.8 million of borrowingsunder repurchase agreements and $12.1 million of interest payable. As ofDecember 31, 2006 KFH had net unrealized gains on its investments insecurities classified as available-for-sale totaling $15.8 million During theyear ended December 31, 2006, KFH had net income of $11.4 millionconsisting of $23.5 million of interest income and $12.1 million of interest expense.

*Income TaxProvision*

We elected to be taxed as a REIT and we believe thatwe complied with the provisions of the Code with respect thereto. Accordingly,we are not subject to federal income tax to the extent that our distributionsto stockholders satisfy the REIT requirements and certain asset, income andownership tests, and recordkeeping requirements are fulfilled.

KKR TRS Holdings Inc. (“TRS Inc.”), our domestictaxable REIT subsidiary, is taxed as a regular subchapter C corporationunder the provisions of the Code. TRS Inc. was formed to make, from time totime, 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, 2006, TRS Inc. hadpre-tax net income of $2.9 million and the provision for income taxestotaled $1.0 million. As of December 31, 2006, TRS Inc. had an income taxliability of $0.3 million.

KKR Financial 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”), KKRFinancial CLO 2006-2 Ltd. (“CLO 2006-2”), and KKR Financial CDO 2005-1 Ltd.(“CLO 2005-1”), are foreign taxable REIT subsidiaries that wereestablished to facilitate securitization transactions, structured as securedfinancing transactions, and KKR TRS Holdings, Ltd. (“TRS Ltd.”), is a foreigntaxable REIT subsidiary that was formed to make from time to time, certain foreigninvestments. They are organized as exempted companies incorporated with limitedliability under the laws of the Cayman Islands, and are generally exempt fromfederal and state income tax at the corporate entity level because theyrestrict their activities in the United States to trading in stock and securitiesfor their own account. Therefore, despite their status as taxable REITsubsidiaries, they generally will not be subject to corporate income tax ontheir earnings, and no provisions for income taxes for the year endedDecember 31, 2006 were recorded; however, we are generally required toinclude their current taxable income in our calculation of REIT taxable income.

**Year endedDecember 31, 2005 compared to period from August 12, 2004 (inception)through December 31, 2004**

*Summary*

Our net income for the year ended December 31,2005 totaled $55.1 million (or $0.92 per diluted share) as compared to anet loss of $6.7 million (or $0.17 per diluted share) for the period fromAugust 12, 2004 (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 ofDecember 31, 2005.

Some of the differencesbetween the two periods discussed below are due to the fact that we commencedour operations on August 12, 2004 and results for 2004 therefore reflect lessthan a full year of operations.

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*Net InvestmentIncome*

The following tablepresents the components of our net investment income for the year endedDecember 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 table above, our net investmentincome increased by $111.6 million in 2005 compared to 2004. The change from2004 to 2005 is primarily attributable to the increase in our investmentportfolio during 2005. As of December 31, 2005, we held $15.0 billionin investments in loans and securities available-for-sale and had borrowingsoutstanding totaling $13.4 billion. Additionally, we recorded a provision forloans losses of $1.5 million during the year ended December 31, 2005. Incomparison, as of December 31, 2004, investments in loans and securitiesavailable-for-sale totaled $2.3 billion and borrowings outstanding totaled $1.6billion. In addition, the results for 2004 reflect less than a full year sincewe 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.

*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 |   |   |

 

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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 2004 results therefore 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 fee payablewas calculated in accordance with the Management Agreement and is based on anannual rate of 1.75% times our “equity” as defined in the Management Agreement.Our Manager is also entitled to a quarterly incentive fee provided that ourquarterly “net income,” as defined in the Management Agreement, before thepayment of the incentive fee exceeds a defined return hurdle. We did not exceedthe applicable hurdle during any quarter in either the year ended December 31,2005 or the period from August 12, 2004 (inception) through December 31,2004; accordingly, no incentive fee was 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. Professionalservices expenses consist of legal, accounting and other professional services.Loan servicing expense consists of fixed servicing fees paid to third-partyservicers related to our residential mortgage investments.

*Income TaxProvision*

We elected to be taxed as a REIT and we believe thatwe complied with the provisions of the Code with respect thereto. Accordingly,we are not subject to federal income tax to the extent that our distributionsto stockholders satisfy the REIT requirements and certain asset, income andownership tests, and recordkeeping requirements are fulfilled. Even though wequalify for federal taxation as a REIT, we may be subject to some amount offederal, state, local and foreign taxes based on our taxable income and we haveprovided for such taxes in the amount of $0.5 million for the year ended December 31,2005.

TRS Inc., our domestic taxable REIT subsidiary, istaxed as a regular subchapter C corporation under the provisions of the Code. TRSInc. was formed to make, from time to time, certain investments that would notbe REIT qualifying investments if made directly by us, and to earn income thatwould not be REIT qualifying income if earned directly by us. For the yearended December 31, 2005, TRS Inc. had pre-tax net income of$6.0 million and the provision for income taxes totaled $2.6 million. Asof December 31, 2005, TRS Inc. had an income tax liability of$2.4 million.

CLO 2005-1, CLO 2005-2,CLO 2006-1, and CDO 2005-1 are foreign taxable REIT subsidiaries that wereestablished to facilitate securitization transactions structured as securedfinancing transactions. They 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 provisions for income taxes for the year ended December 31,2005 were recorded; however, we are generally required to include their currenttaxable income in our calculation of REIT taxable 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 31,2006 and December 31, 2005, classified by interest rate type. Carryingvalue is the value that investments are recorded on our consolidated balancesheets and is estimated fair value for securities and amortized cost for loansheld for investment and the lower of amortized cost or market value for loansheld for sale. Estimated fair values set forth in the tables below are based ondealer quotes and/or nationally recognized pricing services.

Thetable below summarizes our investment portfolio as of December 31, 2006classified by interest rate type:

**InvestmentPortfolio(Dollars in thousands)**

| ** **                                             | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  % by Fair Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating  Rate:**                                    | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Residential ARM  Loans                                 |       |                    | $          | 1,441,959               | ** ** |                           |       | $                                                      | 1,441,959  | ** ** |   | $ | 1,433,151 |   |   | 8.4 | % |   |
| Residential ARM  Securities                            |       |                    | 5,673,932  | ** **              |       |                           | 5,662,830  | ** **                                             |       | 5,673,932 |   |   | 33.2 |   |   |
| Corporate Loans                                        |       |                    | 3,200,567  | ** **              |       |                           | 3,200,567  | ** **                                             |       | 3,221,334 |   |   | 18.8 |   |   |
| Corporate Debt  Securities                             |       |                    | 357,696    | ** **              |       |                           | 344,650    | ** **                                             |       | 357,696 |   |   | 2.1 |   |   |
| Commercial Real  Estate Loans                          |       |                    | 108,693    | ** **              |       |                           | 108,693    | ** **                                             |       | 109,192 |   |   | 0.7 |   |   |
| Total Floating Rate                                    |       |                    | 10,782,847 | ** **              |       |                           | 10,758,699 | ** **                                             |       | 10,795,305 |   |   | 63.2 |   |   |
| **Hybrid  Rate:**                                      | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Residential  Hybrid ARM Loans                          |       |                    | 3,667,302  | ** **              |       |                           | 3,667,302  | ** **                                             |       | 3,647,783 |   |   | 21.3 |   |   |
| Residential  Hybrid ARM Securities                     |       |                    | 1,862,264  | ** **              |       |                           | 1,894,941  | ** **                                             |       | 1,862,264 |   |   | 10.9 |   |   |
| Total Hybrid Rate                                      |       |                    | 5,529,566  | ** **              |       |                           | 5,562,243  | ** **                                             |       | 5,510,047 |   |   | 32.2 |   |   |
| **Fixed  Rate:**                                       | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Corporate Loans                                        |       |                    | 25,000     | ** **              |       |                           | 25,000     | ** **                                             |       | 25,000 |   |   | 0.1 |   |   |
| Corporate Debt  Securities                             |       |                    | 505,753    | ** **              |       |                           | 486,321    | ** **                                             |       | 505,753 |   |   | 2.9 |   |   |
| Commercial Real  Estate Debt Securities                |       |                    | 32,023     | ** **              |       |                           | 32,000     | ** **                                             |       | 32,023 |   |   | 0.2 |   |   |
| Total Fixed Rate                                       |       |                    | 562,776    | ** **              |       |                           | 543,321    | ** **                                             |       | 562,776 |   |   | 3.2 |   |   |
| **Marketable  and Non-Marketable Equity Securities:**  | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Common and  Preferred Stock                            |       |                    | 68,968     | ** **              |       |                           | 68,113     | ** **                                             |       | 68,968 |   |   | 0.4 |   |   |
| Non-Marketable  Equity Securities                      |       |                    | 166,323    | ** **              |       |                           | 166,323    | ** **                                             |       | 166,323 |   |   | 1.0 |   |   |
| Total Marketable and Non-Marketable Equity  Securities |       |                    | 235,291    | ** **              |       |                           | 234,436    | ** **                                             |       | 235,291 |   |   | 1.4 |   |   |
| Total                                                  |       |                    | $          | 17,110,480              | ** ** |                           |       | $                                                      | 17,098,699 | ** ** |   | $ | 17,103,419 |   |   | 100.0 | % |   |

 

As of December 31, 2006, the aggregate fair valueof our investment portfolio exceeded the aggregate amortized cost of ourportfolio by $4.7 million and, as of the same date, we had unrealizedgains totaling $50.8 million related to our cash flow hedges, as definedunder SFAS No. 133. As of December 31, 2006, the aggregate netunamortized purchase discount related to our investment portfolio was $17.3 million.

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Thetable below summarizes our investment portfolio as of December 31, 2005,classified by interest rate type:

**InvestmentPortfolio(Dollars 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 |   |   | 14.4 | % |   |
| Residential ARM  Securities                            |       |                    | 3,375,434  | ** **              |       |                           | 3,369,763  | ** **                                             |       | 3,375,434 |   |   | 22.5 |   |   |
| 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 |   |   | 3.2 |   |   |
| 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 |   |   | 55.0 |   |   |
| **Hybrid  Rate:**                                      | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Residential  Hybrid ARM Loans                          |       |                    | 4,252,893  | ** **              |       |                           | 4,252,893  | ** **                                             |       | 4,224,234 |   |   | 28.1 |   |   |
| Residential  Hybrid ARM Securities                     |       |                    | 2,162,404  | ** **              |       |                           | 2,197,020  | ** **                                             |       | 2,162,404 |   |   | 14.4 |   |   |
| Total Hybrid Rate                                      |       |                    | 6,415,297  | ** **              |       |                           | 6,449,913  | ** **                                             |       | 6,386,638 |   |   | 42.5 |   |   |
| **Fixed  Rate:**                                       | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Corporate Loans                                        |       |                    | 25,000     | ** **              |       |                           | 25,000     | ** **                                             |       | 25,000 |   |   | 0.2 |   |   |
| Corporate Debt  Securities                             |       |                    | 202,474    | ** **              |       |                           | 202,748    | ** **                                             |       | 202,474 |   |   | 1.3 |   |   |
| 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 |   |   | 1.8 |   |   |
| **Marketable  and Non-Marketable Equity Securities:**  | ** ** |                    | ** ** | ** **              |       |                           | ** ** | ** **                                             |       | ** ** | ** ** |   | ** ** | ** ** |   |
| Common and  Preferred Stock                            |       |                    | 47,002     | ** **              |       |                           | 47,158     | ** **                                             |       | 47,002 |   |   | 0.3 |   |   |
| Non-Marketable  Equity Securities                      |       |                    | 52,500     | ** **              |       |                           | 52,500     | ** **                                             |       | 52,500 |   |   | 0.4 |   |   |
| Total Marketable  and Non-Marketable Equity Securities |       |                    | 99,502     | ** **              |       |                           | 99,658     | ** **                                             |       | 99,502 |   |   | 0.7 |   |   |
| Total                                                  |       |                    | $          | 15,049,847              | ** ** |                           |       | $                                                      | 15,077,061 | ** ** |   | $ | 15,022,976 |   |   | 100.0 | % |   |

 

As of December 31,2005, the aggregate amortized cost of our investment portfolio exceeded theaggregate estimated fair value of our portfolio by $54.1 million and, asof the same date, we had unrealized gains totaling $45.6 million relatedto our cash flow hedges, as defined under SFAS No. 133. As of December 31,2005, the aggregate net unamortized purchase discount related to our investmentportfolio was $6.7 million.

**Asset Quality**

*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’s andStandard & Poor’s ratings, and Moody’s weighted average rating factor,or WARF. WARF is the quantitative equivalent of Moody’s traditional ratingcategories (e.g., Ba1, Ba2, etc.) and is used by Moody’s in its creditenhancement calculations for securitization transactions. By monitoring bothMoody’s and Standard & Poor’s ratings and Moody’s WARF we can monitortrends and changes in the credit ratings of our investment portfolio. Forresidential mortgage 

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loansand residential mortgage-backed securities we monitor the credit quality of theunderlying borrowers by monitoring trends and changes in the underlyingborrowers’ FICO®  scores.Borrowers with lower FICO® scores default more frequently than borrowerswith higher FICO® scores. For residential and commercial realestate mortgage 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 par value of our investment securities portfolio by investmentclass stratified by Moody’s and Standard & Poor’s ratings category asof December 31, 2006:

**InvestmentSecurities (Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       |       | $          | 5,622,446                            |       |                                         | $          | 1,831,413                       |       | $                                                      | —     |      |       | $ | — |   |   | $ | 7,453,859 |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | 14,976     |                                 |       | 28,336                                       |       | —                          |       |                                                   | —     |      |       | 43,312 |   |
| A1/A+ through  A3/A-         |       |       | 10,797     |                                 |       | 18,032                                       |       | —                          |       |                                                   | —     |      |       | 28,829 |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | 7,662      |                                 |       | 9,648                                        |       | 21,071                          |       |                                                   | 18,000     |      |       | 56,381 |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 3,831      |                                 |       | 3,864                                        |       | 160,500                         |       |                                                   | 14,000     |      |       | 182,195 |   |
| B1/B+ through  B3/B-         |       |       | 2,786      |                                 |       | 2,576                                        |       | 370,315                         |       |                                                   | —     |      |       | 375,677 |   |
| Caa1/CCC+ and  lower         |       |       | —     |                                 |       | —                                       |       | 208,505                         |       |                                                   | —     |      |       | 208,505 |   |
| Non-Rated                    |       |       | 6,227      |                                 |       | 6,434                                        |       | 86,500                          |       |                                                   | —     |      |       | 99,161 |   |
| Total                        |       |       | $          | 5,668,725                            |       |                                         | $          | 1,900,303                       |       | $                                                      | 846,891    |      |       | $ | 32,000 |   |   | $ | 8,447,919 |   |

 

The following table showsthe par value of our investment securities portfolio by investment classstratified by Moody’s and Standard & Poor’s ratings category 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                      |       |       | $          | 3,310,426                            |       |                                         | $          | 2,132,297                       |       | $                                                      | —     |      |       | $ | — |   |   | $ | 5,442,723 |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | 21,497     |                                 |       | 28,692                                       |       | —                          |       |                                                   | —     |      |       | 50,189 |   |
| A1/A+ through  A3/A-         |       |       | 15,498     |                                 |       | 18,259                                       |       | —                          |       |                                                   | —     |      |       | 33,757 |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | 10,998     |                                 |       | 9,729                                        |       | 41,540                          |       |                                                   | 45,692     |      |       | 107,959 |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 5,499      |                                 |       | 3,913                                        |       | 159,500                         |       |                                                   | 25,000     |      |       | 193,912 |   |
| B1/B+ through  B3/B-         |       |       | 3,999      |                                 |       | 2,608                                        |       | 153,815                         |       |                                                   | —     |      |       | 160,422 |   |
| Caa1/CCC+ and  lower         |       |       | —     |                                 |       | —                                       |       | 108,505                         |       |                                                   | 10,800     |      |       | 119,305 |   |
| Non-Rated                    |       |       | 9,499      |                                 |       | 6,521                                        |       | 27,000                          |       |                                                   | 4,000      |      |       | 47,020 |   |
| Total                        |       |       | $          | 3,377,416                            |       |                                         | $          | 2,202,019                       |       | $                                                      | 490,360    |      |       | $ | 85,492 |   |   | $ | 6,155,287 |   |

 

*Loans*

Our residential mortgage loan portfolio totaled $5.1 billionas of December 31, 2006 and $6.4 billion as of December 31, 2005. Asof December 31, 2006, we owned six real estate properties acquired throughforeclosure. The outstanding loan balance of $1.3 million with respect to thesesix properties (not included 

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in the following table)was reclassified from loans to other assets on our balance sheet. As theestimated fair value of the real estate property approximates the outstandingloan balance we have not recorded a charge against our allowance for loanlosses. As of December 31, 2005, we did not own any real estate propertiesthat we had acquired through foreclosure.

As of December 31, 2006, we had thirty-threeloans that were 90 days or greater past due or in foreclosure and placed onnon-accrual status. During the year ended December 31, 2006, we did not recognizeapproximately $0.3 million in interest income for loans in non-accrual statusor that were classified as real estate owned.

The weighted average original FICO® score and weighted average original LTV ratioof our residential ARM loan portfolio were 739 and 68.6%, respectively, as of December 31,2006. As of December 31, 2005, the weighted average original FICO® score and weighted average LTV ratio of ourresidential ARM loan portfolio were 737 and 67.2%, respectively. As of December 31,2006 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.

Thefollowing table summarizes the delinquency statistics of our residential mortgageloans as of December 31, 2006 (dollar amounts in thousands):

| **Delinquency Status** | ** ** | ** ** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       |       | 90         |                          |       |                      | $          | 35,968 |   |   |
| 60 to 89 days               |       |       | 10         |                          |       |                      | 3,040      |   |   |
| 90 days or more             |       |       | 15         |                          |       |                      | 2,855      |   |   |
| In foreclosure              |       |       | 18         |                          |       |                      | 5,442      |   |   |
| Total                       |       |       | 133        |                          |       |                      | $          | 47,305 |   |   |

 

Thefollowing table summarizes the delinquency statistics of our residentialmortgage loans 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 |   |   |

 

Thefollowing table summarizes the changes in the allowance for loan losses for ourresidential mortgage loan portfolio during the year ended December 31,2006 (amounts in thousands):

| Balance,  January 1, 2006   |   | $      | 1,500  |   |
|----------------------------------|--------|--------|--------|--------|
| Provision for  loan losses       |   | — |   |
| Charge-offs                      |   | — |   |
| Balance,  December 31, 2006 |   | $      | 1,500  |   |

 

Our corporate loan portfolio totaled $3.2 billion asof December 31, 2006 and $1.9 billion as of December 31, 2005.Our corporate loan portfolio consists of debt obligations of corporations,partnerships and other entities in the form of first and second lien loans,mezzanine loans and bridge loans.

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As of December 31, 2006, one corporate loan witha balance of $22.2 million was placed on non-accrual status. Accordingly, wedid not recognize $0.3 million of interest income related to this loan. As partof our allowance for loan losses analysis as of December 31, 2006, wedetermined that the loan is collectible and sufficiently collateralized. Accordingly,no provision for loan losses was recorded for this loan.

We performed an allowance for loan losses analysis asof December 31, 2006 and December 31, 2005, and we have made thedetermination that no allowance for loan losses was required for our corporateloan portfolio as of December 31, 2006 or December 31, 2005.

The following tablesummarizes the par value of our corporate loan portfolio stratified by Moody’sand Standard & Poor’s ratings category as of December 31, 2006and December 31, 2005:

**Corporate Loans (Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **As of  December 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       |       | $          | —                                      |       |                                        |       | $ | — |   |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | —     |                                        |       |                                        | —     |   |   |
| A1/A+ through  A3/A-         |       |       | —     |                                        |       |                                        | —     |   |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | 77,326     |                                        |       |                                        | 2,000      |   |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 1,764,598  |                                        |       |                                        | 673,644    |   |   |
| B1/B+ through  B3/B-         |       |       | 1,153,856  |                                        |       |                                        | 1,095,368  |   |   |
| Caa1/CCC+ and  lower         |       |       | 93,340     |                                        |       |                                        | 21,547     |   |   |
| Non-rated                    |       |       | 143,294    |                                        |       |                                        | 107,826    |   |   |
| Total                        |       |       | $          | 3,232,414                                   |       |                                        |       | $ | 1,900,385 |   |   |

 

Our commercial real estate loan portfolio totaled$108.7 million and $521.7 million as of December 31, 2006 and December 31,2005, respectively.

We performed an allowance for loan losses analysis asof December 31, 2006, and we have made the determination that no allowancefor loan losses was required for our commercial real estate loan portfolio asof December 31, 2006.

The following tablesummarizes the par value of our commercial real estate loan portfolio stratifiedby Moody’s and Standard & Poor’s ratings category as of December 31,2006 and December 31, 2005:

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

| **Ratings Category**    | ** ** | ** ** | ** ** | **As of  December 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       |       | $          | —                                      |       |                                        |       | $ | — |   |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | —     |                                        |       |                                        | —     |   |   |
| A1/A+ through  A3/A-         |       |       | —     |                                        |       |                                        | —     |   |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | —     |                                        |       |                                        | —     |   |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 2,908      |                                        |       |                                        | 60,929     |   |   |
| B1/B+ through  B3/B-         |       |       | 90,882     |                                        |       |                                        | 75,000     |   |   |
| Caa1/CCC+ and  lower         |       |       | —     |                                        |       |                                        | 50,000     |   |   |
| Non-rated                    |       |       | 15,000     |                                        |       |                                        | 336,821    |   |   |
| Total                        |       |       | $          | 108,790                                     |       |                                        |       | $ | 522,750 |   |   |

 

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**Asset RepricingCharacteristics**

*Summary*

The table below summarizesthe repricing characteristics of our investment portfolio as of December 31,2006 and December 31, 2005, and is classified by interest rate type:

**InvestmentPortfolio(Dollars in thousands)**

| ** **                              | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                         | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| Floating Rate:                          |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential ARM  Loans                  |       |                                            | $          | 1,441,959                                       |       |   |   | 8.6 | % |   |   | $ | 2,175,929 |   |   |   | 14.5 | % |   |
| Residential ARM  Securities             |       |                                            | 5,662,830  |                                            |       |   | 33.6 |   |   |   | 3,369,763 |   |   |   | 22.5 |   |   |
| Corporate Loans                         |       |                                            | 3,200,567  |                                            |       |   | 19.0 |   |   |   | 1,872,277 |   |   |   | 12.5 |   |   |
| Corporate Debt  Securities              |       |                                            | 344,650    |                                            |       |   | 2.0 |   |   |   | 277,030 |   |   |   | 1.9 |   |   |
| Commercial Real  Estate Loans           |       |                                            | 108,693    |                                            |       |   | 0.6 |   |   |   | 486,096 |   |   |   | 3.2 |   |   |
| Commercial Real  Estate Debt Securities |       |                                            | —     |                                            |       |   | — |   |   |   | 63,168 |   |   |   | 0.4 |   |   |
| Total Floating Rate                     |       |                                            | 10,758,699 |                                            |       |   | 63.8 |   |   |   | 8,244,263 |   |   |   | 55.0 |   |   |
| Hybrid Rate:                            |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential  Hybrid ARM Loans           |       |                                            | 3,667,302  |                                            |       |   | 21.8 |   |   |   | 4,252,893 |   |   |   | 28.4 |   |   |
| Residential  Hybrid ARM Securities      |       |                                            | 1,894,941  |                                            |       |   | 11.2 |   |   |   | 2,197,020 |   |   |   | 14.7 |   |   |
| Total Hybrid Rate                       |       |                                            | 5,562,243  |                                            |       |   | 33.0 |   |   |   | 6,449,913 |   |   |   | 43.1 |   |   |
| Fixed Rate:                             |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate Loans                         |       |                                            | 25,000     |                                            |       |   | 0.1 |   |   |   | 25,000 |   |   |   | 0.2 |   |   |
| Corporate Debt  Securities              |       |                                            | 486,321    |                                            |       |   | 2.9 |   |   |   | 202,748 |   |   |   | 1.4 |   |   |
| Commercial Real  Estate Loans           |       |                                            | —     |                                            |       |   | — |   |   |   | 35,646 |   |   |   | 0.2 |   |   |
| Commercial Real  Estate Debt Securities |       |                                            | 32,000     |                                            |       |   | 0.2 |   |   |   | 19,833 |   |   |   | 0.1 |   |   |
| Total Fixed Rate                        |       |                                            | 543,321    |                                            |       |   | 3.2 |   |   |   | 283,227 |   |   |   | 1.9 |   |   |
| Total                                   |       |                                            | $          | 16,864,263                                      |       |   |   | 100.0 | % |   |   | $ | 14,977,403 |   |   |   | 100.0 | % |   |

 

The table above excludesmarketable equity securities with a fair value of $69.0 million and amortizedcost of $68.1 million, and non-marketable equity securities with a fair valueof $166.3 million and amortized cost of $166.3 million as of December 31,2006. The table above also excludes marketable equity securities with a fairvalue of $47.0 million and amortized cost of $47.2 million, and non-marketableequity securities with a fair value of $52.5 million and amortized cost of$52.5 million as of December 31, 2005.

*Residential ARMSecurities*

As of December 31,2006 and December 31, 2005, substantially all of our residentialadjustable-rate mortgage (“ARM”) securities were comprised of one-month LIBORfloating rate securities that reprice monthly and were subject to a weightedaverage maximum net interest rate of 11.83% and 11.63%, respectively, which wasmaterially above the then current weighted average net coupon of 6.46% and4.62%, respectively. Our repricing risk on our portfolio of residential ARMsecurities increases materially if interest rates continue to increase to alevel where the weighted average coupon rate approaches the weighted averagemaximum net interest rate of 11.83% and 11.63%, respectively, because theweighted average coupon is subject to a maximum rate, or cap, which isapproximately equal to the weighted average maximum interest rate of 11.83% and11.63% as of December 31, 2006 and December 31, 2005, respectively.

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*Residential HybridARM Securities*

As of December 31,2006 and December 31, 2005, all of our residential hybrid ARM securitieshad underlying mortgage loans that were originated as 5/1 hybrid ARM loans. Asof December 31, 2006 and December 31, 2005, we owned 100% of thesecurities that represent 100% of the beneficial interest in the 5/1 hybrid ARMloans underlying our portfolio of hybrid ARM securities. When the underlyingresidential hybrid mortgage loans convert from fixed rate to floating rate, theunderlying mortgage loans will have an interest rate based on one-year LIBOR orone-year constant maturity treasury index, or CMT, depending upon if theunderlying mortgage loan is a LIBOR- or CMT-based mortgage loan. On thedate that the residential hybrid ARM loans convert from a fixed rate to afloating rate loan, which we refer to as the roll date, our portfolio ofresidential hybrid ARM loans will have a weighted average coupon that is thesum of (i) the post-roll date index, and (ii) the weighted averagepost-roll date net margin. As of December 31, 2006 and December 31,2005, all of the mortgage loans underlying our residential hybrid ARMsecurities had a post-roll date index reset frequency of one year with 34% and35%, respectively, and based on six-month or one-year LIBOR and 66% and 65%,respectively, based on one-year CMT. Our repricing risk on our portfolio ofresidential hybrid ARM loans increases materially if interest rates continue toincrease to a level where, subsequent to the roll date, the weighted averagenet coupon rate approaches the weighted average post roll date maximum netinterest rate of 9.43% because the post roll date weighted average net couponis subject to a maximum rate, or cap, which is approximately equal to theweighted average post roll date maximum net interest rate or 9.43%. Theweighted average coupon on the portfolio of residential hybrid securities was4.18% and 4.13% as of December 31, 2006 and December 31, 2005,respectively. As of December 31, 2006 and December 31, 2005, theweighted average months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 24 and 36, respectively.

*Residential ARMLoans*

As of December 31,2006 and December 31, 2005, all of our residential ARM loans werecomprised of one-month LIBOR floating rate loans that reprice monthly and weresubject to a weighted average maximum net interest rate of 11.92% and 11.90%,respectively, which was well above the then current weighted average net couponof 6.43% and 5.05%, respectively. Our repricing risk on our portfolio ofresidential ARM loans increases materially if interest rates continue toincrease to a level where the weighted average net coupon rate approaches theweighted average maximum interest rate of 11.92% and 11.90%, respectively,because the weighted average coupon is subject to a cap which is approximatelyequal to the weighted average maximum interest rate of 11.92% and 11.90%,respectively.

*Residential HybridARM Loans*

As of December 31,2006 and December 31, 2005, all of our residential hybrid ARM loans wereoriginated as either 3/1 or 5/1 hybrid ARM loans. When the loans convert fromfixed rate to floating rate, the underlying mortgage loans will have aninterest rate based on one-year LIBOR or one-year CMT. On the date that theresidential hybrid ARM loans convert from a fixed rate to a floating rate loan,which we refer to as the roll date, our portfolio of residential hybrid ARMloans will have a weighted average coupon that is the sum of (i) thepost-roll date index, and (ii) the weighted average post-roll date netmargin. As of December 31, 2006 and December 31, 2005, all of ourresidential hybrid ARM loans had a post-roll date index reset frequency ofone-year with 46% and 43%, respectively, based on six-month or one-year LIBORand 54% and 57%, respectively, 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-rolldate maximum net interest rate of 10.13% because the post-roll date weightedaverage net coupon is subject to a cap which is approximately equal to theweighted average post-roll date maximum net interest rate of 10.13%. Theweighted average net coupon on the portfolio of residential 

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hybridloans was 4.85% as of December 31, 2006 and 2005. As of December 31,2006 and December 31, 2005, the weighted average months until roll datefor the mortgage loans underlying our residential hybrid ARM securities was 33and 44, respectively.

*Corporate Loans andSecurities*

All of our floating rate corporate loans and securitieshave index reset frequencies of less than twelve months with the majority ofthe loans resetting at least quarterly. The weighted average coupon on ourfloating rate corporate loans and securities was 8.00% and 7.12% as of December 31,2006 and December 31, 2005, respectively. As of December 31, 2006 andDecember 31, 2005, the weighted average years to maturity of our floatingrate corporate loans and securities was 6.0 years and 6.3 years,respectively.

As of December 31,2006, our fixed rate corporate debt securities had a weighted average coupon of9.75% and a weighted average years to maturity of 6.3 years, as compared to10.58% and 8.7 years, respectively, as of December 31, 2005.

*Commercial RealEstate Loans and Securities*

All of our floating rate commercial real estate loanshave index reset frequencies of less than twelve months. As of December 31,2006 our floating rate commercial real estate loans had a weighted averagecoupon of 8.42% and weighted average years to maturity of 2.5 years. As of December 31,2006, we owned no floating rate commercial real estate securities. As of December 31,2005, our floating rate commercial real estate loans and securities had aweighted average coupon of 8.70% and weighted average years to maturity of 3.7 years.

As of December 31,2006 our fixed rate commercial real estate securities had a weighted averagecoupon of 7.12% and a weighted average years to maturity of 29.9 years. As of December 31,2006, we owned no fixed rate commercial real estate loans. 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.

**Portfolio Purchases**

We purchased $7.8 billion par amount ofinvestments during the year ended December 31, 2006. For the year ended December 31,2005, we purchased $15.6 billion par amount of investments.

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Thetable below summarizes our investment portfolio purchases for the periodsindicated and includes the par amount of the securities and loans that werepurchased:

**InvestmentPortfolio Purchases(Dollars in thousands)**

| ** **                              | ** ** | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                              | ** ** | **Par Amount**                              | ** ** | **%**                                            | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                             | ** ** | ** **                                       | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Residential ARM  Securities             |       | $                                                | 4,080,156  |                                             | 52.4       | % | $ | 2,918,325 |   | 18.7 | % |
| Residential  Hybrid ARM Securities      |       | —                                           |       | —                                           |       | 2,935,532 |   | 18.8 |   |
| Corporate Debt  Securities              |       | 586,516                                          |       | 7.6                                              |       | 557,820 |   | 3.6 |   |
| Commercial Real  Estate Debt Securities |       | 32,000                                           |       | 0.4                                              |       | 85,671 |   | 0.6 |   |
| Total Securities Principal Balance      |       | 4,698,672                                        |       | 60.4                                             |       | 6,497,348 |   | 41.7 |   |
| Loans:                                  |       |                                             |       |                                             |       |   |   |   |   |
| Residential ARM  Loans                  |       | 165,021                                          |       | 2.1                                              |       | 2,172,771 |   | 13.9 |   |
| Residential  Hybrid ARM Loans           |       | —                                           |       | —                                           |       | 4,547,632 |   | 29.2 |   |
| Corporate Loans                         |       | 2,888,684                                        |       | 37.1                                             |       | 1,870,849 |   | 12.0 |   |
| Commercial Real  Estate Loans           |       | 32,000                                           |       | 0.4                                              |       | 493,129 |   | 3.2 |   |
| Total Loans Principal Balance           |       | 3,085,705                                        |       | 39.6                                             |       | 9,084,381 |   | 58.3 |   |
| Grand Total  Principal Balance          |       | $                                                | 7,784,377  |                                             | 100.0      | % | $ | 15,581,729 |   | 100.0 | % |

 

The table above excludes purchases of $40.4 million(purchase cost) of marketable equity securities during the year ended December 31,2006 and $28.3 million (purchase cost) during the year ended December 31,2005. Purchases of $121.5 million (purchase cost) and $52.5 million (purchasecost) of non-marketable equity securities for the year ended December 31,2006 and December 31, 2005, respectively, are also excluded from the tableabove.

During the year ended December 31, 2005, wepurchased $5.9 billion of securities in connection with five securitizationtransactions backed by $4.5 billion of residential hybrid ARM loans and $1.4billion of residential ARM loans. In each of the five securitizationtransactions, we purchased all of the securities issued, including thesubordinate classes. Included in the $5.9 billion of securities purchased, were$0.4 billion of loans we contributed to the securitization transactions,resulting in a net purchase of $5.5 billion of securities. Of the $5.9billion of securities purchased, approximately 96% were rated AAA by Standard &Poor’s. Each of the special-purpose entities that issued the securities are notconsidered qualifying special-purpose entities as defined by SFAS No. 140and are treated as variable interest entities under FIN 46R. We have determinedthat we are the primary beneficiary of each of the special purpose entitiesthat issued the securities; accordingly, we have recorded these investments asloans and not securities on our Consolidated Balance Sheets.

In addition to the fivesecuritization transactions previously described, during September 2005,we securitized $959.2 million of residential ARM loans and retained all of thesecurities issued in the securitization transaction, including the subordinateclasses. While we retained all of the securities from this transaction, theloans transferred in this securitization are owned by a special purpose entityand the loans are not available to us, our creditors or our stockholders. Ofthe $959.2 million of securities issued, approximately $908.8 million, or 95%,were rated AAA by Standard & Poor’s. Even though we transferred theloans to a separate bankruptcy-remote legal entity, we did not account for thetransaction as a sale as the securitization transaction did not meet thecriteria for sales treatment under SFAS No. 140. Accordingly, we did notrecord a gain or loss in connection with the securitization transaction andhave accounted for the transferred assets as loans on our Consolidated BalanceSheets.

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**Stockholders’Equity**

Our stockholders’ equity at both December 31,2006 and December 31, 2005 totaled $1.7 billion. Included in ourstockholders’ equity as of December 31, 2006 and December 31, 2005,is accumulated other comprehensive income totaling $70.5 million and$18.3 million, respectively.

Our average stockholders’ equity and return on averagestockholders’ equity for the year ended December 31, 2006 were$1.7 billion and 7.9%, respectively. Return on average stockholders’equity is defined as net income divided by weighted average stockholders’equity. Our average stockholders’ equity and return on average stockholders’equity for the year ended December 31, 2005 were $1.3 billion and4.5%, respectively.

Our book value per fully diluted share as of December 31,2006 and December 31, 2005 was $21.42 and $20.59, respectively, and iscomputed based on 80,464,713****and 80,374,061shares issued and outstanding as December 31, 2006 and December 31,2005, respectively.

On May 3, 2006, our board of directors authorizeda cash distribution of $0.45 per share to stockholders of record on May 17,2006. This distribution was paid on May 31, 2006. The aggregate amount ofthe distribution, $36.2 million, exceeded net income for the first fiscal quarterof 2006 by $5.8 million.

On August 2, 2006, our board of directorsdeclared a cash distribution of $0.49 per share for the quarter ended June 30,2006 to stockholders of record on August 16, 2006. The distribution waspaid on August 30, 2006. The aggregate amount of the distribution, $39.4 million, exceeded netincome for the second fiscal quarter of 2006 by $4.5 million.

On November 2, 2006, our board of directorsdeclared a cash distribution of $0.52 per share for the quarter ended September 30,2006 to stockholders of record on November 16, 2006. The distribution waspaid on November 30, 2006. The aggregate amount of the distribution,$41.8 million, exceeded net income for the third fiscal quarter of 2006 by$9.2 million.

On February 1, 2007,our board of directors declared a cash distribution of $0.54 per share forthe quarter ended December 31, 2006 to stockholders of record on February 15,2007. The distribution will be paid on February 28, 2007. The aggregateamount of the distribution,****$43.5 million,exceeds net income for the fourth fiscal quarter of 2006 by $6.1 million.

**Liquidity and CapitalResources**

We manage our liquidity with the intention ofproviding the continuing ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis. As of December 31, 2006and December 31, 2005, we had unencumbered assets totaling $612.5** **million and $810.4 million, respectively,consisting of unpledged investments, cash and cash equivalents, and otherassets. We also have the ability to borrow additional amounts related tocertain of our encumbered assets.

We believe that our liquidity level and access toadditional financing is in excess of that necessary to sufficiently enable usto meet our anticipated liquidity requirements including, but not limited to,funding our purchases of investments, required cash payments and additionalcollateral under our borrowings and our derivative transactions, requiredperiodic cash payments related to our derivative transactions, payment of feesand expenses related to our Management Agreement, payment of general corporateexpenses and general corporate capital expenditures and distributions to ourstockholders, although there can be no assurance in this regard. As of December 31,2006, we owed our Manager $6.9 million for the payment of management feesand reimbursable expenses pursuant to the Management Agreement.

An increase in prepayment rates on our investments substantiallyabove our expectations could, however, cause a temporary liquidity shortfalldue to the timing of the necessary margin calls on our 

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financing arrangements andthe actual 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 acceptable terms, it may have anadverse effect on our business and results of operations and our ability tomake distributions to stockholders. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings will receive, and anyholders of preferred stock that we may issue in the future may receive, adistribution of our available assets prior to holders of our common stock. Thedecisions by investors and lenders to enter into equity, and financingtransactions with us will depend upon a number of factors, including ourhistorical and projected financial performance, compliance with the terms ofour current credit arrangements, industry and market trends, the availabilityof capital and our investors’ and lenders’ policies and rates applicablethereto, and the relative attractiveness of alternative investment or lendingopportunities.

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**

*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 28,750 sharesin the IPO. 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, weeffected a reverse stock split of our common stock at a ratio of one share ofcommon stock for every two shares of common stock then outstanding.

*SecuritizationTransactions*

On March 30, 2005, we closed CLO 2005-1, a$1.0 billion CLO transaction that provides us with secured financing forinvestments consisting of corporate loans and certain other loans andsecurities. The investments that are owned by CLO 2005-1 secure the CLO2005-1 senior, mezzanine, and subordinated notes payable, and as aresult, 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.

On September 30, 2005, we closed a $5.0 billionasset-backed secured liquidity note facility. This facility provides us with analternative source of funding our investments in 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 and Fitch Inc.,respectively. Issuances of asset-backed secured liquidity notes are 

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recorded as borrowings onour Consolidated Balance Sheet. At December 31, 2006, we had $4.7 billionof asset-backed secured liquidity notes outstanding under this facility.

On November 3, 2005, we closed CLO 2005-2,our second $1.0 billion CLO transaction that provides us with securedfinancing for investments consisting of corporate loans and certain other loansand 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 subordinated 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.

On March 30, 2006, we closed our second $5.0billion asset-backed secured liquidity note facility. This facility provides uswith an alternative source of funding our investments in residentialmortgage-backed securities by issuing asset-backed secured liquidity notes thatare rated A-1+, P-1, and F1+, by Standard & Poor’s, Moody’sand Fitch Inc, respectively. Issuances of asset-backed secured liquidity notesare recorded as borrowings on our Consolidated Balance Sheets. At December 31,2006, we had $4.0 billion of asset-backed secured liquidity notes outstandingunder this facility.

On September 19, 2006, we closed CLO 2006-1,our third $1.0 billion CLO transaction that provides us with securedfinancing for investments consisting of corporate loans and certain other loansand securities. The investments that are owned by CLO 2006-1collateralize the CLO 2006-1 debt, and as a result, thoseinvestments are not available to us, our creditors or stockholders. CLO 2006-1issued a total of $727.5 million of senior secured notes at par to investors andwe retained $145.5 million of rated mezzanine notes and $144.0 million ofunrated subordinated notes issued by CLO 2006-1. The rated mezzaninenotes consist of $12.5 million rated A2/A, $67.0 million rated Baa3/BBB, $48.0million rated Ba3/BB, and $18.0 million rated B3/B. All of the notes issuedmature on August 25, 2018; however, we have the right to call the notes atpar any time after August 2010.

In preparation for futuresecuritization transactions, during the year ended December 31, 2005 weformed CDO 2005-1 and CLO 2006-2. CLO 2006-2 will beused to provide secured financing principally for the purchase of corporate andcommercial real estate loans and securities. CLO 2006-2 originally executeda $450.0 million warehouse facility, in the form of a repurchase agreement.This facility was amended to increase the total commitment amount to $720.0million in December 2006. At December 31, 2006, there was $631.3million outstanding under this facility. The borrowings bear interest at a rateof 30-day LIBOR plus 0.60%. During October 2006, we determined thatwe would no longer pursue a securitization of commercial real estateinvestments from CDO 2005-1 and therefore converted the existing $300.0million warehouse facility into a credit facility that terminates on March 31,2008. At December 31, 2006 there was $1.1 million outstanding under thisfacility that bears interest at a rate of 30-day LIBOR plus 1.10%.

*RepurchaseAgreements*

As of December 31, 2006, we had $4.5 billionoutstanding on repurchase facilities with five counterparties with a weightedaverage effective rate of 5.52% and a weighted average remaining term tomaturity of 17 days. Because we borrow under repurchase agreements based on theestimated fair value of its pledged investments, and because changes ininterest rates can negatively impact the valuation of our pledged investments,our ongoing ability to borrow under our repurchase facilities may be limitedand our lenders may initiate margin calls in the event interest rates change orthe value of our pledged securities decline as a result of adverse changes ininterest rates or credit spreads.

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At December 31,2006, we had repurchase agreements with the following counterparties (dollarsin thousands):

| **Counterparty(2)**               | ** ** | ** ** | ** ** | **Amount  At Risk(1)** | ** ** | **Weighted Average  Maturity (Days)** | ** ** | **Weighted Average  Interest Rate** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------|------------|--------------------------------------------|------------|-----------------------------------------------|------------|
| Bear  Stearns & Co. Inc. |       | $          | 127,231    |                        |       | 17                                         |       |                                          |       | 5.64 | % |   |
| Citigroup Global  Markets Ltd     |       | 60,950     |       |                        | 24         |                                       |       |                                          | 5.42       |   |   |
| Credit Suisse  First Boston LLC.  |       | 46,867     |       |                        | 18         |                                       |       |                                          | 5.38       |   |   |
| Deutsche Bank AG                  |       | 363        |       |                        | 18         |                                       |       |                                          | 6.45       |   |   |
| J. P. Morgan  Chase Bank, N.A     |       | 8,840      |       |                        | 7          |                                       |       |                                          | 5.93       |   |   |
| Total                             |       | $          | 244,251    |                        |       |                                       |       |                                          |       |   |   |   |

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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 2006 our$275.0 million secured revolving credit facility matured and was replaced witha $375.0 million three year senior secured revolving credit facility. During September 2006,the facility was amended to increase the total commitment amount to $800.0 millionwith the option to further increase the commitment amount to $900.0 million atany time so long as no default or event of default on the facility has occurredand subject to addition of new lenders, increases in the commitments ofexisting lenders, or a combination thereof. The new senior secured revolvingcredit facility matures in June 2009 and consists of two tranches. Outstandingborrowings under the senior secured revolving credit facility bear interest ateither (i) an alternate base rate per annum equal to the greater of (a) theprime rate in effect on such day, and (b) the federal funds in effect onsuch day plus 0.50%, or (ii) an interest rate per annum equal to the LIBORrate for the applicable interest period plus 0.50% for borrowings under trancheA of the facility and 0.75% for borrowings under tranche B of the facility. Asof December 31, 2006, we had $34.7 million in borrowings outstanding undertranche B of this facility.

*Junior SubordinatedNotes*

During March 2006, we formed KKR FinancialCapital Trust I (“Trust I”) for the sole purpose of issuing trust preferredsecurities. On March 28, 2006, Trust I issued preferred securities tounaffiliated investors for gross proceeds of $50.0 million and commonsecurities to us for $1.6 million. The combined proceeds were invested by TrustI in $51.6 million of junior subordinated notes issued by us. The juniorsubordinated notes are the sole assets of Trust I and mature on April 30,2036, but are callable on or after April 30, 2011. Interest is payablequarterly at a fixed rate of 7.64% through March 2016 and thereafter at afloating rate equal to three-month LIBOR plus 2.65%.

During June 2006, we formed KKR Financial CapitalTrust II (“Trust II”) for the sole purpose of issuing trust preferredsecurities. On June 2, 2006, Trust II issued preferred securities tounaffiliated investors for gross proceeds of $50.0 million and commonsecurities to the Company for $1.6 million. The combined proceeds were investedby Trust II in $51.6 million of junior subordinated notes issued by us. Thejunior subordinated notes are the sole assets of Trust II and mature on July 30,2036, but are callable on or after July 30, 2011. Interest is payablequarterly at a fixed rate of 8.09% through July 2016 and thereafter at afloating rate equal to three-month LIBOR plus 2.65%.

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During August 2006, we formed KKR FinancialCapital Trust III (“Trust III”) for the sole purpose of issuing trust preferredsecurities. On August 10, 2006, Trust III issued preferred securities tounaffiliated investors for gross proceeds of $85.0 million and commonsecurities to the Company for $2.6 million. The combined proceeds were investedby Trust III in $87.6 million of junior subordinated notes issued by us. Thejunior subordinated notes are the sole assets of Trust III and mature on October 30,2036, but are callable on or after October 30, 2011. Interest is payablequarterly at a floating rate equal to three-month LIBOR plus 2.35%.

During September 2006, we formed KKR FinancialCapital Trust IV (“Trust IV”) for the sole purpose of issuing trust preferredsecurities. On September 15, 2006, Trust IV issued preferred securities tounaffiliated investors for gross proceeds of $15.0 million and commonsecurities to the Company for $0.5 million. The combined proceeds were investedby Trust IV in $15.5 million of junior subordinated notes issued by us. Thejunior subordinated notes are the sole assets of Trust IV and mature on October 30,2036, but are callable on or after October 30, 2011. Interest is payablequarterly at a floating rate equal to three-month LIBOR plus 2.35%.

During September 2006,we formed KKR Financial Capital Trust V (“Trust V”) for the sole purpose ofissuing trust preferred securities. On September 29, 2006, Trust V issuedpreferred securities to unaffiliated investors for gross proceeds of $50.0million and common securities to the Company for $1.6 million. The combinedproceeds were invested by Trust V in $51.6 million of junior subordinated notesissued by us. The junior subordinated notes are the sole assets of Trust V andmature on October 30, 2036, but are callable on or after October 30,2011. Interest is payable quarterly at a fixed rate of 7.395% through October 2016and thereafter at a floating rate equal to three-month LIBOR plus 2.25%.

*Capital Utilizationand Leverage*

As of both December 31,2006 and December 31, 2005, we had stockholders’ equity totaling $1.7billion and our leverage was 9.1 times and 8.1 times, respectively.

*Off-Balance SheetCommitments*

As of December 31, 2006, we had committed topurchase corporate loans with aggregate commitments totaling$42.5 million. In a typical corporate loan or commercial real estate loansyndication, there is a delay between the time we are informed of our allocableportion of such loan and the actual funding of such loan.

We participate in certain contingentfinancing arrangements, including bridge facilities, whereby we are committedto provide funding at the discretion of the borrower up to a specificpredetermined amount. As of December 31, 2006 we had unfunded bridgefinancing commitments totaling $79.8 million.

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*ContractualObligations*

Thetable below summarizes our contractual obligations as of December 31,2006. The table below excludes accrued interest expenses, contractualcommitments related to our derivatives, and amounts payable under theManagement Agreement that we have with our Manager because those contracts donot 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                |       | $                                         | 4,457,089  |   | $ | 4,457,089 |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |
| CLO 2005-1  senior secured notes      |       | 773,000                                   |       | — |   |   | — |   |   |   | — |   |   | 773,000 |   |
| CLO 2005-2  senior secured notes      |       | 752,000                                   |       | — |   |   | — |   |   |   | — |   |   | 752,000 |   |
| CLO 2006-1  senior secured notes      |       | 727,500                                   |       | — |   |   | — |   |   |   | — |   |   | 727,500 |   |
| Demand loan                           |       | 41,658                                    |       | 41,658 |   |   | — |   |   |   | — |   |   | — |   |
| Secured revolving  credit facility    |       | 34,710                                    |       | 34,710 |   |   | — |   |   |   | — |   |   | — |   |
| Asset-backed  secured liquidity notes |       | 8,705,601                                 |       | 8,705,601 |   |   | — |   |   |   | — |   |   | — |   |
| Junior  subordinated notes            |       | 257,743                                   |       | — |   |   | — |   |   |   | — |   |   | 257,743 |   |
| Operating leases                      |       | 14,276                                    |       | 1,723 |   |   | 2,767 |   |   |   | 2,867 |   |   | 6,919 |   |
| Total                                 |       | $                                         | 15,763,577 |   | $ | 13,240,781 |   |   | $ | 2,767 |   |   |   | $ | 2,867 |   |   | $ | 2,517,162 |   |

 

**REIT Matters**

As of December 31, 2006, we believe that wequalified as a REIT under the provisions of the Code. The Code requires, amongother things, 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, 2006, we believe that we were in compliance with suchrequirements. As of December 31, 2006, we also believe that we met all ofthe REIT requirements regarding the ownership of our common stock and thedistributions of our taxable income. However, the sections of the Code and thecorresponding U.S. Treasury Regulations that relate to qualification and taxationas a REIT are highly technical and complex, and our qualification and taxationas a REIT depend upon our ability to meet various qualification tests imposedunder the Code (such as those described above in this subsection), includingthrough actual annual operating results, asset composition, distribution levelsand diversity of stock ownership. Accordingly, no assurance can be given thatwe have been organized and have operated, or will continue to be organized andoperate, in a manner so as to qualify or remain qualified as a REIT.

To maintain our status as a REIT for federal incometax purposes, we are required to distribute at least 90% of our REIT taxableincome for each year. In addition, for each taxable year, to avoid certainfederal excise taxes, we are required to declare and pay dividends amounting tocertain designated percentages of our taxable income by the end of such taxableyear. For the period covered by our calendar year 2006 federal tax return, we believethat we met all of the distribution requirements of a REIT. Because we expectto make distributions based on taxable income, we expect that our distributionsmay at times be more or less than our reported earnings computed in accordancewith GAAP. Total taxable income and REIT taxable income are non-GAAP financialmeasurements, and do not purport to be an alternative to reported net income(loss) determined in accordance with GAAP as a measure of operating performanceor to cash flows from operating activities determined in accordance with GAAPas a measure of liquidity.

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Total taxable income is the aggregate amount oftaxable income generated by us and by our domestic and foreign taxable REITsubsidiaries. REIT taxable income excludes the undistributed taxable income ofour domestic taxable REIT subsidiary, which is not included in REIT taxableincome until distributed to us. There is no requirement that our domestictaxable REIT subsidiary distribute its earnings to us. REIT taxable income,however, includes the taxable income of our foreign taxable REIT subsidiariesbecause we will generally be required to recognize and report their taxableincome on a current basis. These non-GAAP financial measurements areimportant because we are structured as a REIT and the Code requires that we paysubstantially all of our taxable income in the form of distributions to ourstockholders. The non-GAAP financial measurements of total taxable income andREIT taxable income are important in the determination of the amount of theminimum distributions that we must pay to our stockholders so as to comply withthe rules set forth in the Code. Because not all companies use identicalcalculations, this presentation of total taxable income and REIT taxable incomemay not be comparable to other similarly titled measures prepared and reportedby other companies. The table below reconciles the differences between reportednet income (loss) and total taxable income (loss) and REIT taxable income (loss)for the years ended December 31, 2006 and 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, 2006** | ** ** | **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** | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income (loss)**                                            |       | $                                                                        | 135,332    |                                                          | $          | 1.71                                                                                                                     |       | $ | 55,081 |   | $ | 0.92 |   | $ | (6,709 | ) | $ | (0.17 | ) |
| Interest income  and expense                                               |       | 5,509                                                                    |       | 0.07                                                          |       | 3,564                                                                                                                    |       | 0.06 |   | 11 |   | — |   |
| Share-based  compensation                                                  |       | 29,185                                                                   |       | 0.37                                                          |       | 30,246                                                                                                                   |       | 0.50 |   | (17,651 | ) | (0.43 | ) |
| Vesting of  restricted common stock                                        |       | (14,211                                                                  | )          | (0.18                                                         | )          | (238                                                                                                                     | )          | (0.00 | ) |   |   |   |   |
| Lease abandonment  expense                                                 |       | 48                                                                       |       | 0.00                                                          |       | 795                                                                                                                      |       | 0.01 |   | — |   | — |   |
| Provision for  loan losses                                                 |       | —                                                                   |       | —                                                        |       | 1,500                                                                                                                    |       | 0.02 |   | — |   | — |   |
| Foreign currency  translation gains                                        |       | (97                                                                      | )          | (0.00                                                         | )          | —                                                                                                                   |       | — |   | — |   | — |   |
| Gains on sales of  assets to affiliates                                    |       | 306                                                                      |       | 0.00                                                          |       | 3,313                                                                                                                    |       | 0.06 |   | — |   | — |   |
| Realized and  unrealized derivative gains and losses                       |       | 1,720                                                                    |       | 0.02                                                          |       | (1,697                                                                                                                   | )          | (0.03 | ) | 378 |   | 0.01 |   |
| Book/tax  difference adjustment for domestic taxable REIT subsidiary       |       | 1,683                                                                    |       | 0.02                                                          |       | 1,047                                                                                                                    |       | 0.02 |   | — |   | — |   |
| Book/tax  difference adjustment for foreign taxable REIT subsidiaries |       | (2,189                                                                   | )          | (0.02                                                         | )          | (8,892                                                                                                                   | )          | (0.15 | ) | — |   | — |   |
| Other                                                                      |       | 1,035                                                                    |       | 0.01                                                          |       | 398                                                                                                                      |       | 0.01 |   | 67 |   | — |   |
| Income tax  expense (benefit)                                              |       | 964                                                                      |       | 0.01                                                          |       | 3,144                                                                                                                    |       | 0.05 |   | (228 | ) | (0.01 | ) |
| **Total  taxable income (loss)**                                           |       | 159,285                                                                  |       | 2.01                                                          |       | 88,261                                                                                                                   |       | 1.47 |   | (24,132 | ) | (0.60 | ) |
| Undistributed  taxable (income) loss of domestic taxable REIT subsidiary   |       | (4,944                                                                   | )          | (0.06                                                         | )          | (3,480                                                                                                                   | )          | (0.06 | ) | 193 |   | — |   |
| **REIT  taxable income (loss)**                                            |       | $                                                                        | 154,341    |                                                          | $          | 1.95                                                                                                                     |       | $ | 84,781 |   | $ | 1.41 |   | $ | (23,939 | ) | $ | (0.60 | ) |
| **Number  of common shares outstanding:**                                  |       |                                                                     |       |                                                          |       |                                                                                                                     |       |   |   |   |   |   |   |
| Weighted-average  diluted common shares outstanding during the period |       | 78,948                                                                   |       |                                                          |       | 60,087                                                                                                                   |       |   |   | 39,796 |   |   |   |

 

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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 of operations, ourfinancial condition and our total taxable income and REIT taxable income. Theactual amount and timing of distributions, if any, will be at the discretion ofour board of directors and may not be in even amounts throughout our fiscalyear.

**Tax Treatment ofDistributions**

***DividendIncome***

For federal income taxpurposes, distributions declared and paid in 2006 on our common stock total$1.86 per share. No portion of the distributions is considered a return ofcapital or long term capital gain. All distributions are fully (100%) taxableas dividend 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 will berequired to treat 4.44% 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 inno event will be less than the amount of excess inclusion income.

We recommend thatstockholders discuss the tax consequences of their investment, including theproper tax treatment of any excess inclusion income with their tax advisor.

**Exemption fromRegulation 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, among other 

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things, 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 Fannie Mae, Freddie Mac, and, in the case of GinnieMae, by the U.S. government, that represents the entire beneficial interest inthe underlying pool of mortgage loans. By contrast, an agency certificate thatrepresents less than the entire beneficial interest in the underlying mortgageloans is not considered to be a qualifying real estate asset for purpose of the55% test, but constitutes a real estate-related asset for purposes of the25% 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.

In several such instances, we own all of thesecurities issued by the related securitization trust. There are no otherowners of the securities, and thus we view our investment, economically, as aninvestment in mortgage loans rather than an investment in mortgage-backedsecurities. For these transactions, we classify our entire investment as aninvestment in qualifying real estate assets for purposes of the 55% test.

In another instance, we own the most subordinate classof securities issued in the securitization, designated Class B-6,the class that is most likely to absorb losses on the related pool of mortgageloans, and we have the right to decide whether to foreclose upon defaultedmortgage loans. Thus, based on a series of no-action letters, we classify thisinvestment as an investment in qualifying real estate assets for purposes ofthe 55% test. In addition to our ownership of Class B-6 in thissecuritization, we also own all of the other subordinated classes in thesecuritization: Classes B-5, B-4, B-3, B-2, B-1and M. All of the subordinate classes could have been issued as a singlesubordinate class, but to obtain varying ratings on the classes and to increasethe liquidity of our holdings, our subordinate interest was divided intoseparate classes. Losses on the mortgage loans, to the extent they exceed theprincipal balance of the Class B-6, are allocated to Class B-6,B-5, B-4, B-3, B-2, B-1 and M, in that order. Iflosses 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 have the right to decide whether to foreclose on defaulted mortgageloans. This right continues throughout the subordinate classes, such that the ownerof the most subordinate class that is outstanding at any time has foreclosurerights. Because we own 100% of each class of subordinate securities in thisstructure, and each such class carries with it the right to foreclose if itever becomes the most subordinate class in the structure, we classify all ofthese subordinate securities as qualifying real estate assets for purposes ofthe 55% test. If we were to sell all or a portion of any of those subordinatedclasses, we would recharacterize the remaining portion of that class, togetherwith any classes senior to that class, as real estate-related assets for the25% test, rather than qualifying real estate assets for the 55% test. We own aportion of a senior class issued in this same securitization, but because it isnot a subordinated class, we do not consider it a qualifying real 

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estate asset for purposesof the 55% test, but merely a real estate-related asset for purposes of the25% test.

We will use this same analysis to determine whether toclassify investments we make in the future as qualifying real estate assets. Ifwe acquire securities that, collectively, are expected to receive all of theprincipal and interest paid on the related pool of underlying mortgage loans(less fees, such as servicing and trustee fees, and expenses of thesecuritization), and we have foreclosure rights with respect to those mortgageloans, then we will consider those securities, collectively, to be qualifyingreal estate assets. If another entity acquires any of the securities that areexpected to receive cash flow from the underlying mortgage loans, then we willconsider whether we have the unilateral right to foreclose on the underlyingloans and whether our investment is a first loss position to decide whether itshould be classified as a qualifying real estate asset. If we own more than onesubordinate class, then, to determine the classification of the subordinateclasses that we own other than the first loss class, we would consider whethersuch classes are contiguous with the first loss class (with no other classesabsorbing losses after the first loss class and before any other subordinateclasses that we own), whether we own the entire amount of each such class andwhether we would continue to have the unilateral right to foreclose inconnection with each such class if the more subordinate classes were no longeroutstanding. If the answers to any of these questions is no, then we would notclassify that particular class, or classes senior to that class, as a qualifyingreal estate asset.

To the extent that our investments in mortgage-backedsecurities do not constitute qualifying real estate assets for the 55% test,they will be classified as real estate-related assets for purposes of the25% test. We do not expect that our investments in corporate leveraged loans orhigh yield corporate bonds will constitute qualifying real estate or realestate-related assets. Instead, they will constitute miscellaneousassets, which can constitute no more than 20% of our assets.

We believe that we have satisfied the tests withrespect to our assets, measured on an unconsolidated basis, since the firstanniversary of our initial private placement of our common stock in August 2004.It is not entirely 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.

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**Quantitative andQualitative Disclosures About Market Risk**

*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. Interest rates on our floating rate investments and ourvariable rate borrowings do not reset on the same day or with the samefrequency and, as a result, we are exposed to basis risk with respect to indexreset frequency. Our floating rate investments may reprice on indices that aredifferent than the indices that are used to price our variable rate borrowingsand, as a result, we are exposed to basis risk with respect to repricing index.The basis risks noted above, in addition to other forms of basis risk thatexist between our investments and borrowings, may be material and couldnegatively impact future net interest margins. 

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 generally fundour fixed rate and our hybrid investments with short-term variable rateborrowings and we may use interest rate derivatives to hedge the variability ofthe cash flows associated with our existing or forecasted variable rateborrowings. Hedging activities are complex and accounting for interest ratederivatives as fair value or cash flow hedges in accordance with SFAS No. 133is difficult. We may not be able to execute certain hedging strategies becausewe are a REIT and there are complex rules regarding how our hedges impactour compliance with 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 terminated

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any of the interest ratederivatives or it may negatively impact our future earnings if we have toincrease our interest rate derivative positions because the average lives ofour 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 ARM loanand security investments.

The table below presentsan approximation of the sensitivity of the market value of our residentialmortgage loan and security portfolio and our portfolio of interest ratederivatives excluding those designated as fair value hedges under SFASNo. 133, 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 duration.Positive portfolio duration indicates that the market value of the totalportfolio will decline if interest rates rise and increase if interest ratesdecline. Negative portfolio duration indicates that the market value of thetotal portfolio will decline if interest rates decline and increase if interestrates rise. The closer duration is to zero, the less interest rate changes areexpected to affect the market value of our residential mortgage loan andsecurity portfolio and our investments. Included in the table is a base case durationcalculation for an interest rate scenario that assumes future rates are thoseimplied by the yield curve as of December 31, 2006. The other fourscenarios assume interest rates are instantaneously 50 and 100 basis pointslower and 50 and 100 basis points higher than those implied by the yield curveas of December 31, 2006. For purposes of ARM loans and securities thecalculation includes the use of an industry recognized prepayment model,whereas for purposes of hybrid loans and securities the calculation utilizesprepayment estimates determined by management.

**NetPortfolio DurationDecember 31, 2006**

| ** **                                        | ** ** | **Base Case** | ** ** | **Parallel **-50 bps | ** ** | **Parallel **-100 bps | ** ** | **Parallel +50 bps** | ** ** | **Parallel +100 bps** | ** ** |
|---------------------------------------------------|------------|--------------------|------------|--------------------------------|------------|---------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| Residential mortgage  assets:                     |       |               |       |                           |       |                            |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| ARM loans and  securities                         |       |               | 0.07       |                           |       |                            | 0.04       |                           |       |                            | 0.01       |   |   |   | 0.12 |   |   |   | 0.18 |   |   |
| Hybrid loans and  securities                      |       |               | 1.93       |                           |       |                            | 1.89       |                           |       |                            | 1.86       |   |   |   | 1.93 |   |   |   | 1.92 |   |   |
| Total residential  assets                         |       |               | 0.84       |                           |       |                            | 0.83       |                           |       |                            | 0.82       |   |   |   | 0.83 |   |   |   | 0.83 |   |   |
| Interest rate  swaptions                          |       |               | (0.26      | )                              |       |                            | (0.27      | )                              |       |                            | (0.29      | ) |   |   | (0.25 | ) |   |   | (0.25 | ) |   |
| Amortizing  interest rate swaps and corridor |       |               | (1.49      | )                              |       |                            | (1.53      | )                              |       |                            | (1.52      | ) |   |   | (1.41 | ) |   |   | (1.33 | ) |   |
| Net portfolio duration                            |       |               | 0.15       |                           |       |                            | 0.12       |                           |       |                            | 0.10       |   |   |   | 0.15 |   |   |   | 0.16 |   |   |

 

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 $4.1 billion and$140.7 million, respectively, as of December 31, 2006. Changes inassumptions including, but not limited to, volatility, mortgage spreads,prepayment behavior and defaults, as well as the timing and level of interestrate changes, will affect the results of the model. Therefore, actual resultsare likely to vary from modeled results.

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.

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The use of interest ratederivatives is a critical part of our interest risk management strategy. Thetable below summarizes the contractual notional balance of our amortizinginterest rate swaps and interest rate corridor as of December 31, 2006,and for each of the following five years then ended.

**HedgeInstruments Notional Amounts(Amounts in millions)**

| ** **               | ** ** | **As of December 31,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
| Interest rate  swaps     |       | $                                     | 4,600      |   | $ | 3,446 |   | $ | 2,117 |   | $ | 1,200 |   | $ | 182 |   |
| Interest rate  corridors |       | 702                                   |       | 755 |   | 715 |   | — |   | — |   |
| Total                    |       | $                                     | 5,302      |   | $ | 4,201 |   | $ | 2,832 |   | $ | 1,200 |   | $ | 182 |   |

 

The following tablesummarizes the estimated net fair value of our derivative instruments held at December 31,2006 and December 31, 2005 (amounts in thousands):

**DerivativeFair Value**

| ** **                      | ** ** | **As of  December 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**           |       |                                        |       |                                        |       |   |   |   |   |
| Interest rate corridors         |       |                                        | $          | 13,591                                      |       |   |   | $ | 14,762 |   |   |
| Interest rate swaps             |       |                                        | 45,314     |                                        |       |   | 40,796 |   |   |
| **Fair Value Hedges:**          |       |                                        |       |                                        |       |   |   |   |   |
| Interest rate swaps             |       |                                        | 13         |                                        |       |   | — |   |   |
| **Free-Standing  Derivatives:** |       |                                        |       |                                        |       |   |   |   |   |
| Interest rate swaptions         |       |                                        | 75         |                                        |       |   | 879 |   |   |
| Interest rate swaps             |       |                                        | —     |                                        |       |   | 198 |   |   |
| Credit default swaps            |       |                                        | (618       | )                                           |       |   | 71 |   |   |
| Total rate of return swaps      |       |                                        | 2,343      |                                        |       |   | 727 |   |   |
| Net fair value                  |       |                                        | $          | 60,718                                      |       |   |   | $ | 57,433 |   |   |

 

*Risk Management*

To the extentconsistent with maintaining our REIT status, we seek to manage our interestrate risk exposure to protect our investment portfolio and related borrowingsagainst the effects of major interest rate changes. We generally seek to manageour 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

·       Using interest ratederivatives to adjust the interest rate sensitivity of our investment portfolioand our borrowings.

**Item 7A.**                Quantitativeand Qualitative 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.

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**Item 8.**                        FinancialStatements and Supplementary Data

Our consolidated financialstatements and the related notes to the consolidated financial statements,together with the Report of Independent Registered Public Accounting Firmthereon, are set forth on pages F-1 through F-43 in thisAnnual Report on Form 10-K.

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

None.

**Item 9A.**                Controlsand Procedures

**Disclosure Controlsand Procedures**

We have carried out anevaluation, under the supervision and with the participation of our managementincluding our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures, as that term is defined in Rules 13a-15(e) under the SecuritiesExchange Act of 1934, as amended, as of December 31, 2006. Based on thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective.

**Management’s Annualreport on Internal Control over Financial Reporting**

Management is responsible for establishing andmaintaining adequate internal control over financial reporting as such term isdefined in Rule 13a-15(f) under the Securities Exchange Act of1934, as amended. Under the supervision and with the participation ofmanagement, including the Chief Executive Officer and Chief Financial Officer,we assessed the effectiveness of our internal control over financial reportingas of December 31, 2006. In making this assessment, we used the criteriaset forth by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO) in *Internal Control—IntegratedFramework*. Based on our assessment under the framework in *Internal Control—Integrated Framework*, we concluded that ourinternal control over financial reporting was effective as of December 31,2006. Our assessment of the effectiveness of internal control over financialreporting as of December 31, 2006 has been audited by Deloitte &Touche LLP, an independent registered public accounting firm, as stated intheir report which is included herein.

Management’s Report onInternal Control Over Financial Reporting and the Report of IndependentRegistered Public Accounting Firm are included in “Item 8—Financial Statementsand Supplementary Data.”

**Changes in InternalControl Over Financial Reporting**

During the quarter ended December 31,2006, there has been no change in our internal control over financial reportingthat has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

**Item 9B. OtherInformation**

None.

76

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**PART III**

**Item10.**                 Directors,Executive Officers and Corporate Governance

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, 2006.

**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, 2006.

**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 after December 31,2006.

**Item13.**                 CertainRelationships and Related Transactions, and Director Independence

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, 2006.

**Item 14.**                 PrincipalAccountants Fees and Services

The information required by Item 14 isincorporated herein by reference to the Proxy Statement to be filed with theSEC Pursuant to Regulation 14A within 120 days after December 31,2006.

77

----

**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedules

**Documents filed aspart of this report:**

**1. and 2. FinancialStatements and Schedules**

Allfinancial statement schedules are omitted because of the absence of conditionsunder which they are required or because the required information is includedin our consolidated financial statements or notes thereto, included in Part II,Item 8, of this Annual Report on Form 10-K.

**3. Exhibit Index:**
| Exhibit Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Description** |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 2.1                 |       | Agreement and Plan of  Merger dated as of February 9, 2007 among the Registrant, KKR Financial  Holdings LLC and KKR Financial Merger Corp. (incorporated by reference to the  Registration Statement on Form S-4 (Registration No. 333-140586) and any  subsequent amendments thereto. Such Registration Statement was originally  filed with the Securities and Exchange Commission on February 9, 2007.) |
| 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 (incorporated by reference to the Form 8-K  filed with the Securities and Exchange Commission on February 1, 2007)                                                                                                                                                                                                                                           |
| 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.                                                                                                                                                                                                                                                           |
| 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.                                                                                                                                                                |

78

----

 
| 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                                                                                                              |
| 23.1** |   | Consent of  Deloitte & Touche LLP                                                                                                                |
| 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 on April 15,2005.

**             Filed herewith.

79

----

**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, 2006, 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* |
|        |                      |  |  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this Annual Report on Form 10-K has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.
|                           | **Signature** | ** **                                    | ** ** | ** **             | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------|---------------|-----------------------------------------------|------------|------------------------|-----------|------------|------------|------------|----------|------------|
| /s/ SATURNINO  S. FANLO   |          | Chief Executive Officer  and Director         |       | February 23, 2007 |
| Saturnino S. Fanlo        |          | (Principal  Executive Officer)                |       |                   |
| /s/ JEFFREY B.  VAN HORN  |          | Chief Financial Officer                       |       | February 23, 2007 |
| Jeffrey B. Van Horn       |          | (Principal  Financial and Accounting Officer) |       |                   |
| /s/ PAUL M.  HAZEN        |          | Chairman and Director                         |       | February 23, 2007 |
| Paul M. Hazen             |          |                                          |       |                   |
| /s/ WILLIAM F.  ALDINGER  |          | Director                                      |       | February 23, 2007 |
| William F. Aldinger       |          |                                          |       |                   |
| /s/ TRACY  COLLINS        |          | Director                                      |       | February 23, 2007 |
| Tracy Collins             |          |                                          |       |                   |
| /s/ KENNETH M.  DEREGT    |          | Director                                      |       | February 23, 2007 |
| Kenneth M. deRegt         |          |                                          |       |                   |
| /s/ VINCENT  PAUL FINIGAN |          | Director                                      |       | February 23, 2007 |
| Vincent Paul Finigan      |          |                                          |       |                   |

80

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| /s/ R. GLENN HUBBARD    |   | Director |   | February 23,  2007 |
|-------------------------|--------|----------|--------|-------------------------|
| R. Glenn Hubbard        |   |     |   |                    |
| /s/ ROSS J.  KARI       |   | Director |   | February 23, 2007  |
| Ross J. Kari            |   |     |   |                    |
| /s/ ELY L.  LICHT       |   | Director |   | February 23, 2007  |
| Ely L. Licht            |   |     |   |                    |
| /s/ DEBORAH H.  MCANENY |   | Director |   | February 23, 2007  |
| Deborah H. McAneny      |   |     |   |                    |
| /s/ SCOTT C.  NUTTALL   |   | Director |   | February 23, 2007  |
| Scott C. Nuttall        |   |     |   |                    |
| /s/ WILLY  STROTHOTTE   |   | Director |   | February 23, 2007  |
| Willy Strothotte        |   |     |   |                    |

 

81

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**KKRFINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATEDFINANCIAL STATEMENTS**

**AND**

**REPORTSOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

For Inclusion in Form 10-K

Filed with

Securities and ExchangeCommission

December 31, 2006

F-1

----

**KKRFINANCIAL CORP. AND SUBSIDIARIES**

**Indexto Consolidated Financial Statements**

|                                                                        | ** ** | **Page** | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|
| Management’s Report on  Internal Control over Financial Reporting |       |     | F-3        |   |   |
| Reports of Independent Registered Public Accounting  Firm              |       |     | F-4        |   |   |
| Consolidated  Balance Sheets                                           |       |     | F-7        |   |   |
| Consolidated  Statements of Operations                                 |       |     | F-8        |   |   |
| Consolidated  Statements of Changes in Stockholders’ Equity       |       |     | F-9        |   |   |
| Consolidated  Statements of Cash Flows                                 |       |     | F-10       |   |   |
| Notes to Consolidated Financial  Statements                            |       |     | F-11       |   |   |

 

F-2

----

**MANAGEMENT’S REPORTON INTERNAL CONTROL OVER FINANCIAL REPORTING**

The management of KKR Financial Corp. (the “Company”)is responsible for establishing and maintaining adequate internal control overfinancial reporting. The Company’s internal control system was designed toprovide reasonable assurance to the Company’s management and Board of Directorsregarding the preparation and fair presentation of published financialstatements.

Management assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2006, basedon the framework set forth by the Committee of Sponsoring Organizations of theTreadway Commission (COSO) in *InternalControl—Integrated Framework*. Based on that assessment, managementconcluded that, as of December 31, 2006, the Company’s internal controlover financial reporting was effective.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

TheCompany’s independent auditors, Deloitte & Touche LLP, an independentregistered public accounting firm, have issued an audit report on ourassessment of the Company’s internal control over financial reporting and theirreport follows.
| /s/ SATURNINO  S. FANLO   |   |
|---------------------------|--------|
| Saturnino S. Fanlo        |   |
| *Chief Executive Officer* |   |
| February 23, 2007    |   |

 
| /s/ JEFFREY  B. VAN HORN  |   |
|---------------------------|--------|
| Jeffrey B. Van Horn       |   |
| *Chief Financial Officer* |   |
| February 23, 2007    |   |

 

F-3

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that KKR Financial Corp. and subsidiaries (the “Company”) maintainedeffective internal control over financial reporting as of December 31,2006, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.The Company’s management is responsible for maintaining effective internalcontrol over financial reporting, and for its assessment of the effectivenessof internal control over financial reporting. Our responsibility is to expressan opinion on management’s assessment, and an opinion on the effectiveness ofthe Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on the criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission. Also in our opinion, theCompany maintained, in all material respects, effective internal control overfinancial reporting as of December 31, 2006, based on the criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission.

F-4

----

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated financial statements as of and for the yearended December 31, 2006 of the Company and our report dated February 23,2007 expressed an unqualified opinion on those financial statements.
| /s/ DELOITTE & TOUCHE  LLP |   |
|-------------------------------------|--------|
| San Francisco, California           |
| February 23, 2007                   |

 

F-5

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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 31,2006 and 2005, and the related consolidated statements of operations, changesin stockholders’ equity, and cash flows for the years ended December 31,2006 and 2005 and the period from August 12, 2004 (inception) throughDecember 31, 2004. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of the Companyat December 31, 2006 and 2005, and the results of its operations and itscash flows for the years ended December 31, 2006 and 2005 and the periodfrom August 12, 2004 (inception) through December 31, 2004, inconformity with accounting principles generally accepted in the United Statesof America.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2006, basedon the criteria established in Internal Control—Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission and ourreport dated February 23, 2007 expressed an unqualified opinion onmanagement’s assessment of the effectiveness of the Company’s internal controlover financial reporting and an unqualified opinion on the effectiveness of theCompany’s internal control over financial reporting.
| /s/ DELOITTE & TOUCHE LLP |   |
|------------------------------------|--------|
| San Francisco, California          |
| February 23, 2007                  |

 

F-6

----

**KKR Financial Corp. and SubsidiariesConsolidated Balance Sheets(Amounts in thousands, except share information)**

| ** **                                                                                                                                                                                                    | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                    | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                    |       | $                           | 5,125      |                        | $          | 16,110 |   |
| Restricted cash  and cash equivalents                                                                                                                                                                         |       | 138,065                     |       | 80,223                      |       |
| Securities  available-for-sale, $8,336,435 and $5,910,399 pledged as  collateral as of December 31, 2006 and December 31, 2005,  respectively                                                  |       | 8,500,636                   |       | 6,149,506                   |       |
| Loans, net of  allowance for loan losses of $1,500 as of December 31, 2006 and  December 31, 2005                                                                                                   |       | 8,442,021                   |       | 8,846,341                   |       |
| Derivative assets                                                                                                                                                                                             |       | 63,433                      |       | 58,898                      |       |
| Interest  receivable                                                                                                                                                                                          |       | 84,048                      |       | 59,993                      |       |
| Principal  receivable                                                                                                                                                                                         |       | 4,540                       |       | 7,108                       |       |
| Non-marketable  equity securities                                                                                                                                                                             |       | 166,323                     |       | 52,500                      |       |
| Investment in  unconsolidated affiliate                                                                                                                                                                       |       | 104,035                     |       | —                      |       |
| Other assets                                                                                                                                                                                                  |       | 56,951                      |       | 19,861                      |       |
| **Total assets**                                                                                                                                                                                              |       | $                           | 17,565,177 |                        | $          | 15,290,540 |   |
| **Liabilities**                                                                                                                                                                                               |       |                        |       |                        |       |
| Repurchase  agreements                                                                                                                                                                                        |       | $                           | 4,457,089  |                        | $          | 9,761,258 |   |
| Collateralized  loan obligation senior secured notes                                                                                                                                                          |       | 2,252,500                   |       | 1,500,000                   |       |
| Asset-backed  secured liquidity notes                                                                                                                                                                         |       | 8,705,601                   |       | 2,008,069                   |       |
| Secured revolving  credit facility                                                                                                                                                                            |       | 34,710                      |       | 54,000                      |       |
| Secured demand  loan                                                                                                                                                                                          |       | 41,658                      |       | 40,511                      |       |
| Junior  subordinated notes                                                                                                                                                                                    |       | 257,743                     |       | —                      |       |
| Payable for  securities purchases                                                                                                                                                                             |       | —                      |       | 196,315                     |       |
| Accounts payable,  accrued expenses and other liabilities                                                                                                                                                     |       | 45,237                      |       | 45,925                      |       |
| Accrued interest  payable                                                                                                                                                                                     |       | 36,991                      |       | 21,415                      |       |
| Related party  payable                                                                                                                                                                                        |       | 6,901                       |       | 3,673                       |       |
| Income tax  liabilities                                                                                                                                                                                       |       | 601                         |       | 2,763                       |       |
| Derivative  liabilities                                                                                                                                                                                       |       | 2,715                       |       | 1,465                       |       |
| **Total liabilities**                                                                                                                                                                                         |       | 15,841,746                  |       | 13,635,394                  |       |
| **Stockholders’ Equity**                                                                                                                                                                                 |       |                        |       |                        |       |
| Preferred stock,  $0.01 par value, 50,000,000 shares authorized and none issued and outstanding  at December 31, 2006 and December 31, 2005                                                         |       | —                      |       | —                      |       |
| Common stock,  $0.01 par value, 250,000,000 shares authorized and 80,464,713 shares issued and  outstanding at December 31, 2006 and 80,374,061 shares issued and  outstanding at December 31, 2005 |       | 805                         |       | 804                         |       |
| Additional paid-in-capital                                                                                                                                                                                    |       | 1,670,330                   |       | 1,639,996                   |       |
| Accumulated other  comprehensive income                                                                                                                                                                       |       | 70,520                      |       | 18,344                      |       |
| Accumulated  deficit                                                                                                                                                                                          |       | (18,224                     | )          | (3,998                      | )          |
| **Total stockholders’ equity**                                                                                                                                                                           |       | 1,723,431                   |       | 1,655,146                   |       |
| **Total  liabilities and stockholders’ equity**                                                                                                                                                          |       | $                           | 17,565,177 |                        | $          | 15,290,540 |   |

 

See notes to consolidated financial statements.

F-7

----

**KKR Financial Corp. and SubsidiariesConsolidated Statements of Operations(Amounts in thousands, except per share information)**

| ** **                                                                                          | ** ** | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** | **For the Period from  August 12, 2004  (Inception) through  December 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| **Net investment income:**                                                                          |       |                                             |       |                                             |       |                                                                                                                     |       |   |   |   |   |   |   |
| Securities interest  income                                                                         |       |                                             | $          | 404,957                                          |       |                                                                                                                     |       | $ | 186,510 |   |   |   | $ | 2,715 |   |   |
| Loan interest income                                                                                |       |                                             | 533,037    |                                             |       |                                                                                                                     | 206,663    |   |   |   | 1,914 |   |   |
| Dividend income                                                                                     |       |                                             | 3,656      |                                             |       |                                                                                                                     | 3,421      |   |   |   | 296 |   |   |
| Other interest income                                                                               |       |                                             | 8,387      |                                             |       |                                                                                                                     | 3,335      |   |   |   | 3,197 |   |   |
| Total investment income                                                                             |       |                                             | 950,037    |                                             |       |                                                                                                                     | 399,929    |   |   |   | 8,122 |   |   |
| Interest expense                                                                                    |       |                                             | (741,680   | )                                                |       |                                                                                                                     | (279,718   | ) |   |   | (975 | ) |   |
| Provision for loan  losses                                                                          |       |                                             | —     |                                             |       |                                                                                                                     | (1,500     | ) |   |   | — |   |   |
| Net investment income                                                                               |       |                                             | 208,357    |                                             |       |                                                                                                                     | 118,711    |   |   |   | 7,147 |   |   |
| **Other income (loss):**                                                                            |       |                                             |       |                                             |       |                                                                                                                     |       |   |   |   |   |   |   |
| Net realized and  unrealized gain (loss) on derivatives and foreign exchange                        |       |                                             | 4,448      |                                             |       |                                                                                                                     | 113        |   |   |   | (570 | ) |   |
| Net realized gain on  investments                                                                   |       |                                             | 10,585     |                                             |       |                                                                                                                     | 4,117      |   |   |   | 75 |   |   |
| Fee and other income                                                                                |       |                                             | 5,722      |                                             |       |                                                                                                                     | 3,330      |   |   |   | 7 |   |   |
| Total other income  (loss)                                                                          |       |                                             | 20,755     |                                             |       |                                                                                                                     | 7,560      |   |   |   | (488 | ) |   |
| **Non-investment expenses:**                                                                        |       |                                             |       |                                             |       |                                                                                                                     |       |   |   |   |   |   |   |
| Related party management  compensation                                                              |       |                                             | 65,298     |                                             |       |                                                                                                                     | 50,791     |   |   |   | 11,222 |   |   |
| Professional services                                                                               |       |                                             | 4,904      |                                             |       |                                                                                                                     | 4,121      |   |   |   | 901 |   |   |
| Loan servicing expense                                                                              |       |                                             | 14,750     |                                             |       |                                                                                                                     | 5,143      |   |   |   | — |   |   |
| Insurance expense                                                                                   |       |                                             | 909        |                                             |       |                                                                                                                     | 975        |   |   |   | 335 |   |   |
| Directors expenses                                                                                  |       |                                             | 1,486      |                                             |       |                                                                                                                     | 1,071      |   |   |   | 341 |   |   |
| General and  administrative expenses                                                                |       |                                             | 11,191     |                                             |       |                                                                                                                     | 5,945      |   |   |   | 797 |   |   |
| Total non-investment  expenses                                                                      |       |                                             | 98,538     |                                             |       |                                                                                                                     | 68,046     |   |   |   | 13,596 |   |   |
| Income (loss) before  equity in income of unconsolidated affiliate and income tax expense (benefit) |       |                                             | 130,574    |                                             |       |                                                                                                                     | 58,225     |   |   |   | (6,937 | ) |   |
| Equity in income of  unconsolidated affiliate                                                       |       |                                             | 5,722      |                                             |       |                                                                                                                     | —     |   |   |   | — |   |   |
| Income (loss) before  income tax expense (benefit)                                                  |       |                                             | 136,296    |                                             |       |                                                                                                                     | 58,225     |   |   |   | (6,937 | ) |   |
| Income tax expense  (benefit)                                                                       |       |                                             | 964        |                                             |       |                                                                                                                     | 3,144      |   |   |   | (228 | ) |   |
| Net income (loss)                                                                                   |       |                                             | $          | 135,332                                          |       |                                                                                                                     |       | $ | 55,081 |   |   |   | $ | (6,709 | ) |   |
| Net income (loss) per  common share:                                                                |       |                                             |       |                                             |       |                                                                                                                     |       |   |   |   |   |   |   |
| Basic                                                                                               |       |                                             | $          | 1.73                                             |       |                                                                                                                     |       | $ | 0.93 |   |   |   | $ | (0.17 | ) |   |
| Diluted                                                                                             |       |                                             | $          | 1.71                                             |       |                                                                                                                     |       | $ | 0.92 |   |   |   | $ | (0.17 | ) |   |
| Weighted-average  number of common shares outstanding:                                              |       |                                             |       |                                             |       |                                                                                                                     |       |   |   |   |   |   |   |
| Basic                                                                                               |       |                                             | 78,166     |                                             |       |                                                                                                                     | 58,998     |   |   |   | 39,796 |   |   |
| Diluted                                                                                             |       |                                             | 78,948     |                                             |       |                                                                                                                     | 60,087     |   |   |   | 39,796 |   |   |
| Distributions declared per common share                                                             |       |                                             | $          | 1.86                                             |       |                                                                                                                     |       | $ | 0.97 |   |   |   | $ | — |   |   |

 

See notes to consolidated financial statements.

F-8

----

**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 |   |   |
| Net income                                                                                                   |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | —     |                                  |       |                                  | —     |   |   |   | 135,332 |   |   |   | $ | 135,332 |   |   |   | 135,332 |   |   |
| Net change in  unrealized gain on cash flow hedges                                                           |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | —     |                                  |       |                                  | 5,287      |   |   |   | — |   |   |   | 5,287 |   |   |   | 5,287 |   |   |
| Net change in  unrealized gain on securities  available-for-sale                                             |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | —     |                                  |       |                                  | 38,991     |   |   |   | — |   |   |   | 38,991 |   |   |   | 38,991 |   |   |
| Net change in  unrealized gain on securities  available-for-sale from investment in unconsolidated affiliate |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | —     |                                  |       |                                  | 7,898      |   |   |   | — |   |   |   | 7,898 |   |   |   | 7,898 |   |   |
| Comprehensive  income                                                                                        |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | —     |                                  |       |                                  | —     |   |   |   | — |   |   |   | $ | 187,508 |   |   |   |   |   |   |
| Cash distributions  on common stock                                                                          |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | —     |                                  |       |                                  | —     |   |   |   | (149,558 | ) |   |   |   |   |   |   | (149,558 | ) |   |
| Exercise of common  stock options by Manager                                                                 |       |                              | 58         |                                  |       |                             | 1          |                                          |       |                     | 1,149      |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 1,150 |   |   |
| Grant of  restricted common stock to Directors                                                               |       |                              | 33         |                                  |       |                             | —     |                                          |       |                     | 163        |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 163 |   |   |
| Amortization of  restricted common stock                                                                     |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | 28,352     |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 28,352 |   |   |
| Amortization of  common stock options                                                                        |       |                              | —     |                                  |       |                             | —     |                                          |       |                     | 670        |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 670 |   |   |
| **Balance  at December 31, 2006**                                                                       |       |                              | 80,465     |                                  |       |                             | $          | 805                                           |       |                     |       | $                                     | 1,670,330  |                                  |       |   | $ | 70,520 |   |   |   | $ | (18,224 | ) |   |   |   |   |   |   | $ | 1,723,431 |   |   |

 

See notes to consolidatedfinancial statements.

F-9

----

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

| ** **                                                                                | ** ** | **Year ended  December 31, 2006** | ** **   | **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)                                                                         |       |                                             | $            | 135,332                                          |       |                                                                                                                     |         | $ | 55,081 |   |   |   | $ | (6,709 | ) |   |
| Adjustments to reconcile net income (loss) to net cash  provided by operating activities: |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Net realized and  unrealized (gain) loss on derivatives                                   |       |                                             | (3,191       | )                                                |       |                                                                                                                     | (851         | ) |   |   | 527 |   |   |
| Realized gain on  equity shorts                                                           |       |                                             | (52          | )                                                |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Net realized and  unrealized gain on foreign exchange                                     |       |                                             | (1,257       | )                                                |       |                                                                                                                     | (68          | ) |   |   | — |   |   |
| Provision for loan  losses                                                                |       |                                             | —       |                                             |       |                                                                                                                     | 1,500        |   |   |   | — |   |   |
| Share-based  compensation                                                                 |       |                                             | 29,185       |                                             |       |                                                                                                                     | 30,246       |   |   |   | 6,226 |   |   |
| Net gain on sale  of securities available-for-sale                                        |       |                                             | (5,745       | )                                                |       |                                                                                                                     | (2,667       | ) |   |   | — |   |   |
| Net gain on sale  of loans                                                                |       |                                             | (4,840       | )                                                |       |                                                                                                                     | (1,450       | ) |   |   | — |   |   |
| Depreciation and  amortization                                                            |       |                                             | 4,952        |                                             |       |                                                                                                                     | 10,634       |   |   |   | 81 |   |   |
| Deferred income  tax expense (benefit)                                                    |       |                                             | (1           | )                                                |       |                                                                                                                     | 925          |   |   |   | (228 | ) |   |
| Equity in income  of unconsolidated affiliate                                             |       |                                             | (5,722       | )                                                |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Changes in assets and liabilities:                                                        |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Interest  receivable                                                                      |       |                                             | (27,791      | )                                                |       |                                                                                                                     | (57,621      | ) |   |   | (2,694 | ) |   |
| Other assets                                                                              |       |                                             | (1,468       | )                                                |       |                                                                                                                     | (10,047      | ) |   |   | (710 | ) |   |
| Related party  payable                                                                    |       |                                             | 3,228        |                                             |       |                                                                                                                     | 1,908        |   |   |   | 1,765 |   |   |
| Accounts payable,  accrued expenses and other liabilities                                 |       |                                             | (2,799       | )                                                |       |                                                                                                                     | 46,833       |   |   |   | 1,157 |   |   |
| Accrued interest  payable                                                                 |       |                                             | 15,576       |                                             |       |                                                                                                                     | 20,644       |   |   |   | 771 |   |   |
| Net cash provided  by operating activities                                                |       |                                             | 135,407      |                                             |       |                                                                                                                     | 95,067       |   |   |   | 186 |   |   |
| **Cash flows from investing  activities:**                                                |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Purchase of securities  available-for-sale                                                |       |                                             | (4,928,207   | )                                                |       |                                                                                                                     | (6,279,068   | ) |   |   | (1,664,369 | ) |   |
| Principal payments on  securities available-for-sale                                      |       |                                             | 2,167,583    |                                             |       |                                                                                                                     | 1,561,034    |   |   |   | 14,813 |   |   |
| Proceeds from sale of  securities available-for-sale                                      |       |                                             | 269,381      |                                             |       |                                                                                                                     | 381,134      |   |   |   | — |   |   |
| Purchase of loans                                                                         |       |                                             | (3,118,947   | )                                                |       |                                                                                                                     | (9,219,553   | ) |   |   | (683,377 | ) |   |
| Principal payments on  loans                                                              |       |                                             | 2,445,406    |                                             |       |                                                                                                                     | 846,504      |   |   |   | 620 |   |   |
| Proceeds from sale of loans                                                               |       |                                             | 1,075,880    |                                             |       |                                                                                                                     | 207,160      |   |   |   | — |   |   |
| Purchases of  non-marketable equity securities                                            |       |                                             | (121,515     | )                                                |       |                                                                                                                     | (52,500      | ) |   |   | — |   |   |
| Proceeds from  non-marketable equity securities                                           |       |                                             | 7,692        |                                             |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Purchase of derivatives                                                                   |       |                                             | —       |                                             |       |                                                                                                                     | (1,477       | ) |   |   | — |   |   |
| Net settlements from  derivatives                                                         |       |                                             | 4,145        |                                             |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Proceeds from sale of  derivatives                                                        |       |                                             | 973          |                                             |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Net additions to  restricted cash and cash equivalents                                    |       |                                             | (57,842      | )                                                |       |                                                                                                                     | (78,902      | ) |   |   | (1,321 | ) |   |
| Purchase of leasehold  improvements and equipment                                         |       |                                             | (6,726       | )                                                |       |                                                                                                                     | (1,716       | ) |   |   | (993 | ) |   |
| Investment in  unconsolidated affiliate                                                   |       |                                             | (90,415      | )                                                |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Net cash used in  investing activities                                                    |       |                                             | (2,352,592   | )                                                |       |                                                                                                                     | (12,637,384  | ) |   |   | (2,334,627 | ) |   |
| **Cash flows from financing  activities:**                                                |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Net proceeds from  issuance of common stock                                               |       |                                             | —       |                                             |       |                                                                                                                     | 848,817      |   |   |   | 755,510 |   |   |
| Net proceeds from  exercise of common stock options                                       |       |                                             | 1,150        |                                             |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Proceeds from borrowings:                                                                 |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Repurchase  agreements                                                                    |       |                                             | 162,602,474  |                                             |       |                                                                                                                     | 116,764,832  |   |   |   | 2,285,274 |   |   |
| Asset-backed  secured liquidity notes                                                     |       |                                             | 72,403,120   |                                             |       |                                                                                                                     | 3,265,145    |   |   |   | — |   |   |
| Collateralized  loan obligation senior secured notes                                      |       |                                             | 752,500      |                                             |       |                                                                                                                     | 1,500,000    |   |   |   | — |   |   |
| Secured revolving  credit facility                                                        |       |                                             | 2,809,740    |                                             |       |                                                                                                                     | 87,000       |   |   |   | — |   |   |
| Secured demand  loan                                                                      |       |                                             | 4,996,716    |                                             |       |                                                                                                                     | 12,636       |   |   |   | 27,875 |   |   |
| Junior  subordinated notes                                                                |       |                                             | 250,000      |                                             |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Capitalized financing  Costs                                                              |       |                                             | (37,218      | )                                                |       |                                                                                                                     | (8,288       | ) |   |   | — |   |   |
| Purchase of interest rate  derivatives                                                    |       |                                             | —       |                                             |       |                                                                                                                     | (10,072      | ) |   |   | — |   |   |
| Repayments of borrowings:                                                                 |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Repurchase  agreements                                                                    |       |                                             | (167,906,643 | )                                                |       |                                                                                                                     | (108,561,848 | ) |   |   | (727,000 | ) |   |
| Asset-backed  secured liquidity notes                                                     |       |                                             | (65,691,482  | )                                                |       |                                                                                                                     | (1,261,644   | ) |   |   | — |   |   |
| Secured revolving  credit facility                                                        |       |                                             | (2,829,030   | )                                                |       |                                                                                                                     | (33,000      | ) |   |   | — |   |   |
| Secured demand  loan                                                                      |       |                                             | (4,995,569   | )                                                |       |                                                                                                                     | —       |   |   |   | — |   |   |
| Distributions on common  stock                                                            |       |                                             | (149,558     | )                                                |       |                                                                                                                     | (52,370      | ) |   |   | — |   |   |
| Net cash provided  by financing activities                                                |       |                                             | 2,206,200    |                                             |       |                                                                                                                     | 12,551,208   |   |   |   | 2,341,659 |   |   |
| **Net increase (decrease) in cash  and cash equivalents**                                 |       |                                             | (10,985      | )                                                |       |                                                                                                                     | 8,891        |   |   |   | 7,218 |   |   |
| **Cash and cash equivalents at  beginning of period**                                     |       |                                             | 16,110       |                                             |       |                                                                                                                     | 7,219        |   |   |   | 1 |   |   |
| **Cash and cash equivalents at  end of period**                                           |       |                                             | $            | 5,125                                            |       |                                                                                                                     |         | $ | 16,110 |   |   |   | $ | 7,219 |   |   |
| **Supplemental cash flow  information:**                                                  |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| Cash paid for interest                                                                    |       |                                             | $            | 1,759,435                                        |       |                                                                                                                     |         | $ | 259,074 |   |   |   | $ | 230 |   |   |
| Cash paid for taxes                                                                       |       |                                             | $            | 3,518                                            |       |                                                                                                                     |         | $ | 152 |   |   |   | $ | — |   |   |
| **Non-cash investing and  financing activities:**                                         |       |                                             |         |                                             |       |                                                                                                                     |         |   |   |   |   |   |   |
| (Receivable) Payable for  securities (sales) purchases                                    |       |                                             | $            | (1,358                                           | )          |                                                                                                                     |         | $ | 196,315 |   |   |   | $ | — |   |   |
| Issuance of restricted common stock                                                       |       |                                             | $            | 163                                              |       |                                                                                                                     |         | $ | 42,405 |   |   |   | $ | 24,178 |   |   |

 

See notes to consolidated financial statements.

F-10

----

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

**Note 1. Organization**

KKR Financial Corp., and its subsidiaries(collectively, the “Company” or “KKR Financial”), is a specialty financecompany that invests in multiple asset classes and uses leverage with theobjective of generating competitive leveraged risk-adjusted returns. TheCompany currently makes investments in the following asset classes: (i) residentialmortgage loans and mortgage-backed securities; (ii) corporate loans anddebt securities; (iii) commercial real estate loans and debt securities; (iv) asset-backedsecurities; and (v) marketable and non-marketable equity securities. TheCompany also makes opportunistic investments in other asset classes from timeto 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. (“KKR”). The Company is taxed asa real estate investment trust (“REIT”) and is required to comply with theprovisions of the Internal Revenue Code of 1986, as amended (the “Code”), withrespect thereto.

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 23, 2005, the Company effectuated a reversestock split of its common stock at a ratio of one share of common stock forevery two shares of common stock then outstanding. On June 29, 2005, theCompany completed its initial public offering (the “IPO”) of 37,500,000 sharesof common stock that generated net proceeds of approximately$848.8 million. The Company sold 37,471,250 common shares at a price of$24.00 per share and selling stockholders sold 28,750 shares in the IPO. Theaccompanying consolidated financial statements have been adjusted to giveeffect to the reverse stock split for all periods presented. The Company’sstock is listed on the New York Stock Exchange under the symbol “KFN” and begantrading on June 24, 2005.

**Note 2. Summary ofSignificant Accounting Policies**

**Basis ofPresentation**

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, certainof its taxable REIT subsidiaries, its qualified REIT subsidiaries, consolidatedresidential mortgage loan securitization trusts where the Company is theprimary beneficiary, and entities established to complete secured financingtransactions that are considered to be variable interest entities and for whichthe Company is the primary beneficiary. The Company owns a 49.9% limitedpartnership interest in KKR Financial Holdings I, L.P. (“KFH”) that isaccounted for using the equity method.

**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.

F-11

----

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

**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.

KKR Financial CLO 2005-1, Ltd. (“CLO 2005-1”),KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”), KKR Financial CLO 2006-2,Ltd. (“CLO 2006-2”), and KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”),are entities established to complete secured financing transactions. Theseentities are VIEs and are not considered to be qualifying special-purposeentities (“QSPE”) as defined by Statement of Financial Accounting Standards No. 140,*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*(“SFAS No. 140”). TheCompany has determined it is the primary beneficiary of these entities and hasincluded the accounts of these entities in these consolidated financialstatements. Additionally, the Company is the primary beneficiary of sixresidential mortgage loan securitization trusts that are not considered to beQSPEs under SFAS No. 140 and the Company has therefore included theaccounts of these entities in these consolidated financial statements.

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

**Cash and CashEquivalents**

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.

**Restricted Cash andCash 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.

**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.

F-12

----

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

The Company monitors its available-for-sale securitiesportfolio for impairments. A loss is recognized when it is determined that adecline in the estimated fair value of a security below its amortized cost isother-than-temporary. The Company considers many factors in determining whetherthe impairment of a security is deemed to be other-than-temporary, includingbut not limited to the length of time the security has had a decline inestimated fair value below its amortized cost, the amount of the unrealizedloss, the intent and ability of the Company to hold the security for a periodof time sufficient for a recovery in value, recent events specific to theissuer or industry, external credit ratings and recent 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-marketableEquity 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 below the cost basis of thesecurity 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 expected return maydecrease, the Company may elect to sell a loan held for investment due toadverse changes in credit fundamentals. Once the determination has been made bythe Company that it will no longer hold the loan for investment, the Companyaccounts for the loan at the lower of amortized cost 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, unamortized premiums and discounts are recognizedin interest income over the contractual life, adjusted for actual prepayments,of the loans using the effective interest method. For residential mortgageloans, unamortized premiums and discounts are recognized over the contractuallife, adjusted for estimated prepayments using the effective interest method.

F-13

----

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

**Allowance andProvision for Loan Losses**

The Company maintains an allowance for loan losses ata level that the Company believes is adequate based on an evaluation of knownand inherent risks related to its loan investments. When determining theadequacy of the allowance for loan losses the Company considers historical andindustry loss experience, economic conditions and trends, the estimated fairvalues of our loans, credit quality trends and other factors that the Companydetermines are relevant. 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’s allowance for loan losses consistsof an allocated component and an unallocated component. The allocated componentof our allowance for loan losses reflects our estimate of losses on individualloans and our unallocated component reflects our estimate of losses on pools orgroups of similar loans.

The Company’s investments in commercial real estate loansand corporate loans are not homogeneous and the Company individually reviewseach of the loans for impairments and uses relevant information in itsanalysis, including current estimated fair values, current valuation multiples,estimated fair values and quality of collateral, projected operating cash flowand projected liquidation cash flows. The Company considers a loan to beimpaired when, based on current information and events, the Company believes itis probable that it will be unable to collect all amounts due to it based onthe contractual terms of the loan. When a loan is impaired, the allowance forloan losses is increased by the amount of the excess of the amortized costbasis of the loan over its estimated fair value. Increases in the allowance forloan losses are recognized in the Company’s results of operations as aprovision for loan losses. When the Company makes a determination that some orall of a loan is uncollectible, the Company charges-off or writes-down the loanand the allowance for loan losses is reduced.

The Company’s 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, estimated fair values and quality of collateral, delinquencytrends and credit losses realized to-date on underlying loans. Two criticalassumptions used in estimating the loan loss reserves for the residentialmortgage loan portfolio are an assumed rate of default, which is the expectedrate at which loans go into foreclosure over their life, and an assumed rate ofloss severity, which represents the expected rate of realized loss upondisposition of the properties that have gone into foreclosure.

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 may not be paid whencontractually due; (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 decreases below the Company’s carryingvalue of such loan. While on non-accrual status, previously recognized accruedinterest is reversed and interest income is recognized only upon actual receipt.

**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 

F-14

----

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

theassets might not be recoverable. Equipment is depreciated using thestraight-line method over the estimated useful lives of the respective assetsof three years. Leasehold improvements are amortized on a straight-line basisover the shorter of their estimated useful lives or lease terms. Leaseholdimprovements and equipment, net of accumulated depreciation and amortization,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.

**Trust PreferredSecurities**

Trusts formed by theCompany for the sole purpose of issuing trust preferred securities are notconsolidated by the Company in accordance with FIN 46R as the Company hasdetermined that it is not the primary beneficiary of such trusts. The Company’sinvestment in the common securities of such trusts is included in other assetson the Company’s consolidated financial statements.

**DerivativeFinancial Instruments**

The Company recognizes all derivatives on theconsolidated balance sheet at estimated fair value. On the date the Companyenters into a derivative contract, the Company designates and documents eachderivative contract as one of the following at the time the contract isexecuted: (i) a hedge of a recognized asset or liability (“fair value”hedge); (ii) a hedge of a forecasted transaction or of the variability ofcash flows to be received or paid related to a recognized asset or liability (“cashflow” hedge); (iii) a hedge of a net investment in a foreign operation; or(iv) a derivative instrument not designated as a hedging instrument (“free-standingderivative”). For a fair value hedge, the Company records changes in theestimated fair value of the derivative and, to the extent that it is effective,changes in the fair value of the hedged asset or liability attributable to thehedged risk, in the current period earnings in the same financial statementcategory as the hedged item. For a cash flow hedge, the Company records changesin the estimated fair value of the derivative to the extent that it iseffective in other comprehensive income. The Company subsequently reclassifiesthese changes in estimated fair value to net income in the same period(s) thatthe hedged transaction affects earnings in the same financial statementcategory as the hedged item. For free-standing derivatives, the Company reportschanges in the fair values in current period non-net investment income.

The Company formallydocuments at inception its hedge relationships, including identification of thehedging instruments and the hedged items, its risk management objectives,strategy for undertaking the hedge transaction and the Company’s evaluation ofeffectiveness of its hedged transactions. Periodically, as required by SFAS No. 133,*Accounting for Derivative Instruments andHedging Activities*, as amended and interpreted (“SFAS No. 133”),the Company also formally assesses whether the derivative it designated in eachhedging relationship is expected to be and has been highly effective inoffsetting changes in estimated fair values or cash flows of the hedged itemusing either the dollar offset or the regression analysis method. 

F-15

----

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

If theCompany determines that a derivative is not highly effective as a hedge, itdiscontinues hedge accounting.

**Foreign Currency**

The Company makesinvestments in non-U.S. dollar denominated securities and loans. As a result,the Company is subject to the risk of fluctuation in the exchange rate betweenthe U.S. dollar and the foreign currency in which it makes an investment. Inorder to reduce the currency risk, the Company may hedge the applicable foreigncurrency. All investments denominated in a foreign currency are converted tothe U.S. dollar using prevailing exchange rates on the balance sheet date.Income, expenses, gains and losses on investments denominated in a foreigncurrency are converted to the U.S. dollar using the prevailing exchange rateson the dates when they are recorded. Foreign exchange gains and losses arerecorded in the consolidated statements of operations.

**ManagerCompensation**

The Management Agreementprovides for the payment of a base management fee to the Manager, as well as anincentive fee if the Company’s financial performance exceeds certainbenchmarks. See Note 12 for the specific terms of the computation andpayment of the incentive fee. The base management fee and the incentive fee areaccrued and expensed during the period for which they are earned by theManager.

**Share-Based Compensation**

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’s directorsis measured at its estimated fair value at the grant date, and is amortized andexpensed over the vesting period on a straight-line basis. Compensation costrelated to restricted common stock and common stock options issued to theManager is initially measured at estimated fair value at the grant date, and isremeasured on subsequent dates to the extent the awards are unvested. TheCompany has elected to use the graded vesting attribution method pursuant toSFAS No. 123(R) to amortize compensation expense for the restrictedcommon 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 arefulfilled. Even though the Company qualifies for federal taxation as a REIT, itmay be subject to some amount of federal, state, local and foreign taxes basedon the Company’s taxable income.

KKR TRS Holdings, Inc. (“TRSInc.”), KKR TRS Holdings, Ltd. (“TRS Ltd.”), CLO 2005-1, CLO 2005-2,CLO 2006-1, CLO 2006-2 and CDO 2005-1 are not consolidatedfor federal income tax return purposes. For financial reporting purposes,current and deferred taxes are provided for on the portion of earningsrecognized by the Company with respect to its interest in TRS Inc., adomestic taxable REIT subsidiary, because it is taxed as a regular subchapter Ccorporation under the provisions of the Code. 

F-16

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

Deferredincome tax assets and liabilities are computed based on temporary differencesbetween the GAAP consolidated financial statements and the federal income taxbasis of assets and liabilities as of each consolidated balance sheet date. TRSLtd., CLO 2005-1, CLO 2005-2, CLO 2006-1, CLO 2006-2 andCDO 2005-1, the Company’s foreign taxable REIT subsidiaries, are organizedas exempted companies incorporated with limited liability under the laws of theCayman Islands, and are generally exempt from federal and state income tax atthe corporate entity level because they restrict their activities in the UnitedStates to trading in stock and securities for their own account. Therefore,despite their status as taxable REIT subsidiaries, they generally will not besubject to corporate income tax on their earnings, and no provisions for incometaxes for the year ended December 31, 2006 were required; however, theCompany will generally be required to include their current taxable income inits calculation of REIT taxable income.

**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 AccountingPronouncements**

In February 2006, the FASB issued SFAS No. 155,*Accounting for Certain Hybrid Financial Instruments*(“SFAS No. 155”). Key provisions of SFAS No. 155 include: (1) abroad fair value measurement option for certain hybrid financial instrumentsthat contain an embedded derivative that would otherwise require bifurcation; (2) clarificationthat only the simplest separations of interest payments and principal paymentsqualify for the exception afforded to interest-only strips and principal-onlystrips from derivative accounting under paragraph 14 of SFAS No. 133*,* thereby narrowing such exception; (3) a requirementthat beneficial interests in securitized financial assets be analyzed todetermine whether they are freestanding derivatives or whether they are hybridinstruments that contain embedded derivatives requiring bifurcation; (4) clarificationthat concentrations of credit risk in the form of subordination are notembedded derivatives; and (5) elimination of the prohibition on a QSPEholding passive derivative financial instruments that pertain to beneficialinterests that are or contain a derivative financial instrument. In general,these changes will reduce the operational complexity associated withbifurcating embedded derivatives, and increase the number of beneficialinterests in securitization transactions, including interest-only strips andprincipal-only strips, required to be accounted for in accordance with SFAS No. 133.The Company is required to adopt SFAS No. 155 in the first quarter of 2007and does not expect the adoption of SFAS No. 155 to have a material impacton its consolidated financial statements.

In June 2006, the FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109* (“FIN 48”). FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement No. 109,*Accounting for Income Taxes*. FIN 48prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to be

F-17

----

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

**Note 2.Summary of Significant Accounting Policies (Continued)**

taken in a tax return. TheCompany is required to adopt FIN 48 in the first quarter of 2007 and does notexpect the adoption of FIN 48 to have a material impact on itsconsolidated financial statements.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*(“SFAS No. 157”).This statement defines fair value, establishes a framework for measuring fairvalue in GAAP and expands disclosures about fair value measurements. SFAS No. 157does not require any new fair value measurements. The Company is required toadopt SFAS No. 157 in the first quarter of 2008 and does not expect theadoption of SFAS No. 157 to have a material impact on its consolidatedfinancial statements.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB No. 108”). SAB No. 108 requiresa dual evaluation approach—evaluation of an error from both a balance sheetperspective and results of operations perspective—when quantifying andevaluating the materiality of a misstatement. The Company adopted SAB No. 108as of December 31, 2006 and the adoption of SAB No. 108 did not havea material impact on the Company’s consolidated financial statements.

In February 2007, FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities—Includingan amendment of FASB Statement No. 115*(“SFAS No. 159”).This statement permits entities to choose to measure many financial instrumentsand certain other items at fair value. The Company is required to adopt SFASNo. 159 in the first quarter of 2008 and is currently evaluating theimpact that SFAS No. 159 will have on its consolidated financialstatements.

F-18

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

**Note 3. Earnings perShare**

TheCompany calculates basic net income per common share by dividing net income forthe period by the weighted-average shares of its common stock outstandingfor the period. Diluted net income per common share takes into account theeffect of dilutive instruments, such as common stock options and unvestedrestricted common stock, but uses the average share price for the period indetermining the number of incremental shares that are to be added to theweighted-average number of shares of its common stock outstanding. Thefollowing table presents a reconciliation of basic and diluted net income percommon share for the years ended December 31, 2006 and 2005 (amounts inthousands, except per share information):

| ** **                                                                     | ** ** | **Year ended  December 31, 2006** | ** ** | **Year ended  December 31, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| **Basic:**                                                                     | ** ** |                                             | ** ** | ** **                                       |       |   | ** ** | ** ** |   |
| Net income                                                                     |       |                                             | $          | 135,332                                          | ** ** |   |   | $ | 55,081 | ** ** |   |
| Weighted-average  number of common shares outstanding                          |       |                                             | 78,166     | ** **                                       |       |   | 58,998 | ** ** |   |
| Basic net income  per common share                                             |       |                                             | $          | 1.73                                             | ** ** |   |   | $ | 0.93 | ** ** |   |
| **Diluted:**                                                                   | ** ** |                                             | ** ** | ** **                                       |       |   | ** ** | ** ** |   |
| Net income                                                                     |       |                                             | $          | 135,332                                          | ** ** |   |   | $ | 55,081 | ** ** |   |
| Weighted-average  number of common shares outstanding                          |       |                                             | 78,166     | ** **                                       |       |   | 58,998 | ** ** |   |
| Plus: Incremental  shares from assumed conversion of dilutive instruments |       |                                             | 782        | ** **                                       |       |   | 1,089 | ** ** |   |
| Adjusted  weighted-average number of common shares outstanding                 |       |                                             | 78,948     | ** **                                       |       |   | 60,087 | ** ** |   |
| Diluted net income per  common share                                           |       |                                             | $          | 1.71                                             | ** ** |   |   | $ | 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 unvested restrictedcommon stock in the diluted loss per common share calculation would reduce thenet loss per common share amount; therefore, they are considered anti-dilutive.As a result, the Company’s diluted loss per common share is equal to its basicloss per common share for such period.

F-19

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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, 2006, which are carried at estimatedfair value (amounts in thousands):

| **Description**                         | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value  Hedge  Adjustment** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------------------------------|------------|--------------------------------|------------|
| Residential  mortgage-backed securities |       | $          | 7,557,771  |                |       | $                            | 16,130     |                          |       |                                   | $          | (37,705                        | )          |   |   | $ | — |   |   | $ | 7,536,196 |   |
| Commercial  mortgage-backed securities  |       | 32,000     |       |                | 36         |                         |       |                          | —     |                                   |       |                           | (13        | ) |   | 32,023 |   |
| Asset-backed  securities                |       | 31,071     |       |                | 203        |                         |       |                          | (37        | )                                      |       |                           | —     |   |   | 31,237 |   |
| Corporate  securities                   |       | 799,900    |       |                | 36,697     |                         |       |                          | (4,385     | )                                      |       |                           | —     |   |   | 832,212 |   |
| Common and  preferred stock             |       | 68,113     |       |                | 1,314      |                         |       |                          | (459       | )                                      |       |                           | —     |   |   | 68,968 |   |
| Total                                   |       | $          | 8,488,855  |                |       | $                            | 54,380     |                          |       |                                   | $          | (42,586                        | )          |   |   | $ | (13 | ) |   | $ | 8,500,636 |   |

 

Thefollowing table shows the gross unrealized losses and fair value of the Company’ssecurities investments, aggregated by length of time that the individualsecurities have been in a continuous unrealized loss position, at December 31,2006 (amounts in thousands):

| ** **                              | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**            | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------------|------------|
| **Description**                         | ** ** | ** **                             | ** ** | **Fair Value**                  | ** ** | **Unrealized  Loss** | ** ** | **Fair Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair Value** | ** ** | **Unrealized  Loss** | ** ** |
| Residential  mortgage-backed securities |       | $                                      | —     |                                 |       | $                    | —     |   |   | $ | 1,853,323 |   |   | $ | (37,705 | ) |   | $ | 1,853,323 |   |   | $ | (37,705 | ) |   |
| Commercial  mortgage-backed securities  |       | —                                 |       |                                 | —     |                 |       | — |   |   | — |   |   | — |   |   | — |   |   |
| Asset-backed  securities                |       | 7,462                                  |       |                                 | (37        | )                    |       | — |   |   | — |   |   | 7,462 |   |   | (37 | ) |   |
| Corporate  securities                   |       | 61,848                                 |       |                                 | (4,106     | )                    |       | 18,907 |   |   | (279 | ) |   | 80,755 |   |   | (4,385 | ) |   |
| Common and  preferred stock             |       | 33,063                                 |       |                                 | (459       | )                    |       | — |   |   | — |   |   | 33,063 |   |   | (459 | ) |   |
| Total                                   |       | $                                      | 102,373    |                                 |       | $                    | (4,602     | ) |   | $ | 1,872,230 |   |   | $ | (37,984 | ) |   | $ | 1,974,603 |   |   | $ | (42,586 | ) |   |
|                                         |            |                                        |            |                                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The unrealized losses in the above table are temporaryimpairments due to market factors and are not reflective of creditdeterioration. The Company has performed credit analyses in relation to theseinvestments and has determined that the carrying value of these investments isfully recoverable over their expected holding period. As the Company has theintent and ability to hold these investments until recovery, unrealized lossesare not considered to be other-than-temporary impairments.

F-20

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

**Note 4.Securities Available-for-Sale (Continued)**

The following tablesummarizes the Company’s securities classified as available-for-sale as of December 31,2005, 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 |       | $          | 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 |   |

 

All securities in an unrealized loss position at December 31,2005 had been in an unrealized loss position for less than one year.

During the year ended December 31, 2006, theCompany had gross realized gains and losses from the sales of corporate andcommercial real estate securities of $6.9 million and $1.2 million,respectively. During the year ended December 31, 2005, the Company hadgross realized gains and losses from the sales of securities of $2.8 millionand $0.1 million, respectively, and did not sell any securities during theperiod from Inception through December 31, 2004.

Thefollowing table summarizes the estimated fair value of debt securities bycontractual maturity as of December 31, 2006 (dollars in thousands):

| **Description**         | ** ** | ** ** | ** ** | **Estimated  Fair Value** | ** ** | **Weighted Average  Coupon** | ** ** |
|-------------------------|------------|------------|------------|--------------------------------|------------|-----------------------------------|------------|
| Due within one  year    |       | $          | 32,499     |                           |       | 7.7                               | %          |   |
| One to five years       |       | 182,718    |       |                           | 7.6        |                              |       |
| Five to ten years       |       | 616,995    |       |                           | 10.2       |                              |       |
| Greater than ten  years |       | 7,599,456  |       |                           | 5.9        |                              |       |
| Total                   |       | $          | 8,431,668  |                           |       |                              |       |   |

 

Mortgage-backed and asset-backed securities includedin the table above were allocated based on contractual principal maturitiesassuming no prepayments. Expected maturities may differ from contractualmaturities because borrowers may have the right to call or prepay obligations,with or without call or prepayment penalties.

F-21

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

**Note 4.Securities Available-for-Sale (Continued)**

Note 7 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, 2006 (amounts in thousands):

| ** **                                                                     | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities(1)** | ** ** | **Common and  Preferred Stock** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       |                                         | $          | 1,378,199                                   |       |                         |       | $                                         | 32,023     |   |   |   | $ | 310,856 |   |   |   | $ | — |   |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       |                                         | 6,126,699  |                                        |       |                         | —     |                                      |       |   | — |   |   |   | — |   |   |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       |                                         | —     |                                        |       |                         | —     |                                      |       |   | 33,186 |   |   |   | — |   |   |
| Pledged as  collateral for borrowings under secured demand loan                |       |                                         | —     |                                        |       |                         | —     |                                      |       |   | — |   |   |   | 47,056 |   |   |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       |                                         | —     |                                        |       |                         | —     |                                      |       |   | 408,416 |   |   |   | — |   |   |
| Total                                                                          |       |                                         | $          | 7,504,898                                   |       |                         |       | $                                         | 32,023     |   |   |   | $ | 752,458 |   |   |   | $ | 47,056 |   |   |

----

(1)          Includes asset-backedsecurities.

Thefollowing table summarizes the estimated fair value of securities pledged ascollateral under repurchase agreements, asset-backed secured liquidity notes,and all other secured financing transactions as of December 31, 2005(amounts in thousands):

| ** **                                                                     | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities(1)** | ** ** | **Common and  Preferred Stock** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|
| 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                                   |       |                         |       | $                                         | 70,373     |   |   |   | $ | 540,342 |   |   |   | $ | 45,057 |   |   |

----

(1)          Includes asset-backedsecurities.

F-22

----

**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, 2006(amounts in thousands):

| ** **                                                     | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized  Cost** | ** ** |
|----------------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|--------------------------|------------|
| Residential mortgage  loans                                    |       | $             | 5,092,419  |                                |       | $                        | 16,842     |   |   | $ | 5,109,261 |   |
| Corporate loans                                                |       | 3,232,414     |       |                                | (6,847     | )                        |       | 3,225,567 |   |
| Commercial real estate  loans                                  |       | 108,790       |       |                                | (97        | )                        |       | 108,693 |   |
| Allowance for loan  losses for residential mortgage loans |       | (1,500        | )          |                                | —     |                     |       | (1,500 | ) |
| Total loans held for  investment                               |       | 8,432,123     |       |                                | 9,898      |                     |       | 8,442,021 |   |
| Loans held for sale                                            |       | —        |       |                                | —     |                     |       | — |   |
| Total loans, net of allowance for loan losses                  |       | $             | 8,432,123  |                                |       | $                        | 9,898      |   |   | $ | 8,442,021 |   |

 

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 |   |

 

Note 7 to these consolidatedfinancial statements describes the Company’s borrowings under which the Companyhas pledged loans for borrowings under repurchase agreements, asset-backedsecured liquidity notes, and all other secured financing transactions. Thefollowing table summarizes the carrying value of loans pledged as collateralunder repurchase agreements, asset-backed secured liquidity notes, and allother secured financing transactions as of December 31, 2006 (amounts inthousands):

| ** **                                                                     | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as collateral for borrowings under  repurchase agreements              |       |                                 | $          | 2,136,419                |       |                                        |       | $ | 596,976 |   |   |   | $ | 15,000 |   |   |
| Pledged as collateral for asset-backed secured liquidity  notes           |       |                                 | 2,905,586  |                     |       |                                        | —     |   |   |   | — |   |   |
| Pledged as collateral for borrowings under secured  revolving credit facility  |       |                                 | —     |                     |       |                                        | 174,893    |   |   |   | — |   |   |
| Pledged as collateral for collateralized loan  obligation senior secured notes |       |                                 | —     |                     |       |                                        | 2,452,066  |   |   |   | 93,693 |   |   |
| Total                                                                          |       |                                 | $          | 5,042,005                |       |                                        |       | $ | 3,223,935 |   |   |   | $ | 108,693 |   |   |

 

F-23

----

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

**Note 5.Loans (Continued)**

The following tablesummarizes the carrying value of loans pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of December 31, 2005 (amounts in thousands):

| ** **                                                                     | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       |                                 | $          | 4,904,779                |       |                                        |       | $ | 155,167 |   |   |   | $ | 370,950 |   |   |
| 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 |       |                                 | —     |                     |       |                                        | 1,614,309  |   |   |   | 140,792 |   |   |
| Total                                                                          |       |                                 | $          | 6,271,079                |       |                                        |       | $ | 1,829,441 |   |   |   | $ | 521,742 |   |   |

 

**ResidentialMortgage Loans**

Thefollowing is a reconciliation of carrying amounts of residential mortgage loansfor the years ended December 31, 2006 and 2005 (amount in thousands):

| ** **                   | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|------------------------------|------------|------------|------------|-----------|------------|
| Balance at  January 1   |       | $          | 6,428,822  |      | $          | 229,855 |   |
| Loan purchases  (principal)  |       | 165,021    |       | 6,720,923 |       |
| Principal  payments          |       | (1,477,024 | )          | (545,077  | )          |
| Transfers to REO             |       | (1,279     | )          | —    |       |
| Net unamortized  premium     |       | (6,279     | )          | 23,121    |       |
| Balance at  December 31 |       | $          | 5,109,261  |      | $          | 6,428,822 |   |

 

During the year ended December 31, 2005, theCompany purchased $5.9 billion of securities 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’sRatings Service (“Standard & Poor’s”). Each of the special-purposeentities that issued the securities are not considered qualifyingspecial-purpose entities as defined by SFAS No. 140 and are treated asVIEs under FIN 46R. The Company has determined that it is the primarybeneficiary of each of the special-purpose entities that issued the securities;accordingly, the Company recorded its investments as loans and not securities.

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 

F-24

----

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

**Note 5.Loans (Continued)**

the Company, its creditorsor stockholders. Of the $959.2 million of securities issued, approximately$908.8 million, or 95%, were rated AAA by Standard & Poor’s.While the Company transferred the loans to a separate bankruptcy-remote legalentity, the Company did not account for the transaction as a sale as thesecuritization transaction did not meet the criteria for sales treatment underSFAS No. 140. Accordingly, the Company did not record a gain or loss inconnection with the securitization transaction and accounts for the transferredassets as loans on its consolidated balance sheet.

Thefollowing table summarizes the geographic distribution of the Company’sresidential mortgage loan portfolio as of December 31, 2006 (dollaramounts in thousands):

| **State or Territory** | ** ** | ** ** | ** ** | **Number of  Loans** | ** ** | **Principal Amount** | ** ** | **% of  Principal  Amount** | ** ** |
|----------------------------------|------------|------------|------------|---------------------------|------------|---------------------------|------------|----------------------------------|------------|
| California                       |       |       | 3,321      |                      |       |                      | $          | 1,935,524                        |       |   |   | 38.0 | % |   |
| Florida                          |       |       | 905        |                      |       |                      | 430,069    |                             |       |   | 8.4 |   |   |
| New York                         |       |       | 523        |                      |       |                      | 328,411    |                             |       |   | 6.5 |   |   |
| New Jersey                       |       |       | 443        |                      |       |                      | 235,048    |                             |       |   | 4.6 |   |   |
| Virginia                         |       |       | 453        |                      |       |                      | 208,335    |                             |       |   | 4.1 |   |   |
| Other                            |       |       | 4,572      |                      |       |                      | 1,955,032  |                             |       |   | 38.4 |   |   |
| Total                            |       |       | 10,217     |                      |       |                      | $          | 5,092,419                        |       |   |   | 100.0 | % |   |

 

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of December 31, 2006 (dollar amounts in thousands):

| **Delinquency Status** | ** ** | ** ** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       |       | 90         |                          |       |                      | $          | 35,968 |   |   |
| 60 to 89 days               |       |       | 10         |                          |       |                      | 3,040      |   |   |
| 90 days or more             |       |       | 15         |                          |       |                      | 2,855      |   |   |
| In foreclosure              |       |       | 18         |                          |       |                      | 5,442      |   |   |
| Total                       |       |       | 133        |                          |       |                      | $          | 47,305 |   |   |

 

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      |   |   |
| Total                       |       |       | 99         |                          |       |                      | $          | 36,065 |   |   |

 

As of December 31, 2006, six of the residentialmortgage loans owned by the Company with an outstanding balance of $1.3 million(not included in the table above) were real estate owned (“REO”) as a result offoreclosure on delinquent loans. For each of the six loans, the estimated fairvalue of the underlying property exceeds the loan balance and the Company hastherefore not recorded a charge against the Company’s allowance for loanlosses, and the loans have been reclassified from loans to 

F-25

----

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

**Note 5.Loans (Continued)**

other assets on theCompany’s balance sheet at the lower of cost or estimated fair value. There wasno REO as of December 31, 2005.

As of December 31, 2006, the Company hadthirty-three loans that were either 90 days or greater past due or inforeclosure and placed on non-accrual status. During the year ended December 31,2006, the Company did not recognize approximately $0.3 million in interestincome for loans that were either in non-accrual status or classified asREO.

Thefollowing table summarizes the changes in the allowance for loan losses for theCompany’s residential mortgage loan portfolio during the year ended December 31,2006 (amounts in thousands):

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

 

**Corporate Loans**

As of December 31, 2006, one corporate loan witha balance of $22.2 million was placed on non-accrual status. Accordingly, theCompany did not recognize $0.3 million of interest income related to this loanduring the year ended December 31, 2006. 

As of December 31,2006 and 2005, no corporate loans were delinquent and as of December 31,2006 and 2005, the Company had not recorded an allowance for loan losses forits corporate loan portfolio. In reviewing the Company’s portfolio of corporateloans, the Company determined that no loans were impaired as of December 31,2006 and 2005. 

**Note 6. Investment inUnconsolidated Affiliate**

As of December 31, 2006, the Company’s investmentin an unconsolidated affiliate consisted of a 49.9% limited partnershipinterest in KFH. The remaining 50.1% of KFH is owned by three privateinvestment funds (collectively, the “KKR Strategic Capital Funds”) and thegeneral partner of the KKR Strategic Capital Funds. The KKR StrategicCapital Funds are managed by an affiliate of the Company’s Manager and the KFHgeneral partner is 100% owned by the Company’s Manager. The Company’sinvestment in KFH is accounted for under the equity method. Under the equitymethod, the Company’s initial investment is recorded at cost and issubsequently adjusted to recognize the Company’s share of KFH’s earnings orlosses. Distributions received reduce the carrying amount of the investment.

KFH was formed during the third quarter of 2006 and isthe primary beneficiary of four special purpose entities formed during thethird quarter of 2006 to complete secured financing transactions to financecertain investments in corporate loans and securities. The special purposeentities are KKR Financial CLO 2007-1, Ltd. (“CLO 2007-1”), KKR FinancialCLO 2007-2, Ltd. (“CLO 2007-2), KKR Financial CLO 2007-3, Ltd. (“CLO2007-3”), and KKR Financial CLO 2007-4, Ltd (“CLO 2007-4”). Each of theseentities were established to complete secured financing transactions. CLO2007-1, CLO 2007-2, and CLO 2007-3 have elected to be treated astaxable REIT subsidiaries for federal tax purposes. During August 2006,CLO 2007-1, CLO 2007-2 and CLO 2007-3 each entered into separate 

F-26

----

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

**Note 6.Investment in Unconsolidated Affiliate (Continued)**

credit facilities, with amaximum commitment amount of $600.0 million, $500.0 million and $600.0 million,respectively. Each of these facilities bear interest at a rate of 30-day LondonInterbank Offered Rate (“LIBOR”) plus 0.50%. As of December 31, 2006, CLO2007-4 had not entered into a credit facility agreement and had no assets orliabilities.

As of December 31,2006, KFH had $1.1 billion in assets consisting of $746.3 million of corporateloans, $294.5 million of corporate securities, $12.5 million of restrictedcash, $12.1 million of interest receivable, and $6.6 million of otherreceivables. As of December 31, 2006, KFH had liabilities totaling $863.9million consisting of $851.8 million of borrowings under repurchase agreementsand $12.1 million of interest payable. As of December 31, 2006, KFH hadnet unrealized gains on its investments in securities classified asavailable-for-sale totaling $15.8 million. During the year ended December 31,2006, KFH had net income of $11.4 million consisting of $23.5 million ofinterest income less $12.1 million of interest expense.

**Note 7. 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 facilities used by theCompany bears interest at floating rates based on a spread above LIBOR orasset-backed secured liquidity note interest rates.

Certaininformation with respect to the Company’s borrowings as of December 31,2006 is summarized in the following table (dollars in thousands):

| ** **                            | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral(1)** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|
| Repurchase  agreements                |       | $                           | 3,824,728  |                                   |       | 5.44                                                       | %          |                                       |       | 19 |   |   |   | $ | 3,728,241 |   |   |
| Demand loan                           |       | 41,658                      |       |                                   | 5.88       |                                                       |       |                                       | 1          |   |   |   | 47,056 |   |   |
| Secured revolving  credit facility    |       | 34,710                      |       |                                   | 6.07       |                                                       |       |                                       | 18         |   |   |   | 208,536 |   |   |
| Asset-backed  secured liquidity notes |       | 8,705,601                   |       |                                   | 5.38       |                                                       |       |                                       | 14         |   |   |   | 9,015,211 |   |   |
| CLO 2005-1  senior secured notes      |       | 773,000                     |       |                                   | 5.78       |                                                       |       |                                       | 3,769      |   |   |   | 984,837 |   |   |
| CLO 2005-2  senior secured notes      |       | 752,000                     |       |                                   | 5.65       |                                                       |       |                                       | 3,983      |   |   |   | 982,976 |   |   |
| CLO 2006-1  senior secured notes      |       | 727,500                     |       |                                   | 5.73       |                                                       |       |                                       | 4,255      |   |   |   | 1,001,405 |   |   |
| CDO 2005-1  repurchase agreements     |       | 1,074                       |       |                                   | 6.45       |                                                       |       |                                       | 18         |   |   |   | 1,434 |   |   |
| CLO 2006-2  repurchase agreements     |       | 631,287                     |       |                                   | 5.95       |                                                       |       |                                       | 1          |   |   |   | 734,348 |   |   |
| Junior  subordinated notes            |       | 257,743                     |       |                                   | 7.71       |                                                       |       |                                       | 10,811     |   |   |   | — |   |   |
| Total                                 |       | $                           | 15,749,301 |                                   |       |                                                       |       |                                       |       |   |   |   |   | $ | 16,704,044 |   |   |

----

(1)          Collateral forborrowings consists of securities available-for-sale, loans, and marketableequity securities.

F-27

----

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

**Note 7.Borrowings (Continued)**

Certain information withrespect to the Company’s borrowings as of December 31, 2005 is summarizedin the following table (dollars 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)          Collateral forborrowings consists of securities available-for-sale, loans, and marketableequity securities.

AtDecember 31, 2006, the Company had repurchase agreements with thefollowing counterparties (dollars in thousands): 

| **Counterparty(2)**               | ** ** | ** ** | ** ** | **Amount  At  Risk(1)** | ** ** | **Weighted  Average  Maturity  (Days)** | ** ** | **Weighted  Average  Interest  Rate** | ** ** |
|-----------------------------------|------------|------------|------------|-------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| Bear Stearns &  Co. Inc. |       | $          | 127,231    |                    |       | 17                                      |       |                                  |       | 5.64 | % |   |
| Citigroup Global Markets  Ltd     |       | 60,950     |       |                    | 24         |                                    |       |                                  | 5.42       |   |   |
| Credit Suisse First  Boston LLC.  |       | 46,867     |       |                    | 18         |                                    |       |                                  | 5.38       |   |   |
| Deutsche Bank AG                  |       | 363        |       |                    | 18         |                                    |       |                                  | 6.45       |   |   |
| J. P. Morgan Chase Bank,  N.A     |       | 8,840      |       |                    | 7          |                                    |       |                                  | 5.93       |   |   |
| Total                             |       | $          | 244,251    |                    |       |                                    |       |                                  |       |   |   |   |

----

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)          Counterparty includessubsidiaries and affiliates of each counterparty listed.

F-28

----

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

**Note 7. Borrowings(Continued)**

At December 31,2005, the Company had repurchase agreements with the following counterparties (dollarsin 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)          Counterparty includessubsidiaries and affiliates of each counterparty listed.

On March 30, 2005, the Company closed CLO 2005-1, a$1.0 billion collateralized loan obligation (“CLO”) transaction thatprovides financing for investments in corporate loans and certain other loansand securities. The investments owned by CLO 2005-1 collateralize the CLO2005-1 debt, and as a result, those investments are not available to theCompany, its creditors or stockholders. CLO 2005-1 issued a total of$773.0 million of senior secured notes at par to investors. In addition,the Company retained $148.0 million of rated mezzanine notes and$85.5 million of unrated subordinated notes issued by CLO 2005-1.

The senior notes issued to investors by CLO 2005-1consist of the following three classes of notes: (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 by CLO 2005-1mature on April 26, 2017, though the Company has the right to call thenotes at par any time after April 2008.

During April 2005, the Company formed CDO 2005-1and began borrowing on a $300.0 million warehouse facility, in the form ofa repurchase agreement, to purchase commercial real estate obligations. Therepurchase facility bears interest at a rate of 30-day LIBOR plus 1.10%and as of December 31, 2006, there was $1.1 million outstanding. During thethree month period ended September 30, 2006, the Company determined thatit would not pursue a collateralized debt obligation (“CDO”) transaction issuedby CDO 2005-1 and during October 2006 the Company exercised itsoption to convert the warehouse facility into a $300 million term creditfacility that terminates on March 31, 2008.

F-29

----

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

**Note 7.Borrowings (Continued)**

On September 30, 2005, the Company closed a$5.0 billion asset-backed secured liquidity note facility. This facilityprovides the Company with an alternative source of financing for itsresidential mortgage-backed securities by issuing asset-backed securedliquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s, Moody’s Investors Service (“Moody’s”), and Fitch Inc., respectively.Issuances of asset-backed secured liquidity notes are recorded as borrowings onthe Company’s consolidated balance sheet. As of December 31, 2006, theCompany had $4.7 billion of asset-backed secured liquidity notes outstandingunder this facility.

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 of unratedsubordinated notes issued by CLO 2005-2.

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

During December 2005, the Company formed CLO 2006-2and executed a $450.0 million warehouse facility, in the form of a repurchaseagreement, to finance the purchase of corporate loans and certain other loans andsecurities. This facility was subsequently amended to increase the totalcommitment amount to $720.0 million in December 2006. The repurchasefacility bears interest at a rate of 30-day LIBOR plus 0.60% and as of December31, 2006 there was $631.3 million outstanding.

During March 2006, the Company formed KKRFinancial Capital Trust I (“Trust I”) for the sole purpose of issuing trustpreferred securities. On March 28, 2006, Trust I issued preferredsecurities to unaffiliated investors for gross proceeds of $50.0 million andcommon securities to the Company for $1.6 million. The combined proceedswere invested by Trust I in $51.6 million of junior subordinated notes issuedby the Company. The junior subordinated notes are the sole assets of Trust Iand mature on April 30, 2036, but are callable on or after April 30,2011. Interest is payable quarterly at a fixed rate of 7.64% through March 2016and thereafter at a floating rate equal to three-month LIBOR plus 2.65%.

On March 30, 2006, the Company closed its second$5.0 billion asset-backed secured liquidity note facility. This facilityprovides the Company with an additional alternative source of financing for itsresidential mortgage-backed securities by issuing asset-backed securedliquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s, Moody’s, and Fitch Inc., respectively. As of December 31, 2006,the Company had $4.0 billion in borrowings outstanding under this facility.

During June 2006, the Company formed KKRFinancial Capital Trust II (“Trust II”) for the sole purpose of issuing trustpreferred securities. On June 2, 2006, Trust II issued preferredsecurities to unaffiliated investors for gross proceeds of $50.0 million andcommon securities to the Company for $1.6 million. The combined proceedswere invested by Trust II in $51.6 million of junior subordinated notes issuedby the Company. The junior subordinated notes are the sole assets of Trust IIand mature on 

F-30

----

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

**Note 7.Borrowings (Continued)**

July 30, 2036, butare callable on or after July 30, 2011. Interest is payable quarterly at afixed rate of 8.09% through July 2016 and thereafter at a floating rateequal to three-month LIBOR plus 2.65%.

During June 2006,the Company’s $275.0 million secured revolving credit facility matured and wasreplaced with a $375.0 million three year senior secured revolving creditfacility. During September 2006, the facility was amended to increase thetotal commitment amount to $800.0 million with the option to further increasethe commitment amount to $900.0 million at any time so long as no default orevent of default on the facility has occurred and subject to addition of newlenders, increases in the commitments of existing lenders, or a combinationthereof. The senior secured revolving credit facility matures in June 2009and consists of two tranches. Outstanding borrowings under the senior securedrevolving credit facility 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 in effect on such day plus 0.50%, or (ii) aninterest rate per annum equal to the LIBOR rate for the applicable interestperiod plus 0.50% for borrowings under tranche A of the facility and 0.75% forborrowings under tranche B of the facility. As of December 31, 2006, theCompany had $34.7 million in borrowings outstanding under tranche B ofthis facility.

During August 2006, the Company formed KKRFinancial Capital Trust III (“Trust III”) for the sole purpose of issuing trustpreferred securities. On August 10, 2006, Trust III issued preferredsecurities to unaffiliated investors for gross proceeds of $85.0 million andcommon securities to the Company for $2.6 million. The combined proceedswere invested by Trust III in $87.6 million of junior subordinated notes issuedby the Company. The junior subordinated notes are the sole assets of Trust IIIand mature on October 30, 2036, but are callable on or after October 30,2011. Interest is payable quarterly at a floating rate equal to three-monthLIBOR plus 2.35%.

During September 2006, the Company formed KKRFinancial Capital Trust IV (“Trust IV”) for the sole purpose of issuing trustpreferred securities. On September 15, 2006, Trust IV issued preferredsecurities to unaffiliated investors for gross proceeds of $15.0 million andcommon securities to the Company for $0.5 million. The combined proceeds wereinvested by Trust IV in $15.5 million of junior subordinated notes issued bythe Company. The junior subordinated notes are the sole assets of Trust IV andmature on October 30, 2036, but are callable on or after October 30,2011. Interest is payable quarterly at a floating rate equal to three-monthLIBOR plus 2.35%.

On September 19, 2006, the Company closed CLO 2006-1,its third $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 2006-1 collateralize the CLO 2006-1debt, and as a result, those investments are not available to the Company, itscreditors or stockholders. CLO 2006-1 issued a total of $727.5 million ofsenior secured notes at par to investors. In addition, the Company retained$145.5 million of rated mezzanine notes and $144.0 million of unratedsubordinated notes issued by CLO 2006-1.

The senior notes issued to investors by CLO 2006-1consist of the following five classes of notes as follows: (i) $334.0 millionof class A-1 senior notes bearing interest at three-month LIBOR plus0.28%; (ii) $207.0 million of class A-2a senior notesbearing interest at three-month LIBOR plus 0.24%; (iii) $69.0 millionof class A-2b senior notes bearing interest at three-month LIBORplus 0.40%; (iv) $43.0 million of class B senior notes bearing interest atthree-month LIBOR plus 0.50%; and (v) $74.5 million of class C mezzaninenotes bearing interest at three-month LIBOR plus 0.95%. All of the notes issuedby CLO 2006-1 mature on August 25, 2018, though the Company has theright to call the notes at par any time after August 2010.

F-31

----

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

**Note 7.Borrowings (Continued)**

During September 2006, the Company formed KKRFinancial Capital Trust V (“Trust V”) for the sole purpose of issuing trustpreferred securities. On September 29, 2006, Trust V issued preferredsecurities to unaffiliated investors for gross proceeds of $50.0 million andcommon securities to the Company for $1.6 million. The combined proceeds wereinvested by Trust V in $51.6 million of junior subordinated notes issued by theCompany. The junior subordinated notes are the sole assets of Trust V andmature on October 30, 2036, but are callable on or after October 30,2011. Interest is payable quarterly at a fixed rate of 7.395% through October 2016and thereafter at a floating rate equal to three-month LIBOR plus 2.25%.

Thetable below summarizes the Company’s contractual obligations (excludinginterest) under borrowing agreements as of December 31, 2006 (amounts inthousands):

| ** **                            | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **Total**                                 | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More than  5 years** | ** ** |
| Repurchase  agreements                |       | $                                         | 4,457,089  |   |   | $ | 4,457,089 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |
| CLO 2005-1  senior secured notes      |       | 773,000                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 773,000 |   |
| CLO 2005-2  senior secured notes      |       | 752,000                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 752,000 |   |
| CLO 2006-1  senior secured notes      |       | 727,500                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 727,500 |   |
| Demand loan                           |       | 41,658                                    |       |   | 41,658 |   |   |   | — |   |   |   | — |   |   | — |   |
| Secured revolving  credit facility    |       | 34,710                                    |       |   | 34,710 |   |   |   | — |   |   |   | — |   |   | — |   |
| Asset-backed  secured liquidity notes |       | 8,705,601                                 |       |   | 8,705,601 |   |   |   | — |   |   |   | — |   |   | — |   |
| Junior  subordinated notes            |       | 257,743                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 257,743 |   |
| Total                                 |       | $                                         | 15,749,301 |   |   | $ | 13,239,058 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 2,510,243 |   |

 

**Note 8. DerivativeFinancial Instruments**

The Company enters intoderivative transactions in order hedge its interest rate risk exposure to theeffects of interest rate changes. Additionally, the Company enters intoderivative transactions in the course of its investing. The counterparties tothe Company’s derivative agreements are major financial institutions with whichthe Company and its affiliates may also have other financial relationships. Inthe event of nonperformance by the counterparties, the Company is potentiallyexposed to losses. The counterparties to the Company’s derivative agreementshave investment grade ratings and, as a result, the Company does not anticipatethat any of the counterparties will fail to fulfill their obligations.

**Cash Flow and FairValue Hedges**

The Company uses interestrate derivatives consisting of swaps and corridors to hedge all or a portion ofthe interest rate risk associated with its borrowings under repurchaseagreements, asset-backed secured liquidity notes and CLO senior secured notes. TheCompany designates these financial instruments as cash flow hedges. The Companyalso uses interest rate swaps to hedge all or a portion of the interest raterisk associated with certain fixed interest rate investments. The Companydesignates these financial instruments as fair value hedges.

F-32

----

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

**Note 8.Derivative Financial Instruments (Continued)**

**Free-StandingDerivatives**

Free-standing derivatives are derivatives that theCompany has entered into in conjunction with its investment and risk managementactivities, but for which the Company has not designated the derivativecontract as a hedging instrument for accounting purposes. Such derivativecontracts may include credit default swaps, foreign exchange contracts, andinterest rate derivatives. Free-standing derivatives also include investmentfinancing arrangements (total rate of return swaps) whereby the Companyreceives the sum of all interest, fees and any positive change in fair valueamounts from a reference asset with a specified notional amount and paysinterest on such notional amount plus any negative change in fair value amountsfrom such reference asset.

Thetable below summarizes the aggregate notional amount and estimated net fairvalue of the derivative instruments as of December 31, 2006 and December 31,2005 (amounts in thousands):

| ** **                  | ** ** | **As of  December 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **Notional**                                | ** ** | **Fair Value**                         | ** ** | **Notional** | ** ** | **Fair Value** | ** ** |
| Cash Flow Hedges:           | ** ** | ** **                                  | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Interest rate corridors     |       | $                                           | 702,369    |                                        |       | $ | 13,591 |   |   | $ | 547,155 |   |   | $ | 14,762 | ** ** |   |
| Interest rate swaps         |       | 4,567,828                                   |       |                                        | 45,314     |   |   | 5,727,200 |   |   | 40,796 | ** ** |   |
| Fair Value Hedges:          | ** ** | ** **                                  | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Interest rate swaps         |       | 32,000                                      |       |                                        | 13         |   |   | — |   |   | — | ** ** |   |
| Free-Standing  Derivatives: | ** ** | ** **                                  | ** ** |                                        | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| Interest rate swaptions     |       | 31,000                                      |       |                                        | 75         |   |   | 56,000 |   |   | 879 | ** ** |   |
| Interest rate swaps         |       | —                                      |       |                                        | —     |   |   | 10,000 |   |   | 198 | ** ** |   |
| Credit default swaps        |       | 278,000                                     |       |                                        | (618       | ) |   | 48,000 |   |   | 71 | ** ** |   |
| Total rate of return swaps  |       | 222,647                                     |       |                                        | 2,343      |   |   | 131,679 |   |   | 727 | ** ** |   |
| Foreign exchange contracts  |       | —                                      |       |                                        | —     |   |   | — |   |   | — | ** ** |   |
| Net fair value              |       | $                                           | 5,833,844  |                                        |       | $ | 60,718 |   |   | $ | 6,520,034 |   |   | $ | 57,433 | ** ** |   |

 

During the years ended December 31,2006 and 2005, and the period ended December 31, 2004, the Companyrecognized zero ineffectiveness from its cash flow and fair value hedges inincome. The following table summarizes by derivative instrument type the effecton income from free-standing derivatives for the periods (amounts inthousands):

| **Free-Standing Derivatives:**                                      | ** ** | ** ** | ** ** | **For the year ended  December 31, 2006** | ** ** | **For the year ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (Inception) through  December 31, 2004** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| Interest rate  swaptions                                                 |       |       | $          | (92                                                                | )          |                                                               |       | $                                                                                                                        | (424       | ) |   |   | $ | (28 | ) |   |
| Interest rate  swaps                                                     |       |       | (58        | )                                                                  |       |                                                               | 758        |                                                                                                                     |       |   | — |   |   |
| Credit default  swaps                                                    |       |       | (896       | )                                                                  |       |                                                               | (259       | )                                                                                                                        |       |   | (283 | ) |   |
| Total rate of  return swaps                                              |       |       | 4,237      |                                                               |       |                                                               | 755        |                                                                                                                     |       |   | — |   |   |
| Foreign exchange  contracts                                              |       |       | —     |                                                               |       |                                                               | 2,211      |                                                                                                                     |       |   | (125 | ) |   |
| Net realized and  unrealized gains (losses) on free-standing derivatives |       |       | $          | 3,191                                                              |       |                                                               |       | $                                                                                                                        | 3,041      |   |   |   | $ | (436 | ) |   |

 

F-33

----

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

**Note 9. AccumulatedOther Comprehensive Income**

Thecomponents of accumulated other comprehensive income were as follows (amountsin thousands):
| ** **                                                                                          | ** ** | **As of  December 31, 2006** | ** **    | **As of  December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|---------------|---------------------------------------------|------------|
| Net unrealized  (losses) gains on available-for-sale securities                                     |       |                                        | $ 11,776 |                                        |       |   | $ (27,215 | ) |   |
| Net unrealized  gains on available-for-sale securities from investment in unconsolidated  affiliate |       |                                        | 7,898         |                                        |       |   | — |   |   |
| Net unrealized  gains on cash flow hedges                                                           |       |                                        | 50,846        |                                        |       |   | 45,559 |   |   |
| Accumulated other  comprehensive income                                                             |       |                                        | $ 70,520 |                                        |       |   | $ 18,344 |   |   |

 

The componentsof other comprehensive income were as follows (amounts in thousands):
| ** **                                                                                     | ** ** | **Year ended  December 31, 2006** | ** **    | **Year ended  December 31, 2005** | ** ** | **For the period from  August 12, 2004  (Inception) through  December 31, 2004** | ** **     |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|---------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------|----------------|
| Unrealized gains (losses)  on securities available-for-sale:                                   |       |                                             |          |                                             |       |                                                                                                                     |           |   |   |   |   |   |   |
| Unrealized holding gains (losses) arising during  period                                       |       |                                             | $ 33,246 |                                             |       |                                                                                                                     | $ (26,268 | ) |   |   | $ 1,720 |   |   |
| Reclassification adjustments for gains (losses) realized  in net income              |       |                                             | 5,745         |                                             |       |                                                                                                                     | (2,667         | ) |   |   | — |   |   |
| Unrealized gains  (losses) on securities available-for-sale                                    |       |                                             | 38,991        |                                             |       |                                                                                                                     | (28,935        | ) |   |   | 1,720 |   |   |
| Unrealized gains  on available-for-sale securities from investment in unconsolidated affiliate |       |                                             | 7,898         |                                             |       |                                                                                                                     | —         |   |   |   | — |   |   |
| Unrealized gains  on cash flow hedges                                                          |       |                                             | 5,287         |                                             |       |                                                                                                                     | 45,559         |   |   |   | — |   |   |
| Other comprehensive  income                                                                    |       |                                             | $ 52,176 |                                             |       |                                                                                                                     | $ 16,624  |   |   |   | $ 1,720 |   |   |

 

F-34

----

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

**Note 10. Commitments**

**Operating Lease**

As of December 31,2006, the Company was a party to two non-cancelable operating leases with termsof ten years and one year, respectively. The total lease payments to be madeover the ten-year period, including certain free rent periods, are beingrecognized as rent expense on a straight-line basis over the ten-year period.This expense is included in general and administrative expenses on theConsolidated Statements of Operations. Total rent expense under operatingleases for the years ended December 31, 2006 and 2005 and the period endedDecember 31, 2004 was $1.3 million, $0.7 million and $0.2 million, respectively.Minimum future obligations on leases in effect at December 31, 2006, areapproximately as follows (amounts in thousands):
| **Year**             | ** ** | ** **    | ** ** | **Amount** | ** ** |
|----------------------|------------|---------------|------------|------------|------------|
| 2007                 |       | $ 1,723  |       |
| 2008                 |       | 1,379         |       |
| 2009                 |       | 1,388         |       |
| 2010                 |       | 1,429         |       |
| 2011                 |       | 1,438         |       |
| 2012 and  thereafter |       | 6,919         |       |
| Total                |       | $ 14,276 |       |

 

**Loan Commitments**

As part of its strategy of investing in corporateloans and commercial real estate loans, the Company commits to purchaseinterests in primary market loan syndications, which obligate the Company toacquire a predetermined interest in such loans at a specified price on ato-be-determined settlement date. Consistent with standard industry practices,once the Company has been informed of the amount of its syndication allocationin a particular loan by the syndication agent, the Company bears the risks andbenefits of changes in the fair value of the syndicated loan from that dateforward. As of December 31, 2006, the Company had committed to purchase orparticipate in approximately $42.5 million of corporate loans.

In addition, the Companyparticipates in certain contingent financing arrangements, including bridgefacilities, whereby the Company is committed to provide funding of up to aspecific amount at the discretion of the borrower. As of December 31, 2006,the Company had unfunded bridge financing commitments totaling $79.8 million.

**Note 11. StockOptions and Restricted Stock**

The Company has adopted a stock incentive plan (the “2004Stock Incentive Plan”) that provides for the grant of qualified incentivecommon stock options that meet the requirements of Section 422 of theCode, non-qualified common stock options, stock appreciation rights, restrictedcommon stock and other share-based awards. The 2004 Stock Incentive Planwas amended on May 26, 2005. The compensation committee of the board of directorsadministers the plan. Stock options may be granted to the Manager, Directors,officers and any key employees of the Manager and to any other individual orentity performing services for the Company.

F-35

----

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

**Note 11.Stock Options and Restricted Stock (Continued)**

The exercise price for any stock option granted underthe 2004 Stock Incentive Plan may not be less than 100% of the fair marketvalue of the shares of common stock at the time the common stock option isgranted. Each common stock option must terminate no more than ten years fromthe date it is granted. The 2004 Stock Incentive Plan, as amended, authorizesthat a total of 7,964,625 shares may be used to satisfy awards under the plan.The Company made its initial grants under the 2004 Stock Incentive Plan on August 12,2004, and August 19, 2004, the dates that the Company closed its initialprivate placement of common stock and the date that the over-allotment optionwas exercised, respectively.

Thefollowing table summarizes restricted common stock transactions:
| ** **                                        | ** ** | **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** |       | 2,670,011   |       |          | 28,321     |      |       | 2,699,232 |   |
| Issued                                            |       | —      |       |          | 33,152     |      |       | 33,152 |   |
| Vested                                            |       | (1,022,956  | )          |          | (28,321    | )         |       | (1,051,277 | ) |
| Forfeited                                         |       | —      |       |          | —     |      |       | — |   |
| **Unvested shares as of  December 31, 2006** |       | 1,647,955   |       |          | 33,152     |      |       | 1,681,107 |   |

 

The shares of restricted common stock granted to thedirectors were valued using the fair market value at the time of grant, whichwas $21.30, $24.90 and $20.00 per share, for the shares of restricted commonstock granted in 2006, 2005 and 2004, respectively. Pursuant to SFAS No. 123(R),the Company is required to value any unvested shares of restricted common stockgranted to the Manager at the current market price. The Company valued theunvested restricted common stock at $26.79, $23.99 and $20.00 per share at December 31,2006, December 31, 2005 and December 31, 2004, respectively. Therewere $15.7 million, $40.6 million, and $18.5 million of total unrecognizedcompensation costs related to unvested restricted common stock granted as of December 31,2006, December 31, 2005, and December 31, 2004, respectively.

F-36

----

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

**Note 11.Stock Options and Restricted Stock (Continued)**

The following tablesummarizes common stock option transactions:
| ** **                                    | ** ** | **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 |   |   |
| Granted                                       |       | —                      |       |                                      | —       |   |   |
| Exercised                                     |       | (57,500                     | )          |                                      | 20.00        |   |   |
| Forfeited                                     |       | —                      |       |                                      | —       |   |   |
| **Outstanding as of  December 31, 2006** |       | 1,932,279                   |       |                                      | $ 20.00 |   |   |

 

As of December 31,2006 and December 31, 2005, 1,269,020 and 663,260 common stock optionswere exercisable, respectively, and no common stock options were exercisable asof December 31, 2004. The common stock options are valued using the Black-Scholesmodel with the following assumptions:
| ** **     | ** ** | **As of  December 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|----------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Expected life  |       |                                        | 7.6 years  |                                        |       |                                        | 8.6 years  |   |   |   | 9.6 years |   |   |
| Discount rate  |       |                                        | 4.70       | %                                           |       |                                        | 4.50       | % |   |   | 4.44 | % |   |
| Volatility     |       |                                        | 18         | %                                           |       |                                        | 20         | % |   |   | 20 | % |   |
| Dividend yield |       |                                        | 9          | %                                           |       |                                        | 9          | % |   |   | 9 | % |   |

 

Theestimated fair value of the common stock options was $2.54, $1.90 and $0.98 at December 31,2006, December 31, 2005 and December 31, 2004, respectively. For theyear ended December 31, 2006, 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, 2006** | ** **                   | **Year ended  December 31, 2005** | ** ** | **Period from  August 12, 2004  (Inception) through  December 31, 2004** | ** **    |
|-------------------------------------------------|------------|--------------------------------------------------|------------------------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|---------------|
| Options granted  to Manager                     |       |                                             | $    833 |                                             |       |                                                                                                   | $ 2,155  |   |   |   | $  461 |   |   |
| Restricted shares  granted to Manager           |       |                                             | 27,786                       |                                             |       |                                                                                                   | 27,654        |   |   |   | 5,649 |   |   |
| Restricted shares  granted to certain directors |       |                                             | 566                          |                                             |       |                                                                                                   | 437           |   |   |   | 116 |   |   |
| Total share-based  compensation  expense        |       |                                             | $ 29,185                |                                             |       |                                                                                                   | $ 30,246 |   |   |   | $ 6,226 |   |   |

 

F-37

----

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

**Note 12.** ManagementAgreement and Related Party Transactions

The Manager manages the Company’s day-to-dayoperations, subject to the direction and oversight of the Company’s Board ofDirectors. The Management Agreement expires on December 31, 2007 and isautomatically renewed for a one-year term each anniversary thereafter. TheManagement Agreement may be terminated upon the affirmative vote of at leasttwo-thirds of the Company’s independent directors, or by a vote of the holdersof a majority of the outstanding shares of the Company’s common stock.

The Management Agreement provides, among other things,that the Company pays to the Manager certain fees and reimbursements,consisting of a base management fee, an incentive fee, and reimbursement forout-of-pocket and certain other costs incurred by the Manager on behalf of theCompany.

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 not material.

For the year ended December 31, 2006, the Companyincurred $28.9 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$28.6 million for the year ended December 31, 2006 (see Note 11).The Company also reimbursed the Manager $8.8 million for expenses for the yearended December 31, 2006. For the year ended December 31, 2005, theCompany incurred $21.0 million in base management fees. In addition, theCompany recognized share-based compensation expense related to commonstock options and restricted common stock granted to the Manager of$29.8 million for the year ended December 31, 2005 (see Note 11).The Company also reimbursed the Manager $4.9 million for expenses for the yearended December 31, 2005. The Company incurred base management fees andreimbursed the Manager for expenses of $5.1 million and $1.8 million,respectively, for the period from Inception through December 31, 2004. Inaddition, the Company recognized share-based compensation expense relatedto common stock options and restricted common stock granted to the 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 related party management compensation 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.

Incentive fees of $7.8 million were earned by theManager during the year ended December 31, 2006. No incentive fees wereearned or paid to the Manager during the year ended December 31, 2005 orduring the period from Inception to December 31, 2004.

An affiliate of the Company’s Manager has entered intoseparate management agreements with the respective investment vehicles for CLO2005-1, CLO 2005-2, and CLO 2006-1 and is entitled to receivefees for the services performed as collateral manager. The collateral managerhas permanently waived approximately $4.4 million, $1.3 million, and nil,respectively, for the years ending December 31, 2006, 2005, and the periodfrom Inception to December 31, 2004. The waivers for CLO 2005-1, CLO2005-2, and CLO 2006-1 expire in April 2007, May 2007,and May 2007,****respectively. Thereare no assurances that the collateral manager will waive such management feessubsequent to those dates.

F-38

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

**Note 12.** Management Agreement and Related Party Transactions(Continued)

During January 2006, the Company invested $40.0million in a series of corporate floating rate notes which were rated BB byStandard & Poor’s and were issued by an unaffiliated third party. KKR FinancialAdvisors II, LLC, a wholly-owned subsidiary of the Company’s Manager, is thecollateral manager for the unaffiliated third party in connection with thiscorporate floating rate note transaction.

During the second quarter of 2006, the Company invested$40.7 million in the common equity of Capmark Financial Group Inc. (“Capmark”).Capmark is controlled by an investor group that includes KKR, an affiliate ofthe Manager and the CEO of Capmark is on the Company’s board of directors andthe Company’s CEO is on Capmark’s board of directors. As of December 31,2006, the Company held investments in KKR affiliated companies consistingof $110.8 million of non-marketable equity securities, $257.0 million ofsecurities available-for-sale and $527.3 million of corporate loans.

During the third quarterof 2006, the Company purchased thirteen corporate loans and two corporatesecurities with an aggregate purchase price of $474.8 million, plus accrued andunpaid interest, and the Company simultaneously sold, for settlement in October 2006,all fifteen investments for an aggregate sales price of $474.8 million, plusaccrued and unpaid interest, to KKR Strategic Capital Funds. During the periodbeginning on the Company’s purchase settlement date and ending on the salessettlement date the Company earned 100% of the income on the respectiveinvestments and the KKR Strategic Capital Funds assumed all of the credit riskand market risk on the respective investments. During the quarter ended September 30,2006, the Company earned net interest income of approximately $2.4 millionduring the period that the Company owned and funded the fifteen investments.

**Note 13.** 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 theCompany’s taxable income. TRS Inc., however, is taxed as a regular subchapter Ccorporation under the Code. The income tax provision for the Company (REIT) andTRS Inc. (TRS) for the year ended December 31, 2006, December 31,2005 and the period from Inception through to December 31, 2004 consistedof the following components (amounts in thousands):
| ** **                                  | ** ** | **Year ended  December 31, 2006** | ** **       | **Year ended  December 31, 2005** | ** ** | **Period from  August 12, 2004  (Inception) through  December 31, 2004** | ** **   |
|---------------------------------------------|------------|--------------------------------------------------|------------------|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|--------------|
| Current provision  (benefit):               |       |                                             |             |                                             |       |                                                                                                   |         |   |   |   |   |   |   |
| Federal—TRS                            |       |                                             | $ 1,493     |                                             |       |                                                                                                   | $ 1,473 |   |   |   | $   — |   |   |
| Federal—REIT                           |       |                                             | (15              | )                                                |       |                                                                                                   | 352          |   |   |   | — |   |   |
| State—TRS                              |       |                                             | 183              |                                             |       |                                                                                                   | 242          |   |   |   | — |   |   |
| Foreign—REIT                           |       |                                             | —           |                                             |       |                                                                                                   | 152          |   |   |   | — |   |   |
| Total current  provision (benefit)          |       |                                             | 1,661            |                                             |       |                                                                                                   | 2,219        |   |   |   | — |   |   |
| Deferred provision  (benefit):              |       |                                             |             |                                             |       |                                                                                                   |         |   |   |   |   |   |   |
| Federal—TRS                            |       |                                             | (599             | )                                                |       |                                                                                                   | 788          |   |   |   | (190 | ) |   |
| State—TRS                              |       |                                             | (98              | )                                                |       |                                                                                                   | 137          |   |   |   | (38 | ) |   |
| Total deferred  provision (benefit)         |       |                                             | (697             | )                                                |       |                                                                                                   | 925          |   |   |   | (228 | ) |   |
| Total provision (benefit)  for income taxes |       |                                             | $  964 |                                             |       |                                                                                                   | $ 3,144 |   |   |   | $ (228 | ) |   |

 

F-39

----

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

**Note 13.** IncomeTaxes (Continued)

The above tax provision (benefit) was based on TRS Inc.’seffective tax rate of 40.75% at December 31, 2006, 40.75% at December 31,2005 and 42.02% at December 31, 2004. It was equivalent to the combinedrate of the Federal statutory income tax rate and the State statutory incometax rate, net of Federal benefit.

Thecomponents of the deferred tax assets and liabilities as of December 31,2006 and December 31, 2005 are as follows (amounts in thousands):

|                                      | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Deferred tax assets:                 |       |                        |       |                        |       |   |   |   |   |
| Unrealized  loss—derivatives    |       |                        | $          | 1                           |       |   |   | $ | — |   |   |
| Net operating loss  carryforward     |       |                        | —     |                        |       |   | — |   |   |
| Gross deferred tax asset             |       |                        | $          | 1                           |       |   |   | $ | — |   |   |
| Deferred tax  liabilities:           |       |                        |       |                        |       |   |   |   |   |
| Unrealized  gain—derivatives    |       |                        | $          | —                      |       |   |   | $ | 697 |   |   |
| Net operating loss  carryforward     |       |                        | —     |                        |       |   | — |   |   |
| Gross deferred tax  liabilities      |       |                        | $          | —                      |       |   |   | $ | 697 |   |   |
| Net deferred tax asset  (liability)  |       |                        | $          | 1                           |       |   |   | $ | (697 | ) |   |
| Valuation allowance                  |       |                        | —     |                        |       |   | — |   |   |
| Total deferred tax asset (liability) |       |                        | $          | 1                           |       |   |   | $ | (697 | ) |   |

 

For federal income taxpurposes, the distributions declared and paid during 2006 and 2005 on theCompany’s common stock are 100% taxable as dividend income at ordinary ratesand no portion of the dividends is eligible for the 15% dividend tax rate orthe corporate dividends received deduction.

**Note 14.** LeaseholdImprovements and Equipment

Thefollowing is a summary of the Company’s leasehold improvements and equipment,which are included in other assets in the consolidated balance sheet at December 31,2006 and 2005 (amounts in thousands):

|                                   | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Leasehold improvements            |       |                        | $          | 6,373                       |       |   |   | $ | 1,274 |   |   |
| Furniture and equipment           |       |                        | 1,986      |                        |       |   | 1,435 |   |   |
|                              |       |                        | 8,359      |                        |       |   | 2,709 |   |   |
| Accumulated depreciation          |       |                        | (796       | )                           |       |   | (641 | ) |   |
| Total property and equipment, net |       |                        | $          | 7,563                       |       |   |   | $ | 2,068 |   |   |

 

Depreciation andamortization expense was $0.8 million, $0.6 million and $0.1 million for theyears ended December 31, 2006, 2005 and 2004, respectively.

**Note 15.** 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 securitiesavailable-for-sale, loans, derivatives, and loan commitments is based on quotedmarket prices or estimates 

F-40

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

**Note 15.** Fair Value of Financial Instruments (Continued)

providedby independent pricing sources. The fair value of cash and cash equivalents,interest payable, repurchase agreements, collateralized loan obligation seniorsecured notes, asset-backed secured liquidity notes, secured revolving creditfacility, secured demand loan and interest payable, approximates cost as of December 31,2006 and December 31, 2005, due to the short-term nature of theseinstruments.

The table below disclosesthe carrying value and the fair value of the Company’s financial instruments asof December 31, 2006 (amounts in thousands): 

|                                                      | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|------------------------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| Financial Assets:                                    |       |                 |       |                           |       |   |   |
| Cash, restricted cash,  and cash equivalents         |       | $                    | 143,190    |                           |       | $ | 143,190 |   |   |
| Securities  available-for-sale                       |       | 8,500,636            |       |                           | 8,500,636  |   |   |
| Loans, net of allowance  for loan losses of $1,500   |       | 8,442,021            |       |                           | 8,434,960  |   |   |
| Non-marketable equity  securities                    |       | 166,323              |       |                           | 166,323    |   |   |
| Interest receivable                                  |       | 84,048               |       |                           | 84,048     |   |   |
| Derivatives                                          |       | 63,433               |       |                           | 63,433     |   |   |
| Financial Liabilities:                               |       |                 |       |                           |       |   |   |
| Repurchase agreements                                |       | $                    | 4,457,089  |                           |       | $ | 4,457,089 |   |   |
| Collateralized loan obligation  senior secured notes |       | 2,252,500            |       |                           | 2,252,500  |   |   |
| Asset-backed secured  liquidity notes                |       | 8,705,601            |       |                           | 8,705,601  |   |   |
| Secured revolving credit  facility                   |       | 34,710               |       |                           | 34,710     |   |   |
| Secured demand loan                                  |       | 41,658               |       |                           | 41,658     |   |   |
| Junior subordinated  notes                           |       | 257,743              |       |                           | 257,577    |   |   |
| Interest payable                                     |       | 36,991               |       |                           | 36,991     |   |   |
| Derivatives                                          |       | 2,715                |       |                           | 2,715      |   |   |

 

The table below discloses the carrying value and thefair value of the Company’s financial instruments as of December 31, 2005(amounts in thousands):

|                                                     | ** ** | **Carrying  Amount** | ** ** | **Estimated Fair  Value** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| Financial Assets:                                   |       |                 |       |                           |       |   |   |
| Cash, restricted 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     |   |   |
| Derivative assets                                   |       | 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     |   |   |
| Derivative liabilities                              |       | 1,465                |       |                           | 1,465      |   |   |
| Off-Balance Sheet Items:                            |       |                 |       |                           |       |   |   |
| Loan commitments                                    |       | $                    | —     |                           |       | $ | 346 |   |   |

 

F-41

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

**Note 16. Summary ofQuarterly Information (Unaudited)**

Thefollowing is a presentation of the quarterly results of operations (amounts inthousands, except per share information):

| ** **                                                                         | ** ** | **2006**            | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                                         | ** ** | **Fourth  Quarter** | ** ** | **Third  Quarter** | ** ** | **Second  Quarter** | ** ** | **First  Quarter** | ** ** |
| **Net investment income:**                                                         |       |                |       |   |   |   |   |   |   |
| Total investment  income                                                           |       | $                   | 261,375    |   | $ | 254,037 |   | $ | 226,827 |   | $ | 207,798 |   |
| Interest expense                                                                   |       | (210,658            | )          | (199,365 | ) | (175,094 | ) | (156,563 | ) |
| Provision for  loan losses                                                         |       | —              |       | — |   | — |   | — |   |
| Net investment  income                                                             |       | 50,717              |       | 54,672 |   | 51,733 |   | 51,235 |   |
| **Other  income:**                                                                 |       |                |       |   |   |   |   |   |   |
| Total other  income                                                                |       | 9,076               |       | 5,558 |   | 4,448 |   | 1,673 |   |
| **Non-investment  expenses:**                                                      |       |                |       |   |   |   |   |   |   |
| Related party  management compensation                                             |       | 17,321              |       | 19,759 |   | 13,778 |   | 14,440 |   |
| Professional  services                                                             |       | 2,313               |       | 1,096 |   | 548 |   | 947 |   |
| Loan servicing  expense                                                            |       | 3,408               |       | 3,626 |   | 3,720 |   | 3,996 |   |
| Insurance expense                                                                  |       | 200                 |       | 211 |   | 274 |   | 224 |   |
| Directors  expenses                                                                |       | 405                 |       | 333 |   | 375 |   | 373 |   |
| General and  administrative expenses                                               |       | 3,478               |       | 3,049 |   | 2,436 |   | 2,228 |   |
| Total non-investment  expenses                                                     |       | 27,125              |       | 28,074 |   | 21,131 |   | 22,208 |   |
| Income before  equity in income of unconsolidated affiliate and income tax expense |       | 32,668              |       | 32,156 |   | 35,050 |   | 30,700 |   |
| Equity in income  of unconsolidated affiliate                                      |       | 4,808               |       | 914 |   | — |   | — |   |
| Income before  income tax expense                                                  |       | 37,476              |       | 33,070 |   | 35,050 |   | 30,700 |   |
| Income tax  expense                                                                |       | 79                  |       | 454 |   | 119 |   | 312 |   |
| Net income                                                                         |       | $                   | 37,397     |   | $ | 32,616 |   | $ | 34,931 |   | $ | 30,388 |   |
| Net income per common  share:                                                      |       |                |       |   |   |   |   |   |   |
| Basic                                                                              |       | $                   | 0.47       |   | $ | 0.42 |   | $ | 0.45 |   | $ | 0.39 |   |
| Diluted                                                                            |       | $                   | 0.47       |   | $ | 0.41 |   | $ | 0.44 |   | $ | 0.38 |   |
| Weighted-average  number of common shares outstanding:                             |       |                |       |   |   |   |   |   |   |
| Basic                                                                              |       | 78,784              |       | 78,463 |   | 77,675 |   | 77,675 |   |
| Diluted                                                                            |       | 80,250              |       | 79,578 |   | 79,410 |   | 79,314 |   |
| Distributions declared  per common share                                           |       | $                   | 0.52       |   | $ | 0.49 |   | $ | 0.45 |   | $ | 0.40 |   |

 

F-42

----

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

**Note 16.Summary of Quarterly Information (Unaudited) (Continued)**

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

 

F-43

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

**Note 17.** Subsequent Events

On February 1, 2007, the Company’s board of directorsdeclared a cash distribution for the quarter ended December 31, 2006 onthe Company’s common stock of $0.54 per share. The distribution is payable on February 28,2007 to stockholders of record as of the close of business on February 15,2007.

On February 9,2007, pursuant to a proposed restructuring (the “Conversion Transaction”) thatwould result in the conversion of shares of common stock of KKR Financial Corp.into shares representing limited liability company interests in KKR FinancialHoldings LLC, a Delaware limited liability company (“KKR Financial Holdings LLC”),the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”)among the Company, KKR Financial Holdings LLC and KKR Financial Merger Corp., aMaryland corporation (“KKR Financial Merger Corp.”). On February 9, 2007,the Company filed with the SEC a preliminary proxy statement/prospectus (the “ProxyStatement/Prospectus”) relating to the Conversion Transaction. Pursuant to theConversion Transaction, KKR Financial Holdings LLC will not be a real estateinvestment trust, but is intended to be a pass-through entity for U.S. federalincome tax purposes. The Conversion Transaction was approved by the Company’s boardof directors on January 17, 2007. The Company expects that the ConversionTransaction, which is subject to stockholder approval, will be completed by June 30,2007.

F-44

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