**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

** **

| **ý**                                        | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|---------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                              | ** ** | ** **                                                                                               |
| **For the quarterly period ended: June 30, 2006** |
| ** **                                        | ** ** | ** **                                                                                               |
| **OR**                                            |
| ** **                                        | ** ** | ** **                                                                                               |
| **o**                                             | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**Forthe transition periodfrom                  to                  **

** **

**Commissionfile number 001-32542**

** **

**KKR FINANCIAL CORP.**

**(Exact name of registrant as specifiedin its governing instruments)**

 

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

 

**(415)315-3620**Registrant’s telephone number, including area code

** **

----

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities and Exchange Act of 1934 duringthe preceding 12 months and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý    No  o

 

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

 

Large acceleratedfiler  ý          Accelerated filer  o             Non-accelerated filer   ̈

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theSecurities Exchange Act of 1934). Yes  o    No  ý

 

The number of shares ofthe registrant’s common stock outstanding as of July 28, 2006 was 80,374,061.

 

 

----

 

**TABLEOF CONTENTS**

 
| **PART I.**           |                                                                                        |       |
|-----------------------|---------------------------------------------------------------------------------------------|------------|
| FINANCIAL INFORMATION |                                                                                        |
| Item 1.               | Financial Statements                                                                        |       |
| Item 2.               | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |       |
| Item 3.               | Quantitative  and Qualitative Disclosures about Market Risk                                 |       |
| Item 4.               | Controls and  Procedures                                                                    |       |
| **Part II.**     | ** **                                                                                  | ** ** |
| OTHER INFORMATION     |                                                                                        |
| Item 1.               | Legal Proceedings                                                                           |       |
| Item 2.               | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       |
| Item 3.               | Defaults  Upon Senior Securities                                                            |       |
| Item 4.               | Submission  of Matters to a Vote of Security Holders                                        |       |
| Item 5.               | Other Information                                                                           |       |
| Item 6.               | Exhibits                                                                                    |       |

 

----

 

**PART I. FINANCIALINFORMATION**

 

**Item 1. FinancialStatements (Unaudited)**

 

**KKRFinancial Corp. and Subsidiaries****Condensed Consolidated Balance Sheets****(Unaudited)****(Amounts in thousands, except shareinformation)**

 
| ** **                                                                                                                                              | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| **Assets**                                                                                                                                              | ** ** | ** **         | ** ** | ** **             | ** ** |
| Cash  and cash equivalents                                                                                                                              |       | $                  | 21,684     |                   | $          | 16,110 |   |
| Restricted  cash and cash equivalents                                                                                                                   |       | 105,254            |       | 80,223                 |       |
| Securities  available-for-sale, $6,856,963 and $5,910,399 pledged as collateral as of  June 30, 2006 and December 31, 2005, respectively           |       | 7,268,047          |       | 6,149,506              |       |
| Loans,  net of allowance for loan losses of $1,500 as of June 30, 2006 and  December 31, 2005                                                      |       | 8,423,645          |       | 8,846,341              |       |
| Loans  held for sale                                                                                                                                    |       | 107,262            |       | —                 |       |
| Derivative  assets                                                                                                                                      |       | 129,588            |       | 58,898                 |       |
| Interest  receivable                                                                                                                                    |       | 75,001             |       | 59,993                 |       |
| Principal  receivable                                                                                                                                   |       | 1,258              |       | 7,108                  |       |
| Non-marketable  equity securities                                                                                                                       |       | 139,429            |       | 52,500                 |       |
| Income  tax receivable                                                                                                                                  |       | 908                |       | —                 |       |
| Other  assets                                                                                                                                           |       | 34,859             |       | 19,861                 |       |
| **Total assets**                                                                                                                                        |       | $                  | 16,306,935 |                   | $          | 15,290,540 |   |
| **Liabilities**                                                                                                                                         | ** ** | ** **         | ** ** | ** **             | ** ** |
| Repurchase  agreements                                                                                                                                  |       | $                  | 5,146,903  |                   | $          | 9,761,258 |   |
| Collateralized  loan obligation senior secured notes                                                                                                    |       | 1,525,000          |       | 1,500,000              |       |
| Asset-backed  secured liquidity notes                                                                                                                   |       | 7,292,844          |       | 2,008,069              |       |
| Secured  revolving credit facility                                                                                                                      |       | 112,594            |       | 54,000                 |       |
| Secured  demand loan                                                                                                                                    |       | 41,658             |       | 40,511                 |       |
| Junior  subordinated notes                                                                                                                              |       | 103,100            |       | —                 |       |
| Payable  for securities purchases                                                                                                                       |       | 212,299            |       | 196,315                |       |
| Accounts  payable, accrued expenses and other liabilities                                                                                               |       | 104,347            |       | 45,925                 |       |
| Accrued  interest payable                                                                                                                               |       | 27,287             |       | 21,415                 |       |
| Related  party payable                                                                                                                                  |       | 5,276              |       | 3,673                  |       |
| Income  tax liability                                                                                                                                   |       | 622                |       | 2,763                  |       |
| Derivative  liabilities                                                                                                                                 |       | 188                |       | 1,465                  |       |
| **Total liabilities**                                                                                                                                   |       | 14,572,118         |       | 13,635,394             |       |
| **Stockholders’ Equity**                                                                                                                           | ** ** | ** **         | ** ** | ** **             | ** ** |
| Preferred  stock, $0.01 par value, 50,000,000 shares authorized and none issued and  outstanding at June 30, 2006 and December 31, 2005            |       | —             |       | —                 |       |
| Common  stock, $0.01 par value, 250,000,000 shares authorized and 80,374,061 shares  issued and outstanding at June 30, 2006 and December 31, 2005 |       | 804                |       | 804                    |       |
| Additional  paid-in-capital                                                                                                                             |       | 1,651,922          |       | 1,639,996              |       |
| Accumulated  other comprehensive income                                                                                                                 |       | 89,087             |       | 18,344                 |       |
| Accumulated  deficit                                                                                                                                    |       | (6,996             | )          | (3,998                 | )          |
| **Total stockholders’ equity**                                                                                                                     |       | 1,734,817          |       | 1,655,146              |       |
| **Total liabilities and stockholders’ equity**                                                                                                     |       | $                  | 16,306,935 |                   | $          | 15,290,540 |   |
|                                                                                                                                                         |            |                    |            |                        |            |  |  |  |  |

 

See notes tocondensed consolidated financial statements.

 

2

----

 

**KKRFinancial Corp. and SubsidiariesCondensed Consolidated Statements of Operations(Unaudited)(Amounts in thousands, except per share information)**

** **
| ** **                                                                   | ** ** | **For the three   months ended   June 30, 2006** | ** ** | **For the three   months ended   June 30, 2005** | ** ** | **For the six   months ended   June 30, 2006** | ** ** | **For the six   months ended   June 30, 2005** | ** **   |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|--------------|
| **Net investment income:**                                                   | ** ** | ** **                                       | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** **                                     | ** **   |
| Securities interest  income                                                  |       | $                                                | 94,010     |                                             | $          | 46,048                                         |       | $                                              | 173,974      |   | $ | 69,918 |   |
| Loan interest income                                                         |       | 130,098                                          |       | 21,102                                           |       | 255,204                                        |       | 31,990                                         |         |
| Dividend income                                                              |       | 912                                              |       | 933                                              |       | 1,795                                          |       | 1,467                                          |         |
| Other interest income                                                        |       | 1,807                                            |       | 943                                              |       | 3,652                                          |       | 1,197                                          |         |
| Total investment income                                                      |       | 226,827                                          |       | 69,026                                           |       | 434,625                                        |       | 104,572                                        |         |
| Interest expense                                                             |       | (175,094                                         | )          | (48,281                                          | )          | (331,657                                       | )          | (68,730                                        | )            |
| Net investment income                                                        |       | 51,733                                           |       | 20,745                                           |       | 102,968                                        |       | 35,842                                         |         |
| **Other income:**                                                            | ** ** | ** **                                       | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** **                                     | ** **   |
| Net  realized and unrealized gain (loss) on derivatives and foreign exchange |       | 3,299                                            |       | (176                                             | )          | 3,309                                          |       | (49                                            | )            |
| Net realized gain on  investments                                            |       | 691                                              |       | 790                                              |       | 2,139                                          |       | 1,151                                          |         |
| Fee and other income                                                         |       | 458                                              |       | 1,245                                            |       | 673                                            |       | 1,595                                          |         |
| Total other income                                                           |       | 4,448                                            |       | 1,859                                            |       | 6,121                                          |       | 2,697                                          |         |
| **Non-investment expenses:**                                                 | ** ** | ** **                                       | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** **                                     | ** **   |
| Related party  management compensation                                       |       | 13,778                                           |       | 10,731                                           |       | 28,218                                         |       | 18,739                                         |         |
| Professional services                                                        |       | 548                                              |       | 788                                              |       | 1,495                                          |       | 1,185                                          |         |
| Loan servicing expense                                                       |       | 3,720                                            |       | 363                                              |       | 7,716                                          |       | 630                                            |         |
| Insurance expense                                                            |       | 274                                              |       | 216                                              |       | 498                                            |       | 433                                            |         |
| Directors expenses                                                           |       | 375                                              |       | 152                                              |       | 748                                            |       | 351                                            |         |
| General and  administrative expenses                                         |       | 2,436                                            |       | 858                                              |       | 4,664                                          |       | 1,477                                          |         |
| Total non-investment  expenses                                               |       | 21,131                                           |       | 13,108                                           |       | 43,339                                         |       | 22,815                                         |         |
| Income before income  tax expense                                            |       | 35,050                                           |       | 9,496                                            |       | 65,750                                         |       | 15,724                                         |         |
| Income tax expense                                                           |       | 119                                              |       | 994                                              |       | 431                                            |       | 1,106                                          |         |
| Net income                                                                   |       | $                                                | 34,931     |                                             | $          | 8,502                                          |       | $                                              |  65,319 |   | $ |  14,618 |   |
| Net income per common  share:                                                |       |                                             |       |                                             |       |                                           |       |                                           |         |
| Basic                                                                        |       | $                                                | 0.45       |                                             | $          | 0.21                                           |       | $                                              |  0.84   |   | $ |  0.37 |   |
| Diluted                                                                      |       | $                                                | 0.44       |                                             | $          | 0.21                                           |       | $                                              |  0.82   |   | $ |  0.36 |   |
| Weighted-average number  of common shares outstanding:                       |       |                                             |       |                                             |       |                                           |       |                                           |         |
| Basic                                                                        |       | 77,675                                           |       | 40,212                                           |       | 77,675                                         |       | 40,004                                         |         |
| Diluted                                                                      |       | 79,410                                           |       | 40,994                                           |       | 79,237                                         |       | 40,689                                         |         |
| Distributions declared  per common share                                     |       | $                                                | 0.45       |                                             | $          | 0.40                                           |       | $                                              |  0.85   |   | $ |  0.65 |   |

 

Seenotes to condensed consolidated financial statements.

 

3

----

 

**KKRFinancial Corp. and SubsidiariesCondensed Consolidated Statement of Changes in Stockholders’ Equity(Unaudited)(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 January 1, 2006**                                    |       | 80,374                            |       | $                                     | 804        |                             | $          | 1,639,996                                     |       | $                        | 18,344     |                                  | $          | (3,998                                | )          |   |   | $ | 1,655,146 |   |
| Net  income                                                       |       | —                            |       | —                                |       | —                           |       | —                                        |       | 65,319                   |       | $                                     | 65,319     |                                  | 65,319     |   |
| Net  change in unrealized gain on cash flow hedges                |       | —                            |       | —                                |       | —                           |       | 72,393                                        |       | —                   |       | 72,393                                |       | 72,393                                |       |
| Net  change in unrealized loss on securities available-for-sale   |       | —                            |       | —                                |       | —                           |       | (1,650                                        | )          | —                   |       | (1,650                                | )          | (1,650                                | )          |
| Comprehensive  income                                             |       |                              |       |                                  |       |                             |       |                                          |       |                     |       | $                                     | 136,062    |                                  |       |   |
| Cash  distributions on common stock                               |       | —                            |       | —                                |       | —                           |       | —                                        |       | (68,317                  | )          |                                  |       | (68,317                               | )          |
| Amortization  of restricted common stock and common stock options |       | —                            |       | —                                |       | 11,926                           |       | —                                        |       | —                   |       |                                  |       | 11,926                                |       |
| **Balance at June 30, 2006**                                      |       | 80,374                            |       | $                                     | 804        |                             | $          | 1,651,922                                     |       | $                        | 89,087     |                                  | $          | (6,996                                | )          |   |   | $ | 1,734,817 |   |

 

See notes tocondensed consolidated financial statements.

 

4

----

 

**KKRFinancial Corp. and SubsidiariesCondensed Consolidated Statements of Cash Flows(Unaudited)(Amounts in thousands)**

 
| ** **                                                                     | ** ** | **Six months ended  June 30, 2006** | ** ** | **Six months ended  June 30, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| **Cash flows from operating activities:**                                      | ** ** | ** **                          | ** ** | ** **                          | ** ** |
| Net  income                                                                    |       | $                                   | 65,319     |                                | $          | 14,618 |   |
| Adjustments  to reconcile net income to cash provided by operating activities: |       |                                |       |                                |       |
| Unrealized  gain on derivative positions                                       |       | (547                                | )          | (2,204                              | )          |
| Realized  gain on equity short positions                                       |       | (52                                 | )          | —                              |       |
| Realized  gain (loss) on foreign currency translation                          |       | (1,316                              | )          | 2,536                               |       |
| Share-based  compensation                                                      |       | 11,926                              |       | 12,080                              |       |
| Unrealized  loss on loans held for sale                                        |       | 194                                 |       | —                              |       |
| Net  gain on sale of securities available-for-sale                             |       | (1,864                              | )          | (815                                | )          |
| Net  gain on sale of loans                                                     |       | (275                                | )          | —                              |       |
| Depreciation  and amortization                                                 |       | 912                                 |       | 2,753                               |       |
| Deferred  income tax (benefit) expense                                         |       | (398                                | )          | 228                                 |       |
| Changes  in assets and liabilities:                                            |       |                                |       |                                |       |
| Interest  receivable                                                           |       | (15,876                             | )          | (19,380                             | )          |
| Income  tax receivable                                                         |       | (908                                | )          | —                              |       |
| Other  assets                                                                  |       | (4,303                              | )          | (980                                | )          |
| Related  party payable                                                         |       | 1,603                               |       | (48                                 | )          |
| Accounts  payable, accrued expenses and other liabilities                      |       | 56,729                              |       | 2,140                               |       |
| Income  tax liability                                                          |       | —                              |       | 878                                 |       |
| Accrued  interest payable                                                      |       | 5,872                               |       | 9,503                               |       |
| Net  cash provided by operating activities                                     |       | 117,016                             |       | 21,309                              |       |
| **Cash flows from investing activities:**                                      | ** ** | ** **                          | ** ** | ** **                          | ** ** |
| Purchase  of securities available-for-sale                                     |       | (2,206,292                          | )          | (3,865,604                          | )          |
| Principal  payments on securities available-for-sale                           |       | 1,067,842                           |       | 480,219                             |       |
| Proceeds  from sale of securities available-for-sale                           |       | 45,556                              |       | 13,463                              |       |
| Purchase  of loans                                                             |       | (1,309,627                          | )          | (1,555,761                          | )          |
| Principal  payments on loans                                                   |       | 1,458,291                           |       | 192,878                             |       |
| Proceeds  from sale of loans                                                   |       | 164,936                             |       | —                              |       |
| Purchases  of non-marketable equity securities                                 |       | (91,621                             | )          | —                              |       |
| Proceeds  from non-marketable equity securities                                |       | 4,692                               |       | —                              |       |
| Proceeds  from sale of derivatives                                             |       | 973                                 |       | —                              |       |
| Net  additions to restricted cash and cash equivalents                         |       | (25,031                             | )          | (30,144                             | )          |
| Additions  of property and equipment                                           |       | (3,594                              | )          | (262                                | )          |
| Net  cash used in investing activities                                         |       | (893,875                            | )          | (4,765,211                          | )          |
| **Cash flows from financing activities:**                                      | ** ** | ** **                          | ** ** | ** **                          | ** ** |
| Net proceeds from issuance  of common shares                                   | ** ** | —                              | ** ** | 848,909                             | ** ** |
| Proceeds  from borrowings:                                                     |       |                                |       |                                |       |
| Repurchase  agreements                                                         |       | 77,796,376                          |       | 32,740,601                          |       |
| Asset-backed  secured liquidity notes                                          |       | 25,640,041                          |       | —                              |       |
| Collateralized  loan obligation senior secured notes                           |       | 25,000                              |       | 696,448                             |       |
| Secured  revolving credit facility                                             |       | 760,171                             |       | —                              |       |
| Secured  demand loan                                                           |       | 2,372,236                           |       | 12,636                              |       |
| Junior  subordinated notes                                                     |       | 100,000                             |       | —                              |       |
| Other  capitalized costs                                                       |       | (21,037                             | )          | —                              |       |
| Purchase  of interest rate derivatives                                         |       | —                              |       | (10,106                             | )          |
| Repayments  of borrowings:                                                     |       |                                |       |                                |       |
| Repurchase  agreements                                                         |       | (82,410,732                         | )          | (29,527,119                         | )          |
| Asset-backed  secured liquidity notes                                          |       | (20,338,640                         | )          | —                              |       |
| Secured  demand loan                                                           |       | (2,371,088                          | )          | —                              |       |
| Secured  revolving credit facility                                             |       | (701,577                            | )          | —                              |       |
| Distributions  on common stock                                                 |       | (68,317                             | )          | (10,251                             | )          |
| Net  cash provided by financing activities                                     |       | 782,433                             |       | 4,751,118                           |       |
| **Net increase in cash and cash equivalents**                                  |       | 5,574                               |       | 7,216                               |       |
| **Cash and cash equivalents at beginning of period**                           |       | 16,110                              |       | 7,219                               |       |
| **Cash and cash equivalents at end of period**                                 |       | $                                   | 21,684     |                                | $          | 14,435 |   |
| **Supplemental cash flow information:**                                        | ** ** | ** **                          | ** ** | ** **                          | ** ** |
| Cash  paid for interest                                                        |       | $                                   | 432,010    |                                | $          | 59,227 |   |
| Cash  paid for taxes                                                           |       | $                                   | 3,518      |                                | $          | — |   |
| **Non-cash investing and financing activities:**                               | ** ** | ** **                          | ** ** | ** **                          | ** ** |
| Distributions  on common stock declared but not paid                           | ** ** | $                                   | **—** | ** **                          | $          | 16,400 |   |
| Unsettled  securities trades                                                   |       | $                                   | 212,299    |                                | $          | 43,692 |   |
| Transfers  of loans held for investment to held for sale                       |       | $                                   | 107,456    |                                | $          | — |   |

 

Seenotes to condensed consolidated financial statements.

 

5

----

 

**KKRFinancial Corp. and Subsidiaries**

 

**Notes toCondensed Consolidated Financial Statements (Unaudited)**

 

**Note 1.Organization**

 

KKR Financial Corp., andits subsidiaries, (the “Company” or “KKR Financial”) is a specialty financecompany that invests in multiple asset classes and uses leverage to generatecompetitive leveraged risk-adjusted returns. The Company currently makesinvestments in the following asset classes: (i) residential mortgage loansand mortgage-backed securities; (ii) corporate loans and debt securities;(iii) commercial real estate loans and debt securities;(iv) asset-backed securities; and (v) marketable and non-marketableequity securities. The Company also makes opportunistic investments in otherasset classes from time to time.

 

The Company wasorganized as a Maryland corporation on July 7, 2004, and commencedoperations on August 12, 2004 (“Inception”). KKR Financial Advisors LLC(the “Manager”) manages the Company pursuant to a management agreement (the“Management Agreement”). The Manager is an affiliate of Kohlberg KravisRoberts & Co. L.P. (“KKR”).  TheCompany is taxed as a real estate investment trust (“REIT”) and is required tocomply with the provisions of the Internal Revenue Code of 1986, as amended(the “Code”), with respect thereto.

 

OnAugust 12, 2004, the Company completed its initial private placement ofshares of its common stock at $20.00 per share that generated net proceeds ofapproximately $755.5 million. On June 23, 2005 the Companyeffectuated a reverse stock split of its common stock at a ratio of one shareof common stock for every two shares of common stock then outstanding.  On June 29, 2005, the Company completedits initial public offering (the “IPO”) of 37,500,000 shares of common stockthat generated net proceeds of approximately $848.8 million. The Companysold 37,471,250 common shares at a price of $24.00 per share and sellingstockholders sold 28,750 shares.  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 of Presentation**

** **

The accompanyingcondensed consolidated financial statements have been prepared in conformitywith accounting principles generally accepted in the United States of America(“GAAP”). The consolidated financial statements include the accounts of theCompany, its taxable REIT subsidiaries, its qualified REIT subsidiaries,consolidated residential mortgage loan securitization trusts where the Companyis the primary beneficiary, and entities established to complete securedfinancing transactions that are considered to be variable interest entities andfor which the Company is the primary beneficiary. For additional information,see “Consolidation” below. Certain amounts for prior periods have beenreclassified to conform to the current****presentation. 

 

Descriptions ofthe significant accounting policies of the Company are included in Note 2 tothe consolidated financial statements in the Company’s 2005 Annual Report onForm 10-K.  There have been nosignificant changes to these policies during 2006.  See description of newly adopted and newlyapplicable accounting policies below. The Company’s results for any interim period are not necessarilyindicative of results for a full year or any other interim period.

 

**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.

 

6

----

 

**Consolidation**

** **

The Company consolidatesall non-variable interest entities in which it holds a greater than50 percent voting interest. The Company also consolidates all variableinterest entities (“VIEs”) for which it is considered to be the primary beneficiarypursuant to Financial Accounting Standards Board (“FASB”) InterpretationNo. 46R, *Consolidation of VariableInterest Entities—an interpretation of ARB No. 51*, as revised(“FIN 46R”). In general, FIN 46R requires an enterprise to consolidate aVIE when the enterprise holds a variable interest in the VIE and is deemed tobe the primary beneficiary of the VIE. An enterprise is the primary beneficiaryif it absorbs a majority of the VIE’s expected losses, receives a majority ofthe VIE’s expected residual returns, or both.

 

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 CDO2005-1, Ltd. (“CDO 2005-1”), are entities established to complete securedfinancing transactions.  These entitiesare VIEs and are not considered to be qualifying special-purpose entities(“QSPE”) as defined by Statement of Financial Accounting StandardsNo. 140, *Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities*(“SFAS No. 140”). The Company has determined it is the primary beneficiaryof these entities and has included the accounts of these entities in theseconsolidated financial statements. Additionally, the Company is the primary beneficiary of six residentialmortgage loan securitization trusts that are not considered to be QSPEs underSFAS No. 140 and the Company has therefore included the accounts of theseentities in these consolidated financial statements.

 

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

 

**TrustPreferred Securities**

 

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.

 

**Recent AccountingPronouncements**

 

In February 2006,the FASB issued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments*. Key provisions of SFAS No. 155include: (1) a broad fair value measurement option for certain hybridfinancial instruments that contain an embedded derivative that would otherwiserequire bifurcation; (2) clarification that only the simplest separationsof interest payments and principal payments qualify for the exception affordedto interest-only strips and principal-only strips from derivative accountingunder paragraph 14 of SFAS No. 133, *Accounting for DerivativeInstruments and Hedging Activities,* thereby narrowing suchexception; (3) a requirement that beneficial interests in securitizedfinancial assets be analyzed to determine whether they are freestandingderivatives or whether they are hybrid instruments that contain embeddedderivatives requiring bifurcation; (4) clarification that concentrationsof credit risk in the form of subordination are not embedded derivatives; and(5) elimination of the prohibition on a QSPE holding passive derivativefinancial instruments that pertain to beneficial interests that are or containa derivative financial instrument. In general, these changes will reduce the operationalcomplexity associated with bifurcating embedded derivatives, and increase thenumber of beneficial interests in securitization transactions, includinginterest-only strips and principal-only strips, required to be accounted for inaccordance with SFAS No. 133. The Company is required to adopt SFAS No.155 in the first quarter of 2007. The Company does not expect that the adoptionof SFAS No. 155 will have a material effect on its consolidated financialstatements.

 

In June 2006, the FASBissued Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes – an interpretation of FASB Statement No. 109* (“FIN48”).  FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109, *Accountingfor 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.  The Company is requiredto adopt FIN 48 in the first quarter of 2007 and is currently assessing theimpact that it will have on its consolidated financial statements.

 

7

----

 

**Note 3. Earningsper Share**

** **

The Company calculatesbasic net income per common share by dividing net income for the period by theweighted-average shares of its common stock outstanding for the period. Dilutednet income per common share takes into account the effect of dilutiveinstruments, such as common stock options and unvested restricted common stock,but uses the average share price for the period in determining the number ofincremental shares that are to be added to the weighted-average number ofshares of its common stock outstanding. The following table presents areconciliation of basic and diluted net income per common share for the threeand six months ended June 30, 2006 and 2005 (amounts in thousands, except pershare information):

 
| ** **                                                                | ** ** | **Three months ended   June 30, 2006** | ** ** | **Three months ended   June 30, 2005** | ** ** | **Six months ended   June 30, 2006** | ** ** | **Six months ended   June 30, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| **Basic:**                                                                | ** ** | ** **                             | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **                           | ** ** |
| Net income                                                                |       | $                                      | 34,931     |                                   | $          | 8,502                                |       | $                                    | 65,319     |   | $ | 14,618 |   |
| Weighted-average  number of common shares outstanding                     |       | 77,675                                 |       | 40,212                                 |       | 77,675                               |       | 40,004                               |       |
| Basic net income  per common share                                        |       | $                                      | 0.45       |                                   | $          | 0.21                                 |       | $                                    | 0.84       |   | $ | 0.37 |   |
| **Diluted:**                                                              | ** ** | ** **                             | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **                           | ** ** |
| Net income                                                                |       | $                                      | 34,931     |                                   | $          | 8,502                                |       | $                                    | 65,319     |   | $ | 14,618 |   |
| Weighted-average  number of common shares outstanding                     |       | 77,675                                 |       | 40,212                                 |       | 77,675                               |       | 40,004                               |       |
| Plus:  Incremental shares from assumed conversion of dilutive instruments |       | 1,735                                  |       | 782                                    |       | 1,562                                |       | 685                                  |       |
| Adjusted  weighted-average number of common shares outstanding            |       | 79,410                                 |       | 40,994                                 |       | 79,237                               |       | 40,689                               |       |
| Diluted net  income per common share                                      |       | $                                      | 0.44       |                                   | $          | 0.21                                 |       | $                                    | 0.82       |   | $ | 0.36 |   |

 

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

 

The following tablesummarizes the Company’s securities classified as available-for-sale as of June30, 2006, 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 |       | $                   | 6,426,923  |                         | $          | 14,807                        |       | $                              | (55,998    | ) | $ | 6,385,732 |   |
| Commercial  mortgage-backed securities  |       | 69,217              |       | 527                          |       | (201                          | )          | 69,543                         |       |
| Asset-backed securities                 |       | 31,444              |       | 213                          |       | (19                           | )          | 31,638                         |       |
| Corporate securities                    |       | 700,721             |       | 18,849                       |       | (4,920                        | )          | 714,650                        |       |
| Common and preferred  stock             |       | 68,608              |       | 262                          |       | (2,386                        | )          | 66,484                         |       |
| Total                                   |       | $                   | 7,296,913  |                         | $          | 34,658                        |       | $                              | (63,524    | ) | $ | 7,268,047 |   |

 

The followingtable 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 June 30,2006:

 
| ** **                              | ** ** | **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 |       | $                       | 180,507    |                  | $          | (484           | )          | $ | 1,985,306 |   | $ | (55,514 | ) | $ | 2,165,813 |   | $ | (55,998 | ) |
| Commercial  mortgage-backed securities  |       | 41,294                  |       | (201                  | )          | —         |       | — |   | 41,294 |   | (201 | ) |
| Asset-backed  securities                |       | 7,481                   |       | (19                   | )          | —         |       | — |   | 7,481 |   | (19 | ) |
| Corporate  securities                   |       | 93,056                  |       | (3,972                | )          | 6,304          |       | (948 | )  | 99,360 |   | (4,920 | ) |
| Common  and preferred stock             |       | 40,279                  |       | (2,386                | )          | —         |       | — |   | 40,279 |   | (2,386 | ) |
| Total                                   |       | $                       | 362,617    |                  | $          | (7,062         | )          | $ | 1,991,610 |   | $ | (56,462 | ) | $ | 2,354,227 |   | $ | (63,524 | ) |
|                                         |            |                         |            |                       |            |                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The unrealizedlosses in the above table are temporary impairments due to changes in marketinterest rates and are not reflective of credit deterioration.  As the Company has the intent and ability tohold these investments until recovery, unrealized losses are not considered tobe other-than-temporary impairments.

 

8

----

 

The following tablesummarizes the Company’s securities classified as available-for-sale as ofDecember 31, 2005, which are carried at estimated fair value (amounts inthousands):

 
| **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 anunrealized loss position at December 31, 2005 had been in an unrealizedloss position for less than one year.

 

During the three and sixmonths ended June 30, 2006, the Company’s gross realized gains from the salesof securities were $1.4 million and $2.1 million, respectively. The Company hadgross realized losses of $0.1 million from the sales of securities during thethree and six months ended June 30, 2006. In the three and six months endedJune 30, 2005, the Company’s gross realized gains from the sales of securitieswere $0.5 million and $0.8 million, respectively. The Company had no grossrealized losses from the sales of securities during the three and six monthsended June 30, 2005.

 

Note 6 to theseconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged securities available-for-sale for borrowingsunder repurchase agreements, asset-backed secured liquidity notes, and allother secured financing transactions. The following table summarizes theestimated fair value of securities pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of June 30, 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              |       | $                                            | 1,563,733  |                                        | $          | 55,309                        |       | $                               | 490,847    |   | $ | — |   |
| Pledged  as collateral for asset-backed secured liquidity notes                |       | 4,545,573                                    |       | —                                      |       | —                        |       | —                          |       |
| Pledged  as collateral for borrowings under secured revolving credit facility  |       | —                                       |       | —                                      |       | 16,975                        |       | —                          |       |
| Pledged  as collateral for borrowings under secured demand loan                |       | —                                       |       | —                                      |       | —                        |       | 51,416                          |       |
| Pledged  as collateral for collateralized loan obligation senior secured notes |       | —                                       |       | —                                      |       | 133,110                       |       | —                          |       |
| Total                                                                          |       | $                                            | 6,109,306  |                                        | $          | 55,309                        |       | $                               | 640,932    |   | $ | 51,416 |   |

 

The following tablesummarizes the estimated fair value of securities pledged as collateral underrepurchase agreements, asset-backed secured liquidity notes, and all othersecured 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)             Includesasset-backed securities.

 

9

----

 

**Note 5. Loans**

 

As of June 30, 2006seventeen corporate loans were classified as held for sale by the Company.  Accordingly, these loans are recorded at thelower of cost or market on the Company’s consolidated balance sheet. Of theseventeen loans classified as held for sale, seven of the loans had a marketvalue below amortized cost and a loss of $0.2 million was recognized to reducethe aggregate carrying value of the loans to market value as of June 30, 2006.

 

The following tablesummarizes the Company’s loans as of June 30, 2006 (amounts in thousands):

 
| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|-------------------------|------------|
| Residential mortgage  loans                               |       | $             | 5,723,061  |                                | $          | 19,895                  |       | $ | 5,742,956 |   |
| Corporate loans                                           |       | 2,373,552     |       | (2,355                              | )          | 2,371,197               |       |
| Commercial real estate  loans                             |       | 311,977       |       | (985                                | )          | 310,992                 |       |
| Allowance for loan  losses for residential mortgage loans |       | (1,500        | )          | —                              |       | (1,500                  | )          |
| Total  loans held for investment                          |       | 8,407,090     |       | 16,555                              |       | 8,423,645               |       |
| Loans held for sale                                       |       | 107,262       |       | —                              |       | 107,262                 |       |
| Total  loans, net of allowance for loan losses            |       | $             | 8,514,352  |                                | $          | 16,555                  |       | $ | 8,530,907 |   |

 

The following tablesummarizes of the Company’s loans as of December 31, 2005 (amounts inthousands):

 
| ** **                                                | ** ** | **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 6 to theseconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged loans for borrowings under repurchase agreements,asset-backed secured liquidity notes, and all other secured financingtransactions. The following table summarizes the carrying value of loanspledged as collateral under repurchase agreements, asset-backed secured liquiditynotes, and all other secured financing transactions as of June 30, 2006:

 
| **(amounts in thousands)**                                           | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged  as collateral for borrowings under repurchase agreements              |       | $                                    | 2,643,525  |                     | $          | 547,925                                     |       | $ | 227,027 |   |
| Pledged  as collateral for asset-backed secured liquidity notes                |       | 3,037,641                            |       | —                   |       | —                                      |       |
| Pledged  as collateral for borrowings under secured revolving credit facility  |       | —                               |       | 135,476                  |       | —                                      |       |
| Pledged  as collateral for collateralized loan obligation senior secured notes |       | —                               |       | 1,819,465                |       | —                                      |       |
| Total                                                                          |       | $                                    | 5,681,166  |                     | $          | 2,502,866                                   |       | $ | 227,027 |   |

 

10

----

 

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 |   |

** **

**Residential MortgageLoans**

** **

**During the year ended December 31, 2005, the Companypurchased $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, the Company purchased all of the securities issued, including thesubordinate classes. Included in the $5.9 billion of securities purchased were$0.4 billion of loans contributed to the securitization transactions by theCompany, resulting in a net purchase by the Company of $5.5 billion of securities.Of the $5.9 billion of securities purchased, approximately 96% were rated AAAby Standard & Poor’s Ratings Service (“Standard & Poor’s” or“S&P”). Each of the special-purpose entities that issued the securities arenot considered qualifying special-purpose entities as defined by SFASNo. 140 and are treated as VIEs under FIN 46R. The Company has determinedthat it is the primary beneficiary of each of the special-purpose entities thatissued the securities; accordingly, the Company recorded its investments asloans and not securities.**

 

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

** **

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of June 30, 2006 (dollar amounts in thousands):

 
| **Delinquency Status** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       | 88                            |       | $                         | 33,681     |   |
| 60 to 89 days               |       | 12                            |       | 3,906                     |       |
| 90 days or more             |       | 1                             |       | 446                       |       |
| In foreclosure              |       | 12                            |       | 3,192                     |       |
| Total                       |       | 113                           |       | $                         | 41,225     |   |

 

The following tablesummarizes the delinquency statistics of residential mortgage loans as ofDecember 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     |   |

 

11

----

 

As of June 30, 2006 one ofthe residential mortgage loans owned by the Company with an outstanding balanceof  $0.3 million (not included in thetable above) became real estate owned (“REO”) as a result of foreclose on adelinquent loan.  The estimated fairvalue of the underlying property exceeds the outstanding loan balance andtherefore the Company has not recorded a charge against the Company’s allowancefor loan losses, and the loan has been reclassified from loans to other assetson the Company’s balance sheet at the lower of cost or estimated fair value.  There were no REOs as of December 31, 2005.

 

As of June 30, 2006 theCompany had 13 loans that were 90 days or greater past due or in foreclosureand placed on non-accrual status.  Duringthe quarter ended June 30, 2006 the Company did not recognize approximately$0.1 million in interest income for loans in non-accrual status or that wereclassified as REO.

 

The following tablesummarizes the changes in the allowance for loan losses for the Company’sresidential mortgage loan portfolio during the six months ended June 30, 2006(amounts in thousands):

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

** **

**Corporate and CommercialReal Estate Loans**

 

As of June 30, 2006 andDecember 31, 2005, no corporate or commercial real estate loans weredelinquent and as of June 30, 2006 and December 31, 2005, the Company had notrecorded an allowance for loan losses for its commercial real estate orcorporate loan portfolios. In reviewing the Company’s portfolio of commercialreal estate loans and corporate loans, the Company determined that no loanswere impaired as of June 30, 2006 or December 31, 2005.  The Company considers a loan to be impairedwhen, based on current information and events, management believes it isprobable that the Company will be unable to collect all amounts due pursuant tothe contractual terms of the loan agreement.

 

**Note 6. Borrowings**

** **

The Company leveragesits portfolio of securities and loans through the use of repurchase agreements,asset-backed secured liquidity notes, warehouse facilities, demand loans, andsecuritization transactions structured as secured financings. Each of theborrowing vehicles used by the Company bears interest at floating rates basedon a spread above the London InterBank Offered Rate (“LIBOR”) or asset-backedsecured liquidity note interest rates.

 

Certain information withrespect to the Company’s borrowings as of June 30, 2006 is summarized in thefollowing table (amounts in thousands):

 
| ** **                            | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral (1)** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Repurchase agreements                 |       | $                           | 4,344,199  |                                   | 5.38       | %                                                          | 21         |                                             | $          | 4,355,255 |   |
| Demand loan                           |       | 41,658                      |       | 5.81                                   |       | 1                                                          |       | 46,413                                           |       |
| Secured revolving  credit facility    |       | 112,594                     |       | 6.06                                   |       | 25                                                         |       | 221,547                                          |       |
| Asset-backed secured  liquidity notes |       | 7,292,844                   |       | 5.32                                   |       | 19                                                         |       | 7,545,725                                        |       |
| CLO 2005-1 senior  secured notes      |       | 773,000                     |       | 5.39                                   |       | 3,953                                                      |       | 982,695                                          |       |
| CLO 2005-2 senior  secured notes      |       | 752,000                     |       | 5.49                                   |       | 4,167                                                      |       | 980,417                                          |       |
| CLO 2006-1 repurchase  agreements     |       | 615,798                     |       | 5.81                                   |       | 75                                                         |       | 907,516                                          |       |
| CDO 2005-1 repurchase  agreements     |       | 186,906                     |       | 6.36                                   |       | 18                                                         |       | 274,336                                          |       |
| Junior subordinated  notes            |       | 103,100                     |       | 7.86                                   |       | 10,943                                                     |       | —                                           |       |
| Total                                 |       | $                           | 14,222,099 |                                   |       |                                                       |       |                                             | $          | 15,313,904 |   |

 

12

----

 

Certaininformation with respect to the Company’s borrowings as of December 31,2005 is summarized in the following table (amounts in thousands):

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

 

----

(1)             Collateralfor borrowings consists of securities available-for-sale, loans, and marketableequity investments.

 

OnMarch 30, 2005, the Company closed CLO 2005-1, a $1.0 billion CLOtransaction that provides financing for investments consisting of corporateloans and certain other loans and securities. The investments that are owned byCLO 2005-1 collateralize the CLO 2005-1 debt, and as a result, thoseinvestments are not available to the Company, its creditors or stockholders.CLO 2005-1 issued a total of $773.0 million of senior secured notes at parto investors. In addition, the Company retained $148.0 million of ratedmezzanine notes and $85.5 million of unrated subordinated notes issued byCLO 2005-1.

 

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

 

During April 2005,the Company formed CDO 2005-1 and began borrowing on a $300.0 millionwarehouse facility, in the form of a repurchase agreement, to purchasecommercial real estate obligations. The repurchase facility bears interest at arate of 30-day LIBOR plus 1.10% and as of June 30, 2006, there was $186.9million outstanding.

 

On September 30,2005, the Company closed a $5.0 billion asset-backed secured liquiditynote facility. This facility provides the Company with an alternative source offunding its residential mortgage-backed securities by issuing asset-backedsecured liquidity 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. At June 30, 2006, the Company had $4.6billion of asset-backed secured liquidity notes under this facility outstanding.

 

On November 3,2005, the Company closed CLO 2005-2, its second $1.0 billion CLO transactionthat provides financing for investments consisting of corporate loans andcertain other loans and securities. The investments that are owned by CLO2005-2 collateralize the CLO 2005-2 debt, and as a result, those investmentsare not available to the Company, its creditors or stockholders. CLO 2005-2issued a total of $752.0 million of senior secured notes at par to investors.In addition, the Company retained $168.0 million of rated mezzanine notes and$98.5 million of unrated subordinate notes issued by CLO 2005-2.

 

The senior notes issuedto investors by CLO 2005-2 consist of three classes of notes as follows:(i) $545.0 million of class A-1 notes bearing interest atthree-month LIBOR plus 0.26%; (ii) $57.0 million of class Bnotes bearing interest at three-month LIBOR plus 0.43%; and(iii) $150.0 million of class A-2 Delayed Draw notes bearinginterest on the drawn amount at three-month LIBOR plus 0.26%. All of the notesissued mature on November 26, 2017, though the Company has the right tocall the notes at par any time after November 2009.

 

13

----

 

During 2005, the Companyformed CLO 2006-1 and during December 2005 executed a $500.0 millionwarehouse facility, in the form of a repurchase agreement, to finance thepurchase of corporate loans and certain other loans and securities. Thewarehouse facility was increased to $650.0 million during June 2006. Therepurchase facility bears interest at a rate of 30-day LIBOR plus 0.65% and asof June 30, 2006, there was****$498.9 millionoutstanding. Additionally, CLO 2006-1 had $116.9 million outstanding under arepurchase agreement separate from the repurchase facility as of June 30, 2006.Also during December 2005, the Company formed CLO 2006-2 and executed a$450.0 million warehouse facility, in the form of a repurchase agreement, tofinance the purchase of corporate loans and certain other loans and securities.The repurchase facility bears interest at a rate of 30-day LIBOR plus 0.65% andas of June 30, 2006, there were no borrowings outstanding.

 

During March 2006, theCompany formed KKR Financial Capital Trust I (“Trust I”) for the sole purposeof issuing trust preferred securities. On March 28, 2006, Trust I 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 I in $51.6 million of junior subordinated notesissued by the Company. The junior subordinated notes are the sole assets ofTrust I and 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% (ten-year LIBORplus 2.45%) through March 2016 and thereafter at a floating rate equal tothree-month LIBOR plus 2.65%.

 

On March 30, 2006, theCompany closed its second $5.0 billion asset-backed secured liquidity notefacility. This facility provides the Company with an alternative source offunding its residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s, Moody’s, and Fitch Inc., respectively. At June 30, 2006, the Companyhad $2.7 billion in borrowings outstanding under this facility.

 

During June 2006, theCompany formed KKR Financial Capital Trust II (“Trust II”) for the sole purposeof issuing trust preferred securities. On June 2, 2006, Trust II 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 II in $51.6 million of junior subordinatednotes issued by the Company. The junior subordinated notes are the sole assetsof Trust II and mature on July 30, 2036, but are callable on or after July 30,2011. Interest is payable quarterly at a fixed rate of 8.09% (ten-year LIBORplus 2.45%) through July 2016 and thereafter at a floating rate equal tothree-month LIBOR plus 2.65%.

 

During June 2006, the Company’s$275.0 million secured revolving credit facility matured and was replaced witha $375.0 million three year senior secured revolving credit facility.  The Company has the option to increase thesenior secured revolving credit facility size up to $550.0 million at any timeso long as no default or event of default on the facility has occurred and subjectto addition of new lenders, increases in the commitments of existing lenders,or a combination thereof.  The seniorsecured revolving credit facility matures in June 2009 and consists of twotranches.   Outstanding borrowings underthe senior secured revolving credit facility bear interest at either (i) analternate base rate per annum equal to the greater of (a) the prime rate ineffect on such day, and (b) the federal funds in effect on such day plus 0.50%,or (ii) an interest rate per annum equal to the LIBOR rate for the applicableinterest period plus 0.50% for borrowings under tranche A of the facility and0.75% for borrowings under tranche B of the facility. As of June 30, 2006 theCompany had $112.6 million in****borrowingsoutstanding under this facility.

 

**Note 7. DerivativeFinancial Instruments**

** **

The Company enters intoderivative financial instruments to hedge all or a portion of the interest raterisk associated with its borrowings under repurchase agreements andasset-backed secured liquidity notes.  TheCompany designates these financial instruments as cash flow hedges.  Additionally, the Company purchasesderivative financial instruments for investing purposes which includeinvestment financing arrangements (total rate of return swaps) whereby theCompany receives the sum of all interest, fees and any positive economic changein value amounts from a reference asset with a specified notional amount andpays interest on such notional plus any negative change in value amounts fromsuch asset.  The counterparties to theCompany’s derivative agreements are major financial institutions with which theCompany and its affiliates may also have other financial relationships. In theevent 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.

 

14

----

** **

**KKRFinancial Corp. and Subsidiaries**

**Notes toConsolidated Financial Statements (Continued)**

 

Thetable below summarizes the estimated net fair value of the derivativeinstruments as of June 30, 2006 and December 31, 2005 (amounts inthousands):

 
| ** **                     | ** ** | **As of  June 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|--------------------------------|------------|------------------------------------|------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**          |       |                               |       |                                        |       |
| Interest  rate corridors       |       | $                                  | 22,464     |                                        | $          | 14,762 |   |
| Interest  rate swaps           |       | 104,949                            |       | 40,796                                      |       |
| **Free-Standing Derivatives:** |       |                               |       |                                        |       |
| Interest  rate swaptions       |       | 226                                |       | 879                                         |       |
| Interest  rate swaps           |       | —                             |       | 198                                         |       |
| Credit  default swaps          |       | (19                                | )     | 71                                          |       |
| Total  rate of return swaps    |       | 1,780                              |       | 727                                         |       |
| Net  fair value                |       | $                                  | 129,400    |                                        | $          | 57,433 |   |

 

**Note 8. AccumulatedOther Comprehensive Income**

 

Thecomponents of accumulated other comprehensive income were as follows (amountsin thousands):

 
| ** **                                              | ** ** | **As of  June 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------------------------------|------------|------------------------------------|------------|---------------------------------------------|------------|
| Net  unrealized losses on available-for-sale securities |       | $                                  | (28,865    | )                                           | $          | (27,215 | ) |
| Net  unrealized gains on cash flow hedges               |       | 117,952                            |       | 45,559                                      |       |
| Accumulated  other comprehensive income                 |       | $                                  | 89,087     |                                        | $          | 18,344 |   |

 

Thechanges in the components of other comprehensive income (loss) were as follows(amounts in thousands):

 
| ** **                                                              | ** ** | **Three months  ended June 30,  2006** | ** ** | **Three months  ended June 30,  2005** | ** ** | **Six months  ended June 30,  2006** | ** ** | **Six months  ended June 30,  2005** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| Unrealized gains  on securities available-for-sale:                     |       |                                             |       |                                             |       |                                           |       |                                           |       |
| Unrealized  holding gains (losses) arising during period                |       | $                                                | 542        |                                             | $          | 29,431                                         |       | $                                              | (3,514     | ) | $ | (7,625 | ) |
| Reclassification  adjustments for gains (losses) realized in net income |       | 1,225                                            |       | (472                                             | )          | 1,864                                          |       | (815                                           | )          |
| Unrealized gains  (losses) on securities available-for-sale             |       | 1,767                                            |       | 28,959                                           |       | (1,650                                         | )          | (8,440                                         | )          |
| Unrealized gains  on cash flow hedges                                   |       | 25,326                                           |       | (18,764                                          | )          | 72,393                                         |       | (3,554                                         | )          |
| Other  comprehensive income (loss)                                      |       | $                                                | 27,093     |                                             | $          | 10,195                                         |       | $                                              | 70,743     |   | $ | (11,994 | ) |

 

**Note 9. StockOptions and Restricted Stock**

 

TheCompany has adopted a stock incentive plan (the “2004 Stock Incentive Plan”)that provides for the grant of qualified incentive common stock options thatmeet the requirements of Section 422 of the Code, non-qualified commonstock options, stock appreciation rights, restricted common stock and othershare-based awards. The 2004 Stock Incentive Plan was amended on May 26,2005. The Compensation Committee of the Board of Directors administers theplan. Stock options may be granted to the Manager, Directors, officers and anykey employees of the Manager and to any other individual or entity performingservices for the Company.

 

15

----

 

Theexercise price for any stock option granted under the 2004 Stock Incentive Planmay not be less than 100% of the fair market value of the shares of commonstock at the time the common stock option is granted. Each common stock optionmust terminate no more than ten years from the date it is granted. The 2004Stock Incentive Plan, as amended, authorizes that a total of 7,964,625 sharesmay be used to satisfy awards under the 2004 Stock Incentive Plan. The Companymade 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 January 1, 2006** |       | 2,670,911   |       | 28,321        |       | 2,699,232 |       |
| Issued                                                                  |       | —      |       | —        |       | —    |       |
| Vested                                                                  |       | —      |       | —        |       | —    |       |
| Forfeited                                                               |       | —      |       | —        |       | —    |       |
| **Unvested shares as of June 30, 2006**                                 |       | 2,670,911   |       | 28,321        |       | 2,699,232 |       |

 

Theshares of restricted common stock granted to the directors were valued usingthe fair market value at the time of grant, which was $24.90 and $20.00 pershare, for the shares of restricted common stock granted in 2005 and 2004,respectively. Pursuant to SFAS No. 123(R), the Company is required tovalue any unvested shares of restricted common stock granted to the Manager atthe current market price. The Company valued the unvested restricted commonstock at $20.81 and $25.00 per share at June 30, 2006 and June 30, 2005,respectively.  There were $19.7 millionand $13.8 million of total unrecognized compensation costs related to nonvestedrestricted common stock granted as of June 30, 2006 and June 30, 2005,respectively.  The cost is expected to berecognized over a weighted average period of eight months at June 30, 2006.

 

Thefollowing table summarizes common stock option transactions:

 
| ** **                            | ** ** | **Number  of Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Outstanding as of January 1, 2006** |       | 1,989,779                   |       | $                                              | 20.00      |   |
| Granted                               |       | —                      |       | —                                         |       |
| Exercised                             |       | —                      |       | —                                         |       |
| Forfeited                             |       | —                      |       | —                                         |       |
| **Outstanding as of June 30, 2006**   |       | 1,989,779                   |       | $                                              | 20.00      |   |

 

Noneof the common stock options outstanding were exercised at June 30, 2006 andJune 30, 2005, respectively. As of June 30, 2006, 663,260****commonstock options were exercisable, and no common stock options were exercisable asof June 30, 2005. The common stock options are valued using theBlack-Scholes model using the following assumptions:

 
| ** **      | ** ** | **As of  June 30, 2006** | ** ** | **As of  June 30, 2005** | ** ** |
|-----------------|------------|------------------------------------|------------|------------------------------------|------------|
| Expected  life  |       | 8.1 years                          |       | 9.1 years                          |       |
| Discount  rate  |       | 5.19                               | %          | 4.07                               | %          |
| Volatility      |       | 16                                 | %          | 20                                 | %          |
| Dividend  yield |       | 9                                  | %          | 9                                  | %          |

 

Theestimated fair value of the common stock options was $0.91 and $1.90 at June30, 2006 and June 30, 2005, respectively. There were $0.3 million and $1.7million of total unrecognized compensation costs related to nonvested commonstock options granted as of June 30, 2006 and June 30, 2005, respectively.  The cost is expected to be recognized over aweighted average period of 1.1 years at June 30, 2006.

 

Forthe three and six months ended June 30, 2006 and June 30, 2005, the componentsof share-based compensation expense are as follows (amounts in thousands): 

 
| ** **                                      | ** ** | **For the three  months ended  June 30, 2006** | ** ** | **For the three  months ended  June 30, 2005** | ** ** | **For the six  months ended  June 30, 2006** | ** ** | **For the six  months ended  June 30, 2005** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| Options  granted to Manager                     |       | $                                                                  | (497       | )                                                                  | $          | 1,069                                                            |       | $                                                                | (509       | ) | $ | 1,577 |   |
| Restricted  shares granted to Manager           |       | 5,465                                                              |       | 6,278                                                              |       | 12,086                                                           |       | 10,442                                                           |       |
| Restricted  shares granted to certain directors |       | 175                                                                |       | (13                                                                | )          | 349                                                              |       | 61                                                               |       |
| Total  share-based compensation expense         |       | $                                                                  | 5,143      |                                                               | $          | 7,334                                                            |       | $                                                                | 11,926     |   | $ | 12,080 |   |

 

16

----

 

**Note 10.** ManagementAgreement and Related Party Transactions

** **

TheManager manages the Company’s day-to-day operations, subject to the directionand oversight of the Company’s Board of Directors. The Management Agreement wasexecuted on August 12, 2004. The initial term expires on December 31,2006 and shall be automatically renewed for a one-year term on each anniversarydate thereafter. Following the initial term, the Management Agreement may beterminated upon the affirmative vote of at least two-thirds of the Company’sindependent Directors, or by a vote of the holders of a majority of theoutstanding shares of the Company’s common stock.

 

TheManagement Agreement provides, among other things, that the Company pays to theManager, in exchange for managing the day-to-day operations of the Company,certain fees and reimbursements, consisting of a base management fee, anincentive fee, and reimbursement for out-of-pocket and certain other costsincurred by the Manager on behalf of the Company. All rent incurred by theManager is paid by the Company and the Company is a party to the lease.

 

TheManagement Agreement contains certain provisions requiring the Company toindemnify the Manager with respect to all losses or damages arising from actsnot constituting bad faith, willful misconduct, or gross negligence. TheCompany has evaluated the impact of these obligations on its consolidated financialstatements and determined that they are immaterial.

 

Forthe three and six months ended June 30, 2006, the Company incurred $7.2 millionand $14.4 million in base management fees and $1.6 million and $2.3 million inmanagement incentive fees, respectively. In addition, the Company recognizedshare-based compensation expense related to common stock options and restrictedcommon stock granted to the Manager of $5.0 million and $11.6 million for thethree and six months ended June 30, 2006 (see Note 9). The Company alsoreimbursed the Manager $1.4 million and $2.8 million for expenses for the threeand six months ended June 30, 2006. The Company incurred base management feesof $3.4 million and $6.7 million, respectively, and reimbursed theManager for expenses of $0.8 million and $1.7 million, respectively, for thethree and six months ended June 30, 2005. The Company incurred no managementincentive fees for the three and six months ended June 30, 2005. In addition,the Company recognized share-based compensation expense related to common stockoptions and restricted common stock granted to the Manager of $7.3 millionand  $12.0 million for the three and sixmonths ended June 30, 2005. Base management fees incurred and share-basedcompensation expense relating to common stock options and restricted commonstock granted to the Manager are included in related party managementcompensation on the consolidated statements of operations. Expenses incurred bythe Manager and reimbursed by the Company are reflected in the respectiveconsolidated statement of operations non-investment expense category based onthe nature of the expense.

 

Anaffiliate of the Company’s Manager has entered into separate managementagreements with the respective investment vehicles for CLO 2005-1 and CLO2005-2 and is entitled to receive fees for the services performed as collateralmanager. To date, the collateral manager has waived approximately $1.5 millionof management fees payable to it from CLO 2005-1, which covers the period commencingin March 2005 and ending in October 2006 and has waived approximately $0.7million of management fees payable to it from CLO 2005-2, which covers theperiod commencing November 2005 and ending in November 2006. The waivers forCLO 2005-1 and CLO 2005-2 expire in October 2006 and November 2006,respectively, and there is no guarantee that the collateral manager will waivesuch management fees subsequent to those dates.

 

DuringJanuary 2006, the Company invested $40.0 million in a series of corporatefloating rate notes which were rated BB by Standard & Poor’s and wereissued by an unaffiliated third party. KKR Financial Advisors II, LLC, awholly-owned subsidiary of the Company’s Manager, is the collateral manager forthe unaffiliated third party in connection with this corporate floating ratenote transaction.

 

During the second quarter of 2006, the Companyinvested $40.7 million in Capmark Financial Group. Inc. (“Capmark”). Capmark iscontrolled by an investor group that includes KKR, an affiliate of the Manager.As of June 30, 2006, the Company held investments in KKR affiliated companiesconsisting of $90.8 million of non-marketable equity securities and $583.3million of corporate loans. In addition, during July 2006 the Company madeinvestments in Branbles Industrial Services, an affiliate of KKR, consisting of$20.0 million of non-marketable equity securities and $40.0 million insubordinated zero-coupon securities.

 

**Note 11.** Subsequent Event

** **

OnAugust 2, 2006, the Company’s Board of Directors declared a cash distributionfor the three months ended June 30, 2006 on the Company’s common stock of $0.49per share, payable on August 30, 2006 to stockholders of record as of the closeof business on August 16, 2006.

 

17

----

 

**Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*Except where the context suggests otherwise, theterms “we,” “us” and “our” refer to KKR Financial Corp. and its subsidiaries.The following management’s discussion and analysis (“MD&A”) is intended toassist the reader in understanding our business. The MD&A is provided as asupplement to, and should be read in conjunction with, our CondensedConsolidated Financial Statements and accompanying notes included in thisQuarterly Report on Form 10-Q and our Consolidated Financial Statements andaccompanying notes included in our Annual Report on Form 10-K for the yearended December 31, 2005.*

 

**ForwardLooking Statements**

 

Certain informationcontained in this Quarterly Report on Form 10-Q constitutes“forward-looking” statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934 that are based on our current expectations, estimates and projections.Pursuant to those sections, we may obtain a “safe harbor” for forward-lookingstatements by identifying those and by accompanying those statements withcautionary statements, which identify factors that could cause actual resultsto differ from those expressed in the forward-looking statements. Statementsthat are not historical facts, including statements about our beliefs andexpectations, are forward-looking statements. The words “believe,”“anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,” “estimate,” and“project,” and similar words identify forward-looking statements. Suchstatements are not guarantees of future performance, events or results andinvolve potential risks and uncertainties. Accordingly, actual results and thetiming of certain events could differ materially from those addressed inforward-looking statements due to a number of factors including, but notlimited to, changes in interest rates and market values, changes in prepaymentrates, general economic conditions, and other factors not presently identified.Other factors that may impact our actual results are discussed in our AnnualReport on Form 10-K under the section titled “Risk Factors.”  We do not undertake, and specificallydisclaim, any obligation to publicly release the result of any revisions thatmay be made to any forward-looking statements to reflect the occurrence ofanticipated or unanticipated events or circumstances after the date of suchstatements.

 

**Executive Overview**

** **

Weare a specialty finance company that invests in multiple asset classes and usesleverage to generate competitive leveraged risk-adjusted returns subject tomaintaining our status as a REIT, and our exemption from regulation under theInvestment Company Act of 1940, as amended (the “Investment Company Act”). Ourobjective is to provide competitive returns to our investors through acombination of dividends and capital appreciation. As part of our multi-assetclass strategy, we seek to invest opportunistically in those asset classes thatcan generate competitive leveraged risk-adjusted returns. Investing in multipleasset classes does not, however, reduce or eliminate many of the risksassociated with our investment portfolio such as geographic concentration risk,asset class 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 debt securities;(iii) commercial real estate loans and debt securities;(iv) asset-backed securities; and (v) marketable and non-marketableequity securities. We also make opportunistic investments in other assetclasses from time to time. Our investment guidelines generally do not imposeany limitations on the amount of our investments in any specific asset class,industry, or investment. Our income is generated primarily from the differencebetween the interest and dividend income earned on our investments and the costof our borrowings, plus (i) realized and unrealized gains and losses ourfree-standing derivatives, (ii) realized gains and losses from the sales ofinvestments, and (iii) fee income.

 

Wecommenced our investment activities by funding our first investment onSeptember 30, 2004. As of the end of the second quarter of 2006, we havedeployed a significant amount of our capital and we expect to have fullydeployed our capital on a fully- leveraged basis by the end of the thirdquarter of 2006. We used the proceeds from our IPO to reduce short-termborrowings and intend to fund future investments principally through borrowingsuntil such time that we fully deploy our capital on a fully leveraged basis.Provided that market conditions and market opportunities are favorable, we mayundertake to raise additional equity capital, including future issuances oftrust preferred securities, subsequent to the deployment of our existingcapital and leverage.

 

18

----

 

***CashDistributions to Stockholders***

*** ***

OnAugust 2, 2006, our Board of Directors declared a cash distribution for thequarter ended June 30, 2006 on our common stock of $0.49 per common share. Thedistribution will be payable on August 30, 2006 to stockholders of record as ofthe close of business on August 16, 2006.

 

***InvestmentPortfolio***

*** ***

Asof June 30, 2006 our investment portfolio totaled $15.9 billion, representingan increase of 6.0% from $15.0 billion as of December 31, 2005. As of June30, 2006, our investment portfolio primarily consisted of residential mortgageloans and securities totaling $12.1 billion, corporate loans and securitiestotaling $3.2 billion, commercial real estate loans and securities totaling $380.5million, marketable equity securities consisting of preferred and common stocktotaling $66.5 million, and investments in non-marketable equity securitiestotaling $139.4 million.

 

***FundingActivities***

*** ***

OnMarch 30, 2006, we closed our second $5.0 billion asset-backed securedliquidity note facility. This facility provides us with an alternative sourceof funding our residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s Ratings Service, or Standard & Poor’s, Moody’s Investors Service, orMoody’s, and Fitch Inc., respectively. At June 30, 2006, we had $2.7 billion inborrowings outstanding under this facility.

 

DuringMarch 2006, we formed KKR Financial Capital Trust I (“Trust I”) for the solepurpose of issuing and selling trust preferred securities. On March 28, 2006, TrustI issued preferred securities to unaffiliated investors for gross proceeds of$50.0 million and common securities to us for $1.6 million. The combinedproceeds were invested by Trust I in $51.6 million of junior subordinated notesissued by us. The junior subordinated notes are the sole assets of Trust I andmature on April 30, 2036, but are callable on or after April 30, 2011. Interestis payable quarterly at a fixed rate of 7.64% (ten-year LIBOR plus 2.45%)through March 2016 and thereafter at a floating rate equal to three-month LIBORplus 2.65%.

 

During June 2006, weformed KKR Financial Capital Trust II (“Trust II”) for the sole purpose ofissuing trust preferred securities. On June 2, 2006, Trust II issued preferredsecurities to unaffiliated investors for gross proceeds of $50.0 million andcommon securities to us 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 July30, 2036, but are callable on or after July 30, 2011. Interest is payablequarterly at a fixed rate of 8.09% (ten-year LIBOR plus 2.45%) through July2016 and thereafter at a floating rate equal to three-month LIBOR plus 2.65%.

 

DuringJune 2006, we replaced our existing $275.0 million secured revolving creditfacility with a new three year $375.0 million senior secured revolving creditfacility. We have the option to increase the size of this new facility up to$550.0 million so long as no default or event of default (as defined in suchcredit facility) has occurred and subject to addition of new lenders, increasesin the commitments of existing lenders, or a combination thereof.The newsenior secured revolving credit facility matures in June 2009 and consists oftwo 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 on suchday plus 0.50%, or (ii) an interest rate per annum equal to the LIBOR rate forthe applicable interest period plus 0.50% for borrowings under tranche A of thefacility and 0.75% for borrowings under tranche B of the facility. As of June30, 2006 we had $112.6 million in borrowings outstanding under this facility.

 

**Critical AccountingPolicies**

** **

Ourconsolidated financial statements are prepared by management in conformity withaccounting principles generally accepted in the United States of America(“GAAP”). Our significant accounting policies are fundamental to understandingour financial condition and results of operations because some of thesepolicies require that we make significant estimates and assumptions that may affectthe value of our assets or liabilities and financial results. We believe thatcertain of our policies are critical because they require us to make difficult,subjective, and complex judgments about matters that are inherently uncertain.We have reviewed these critical accounting policies with our Board of Directorsand our Audit Committee.

 

19

----

 

***RevenueRecognition***

*** ***

Weaccount for interest income on our investments using the effective yieldmethod. For investments purchased at par, the effective yield is thecontractual coupon rate on the investment. Unamortized premiums and discountson non-residential mortgage-backed securities are recognized in interest incomeover the contractual life, adjusted for actual prepayments, of the securitiesusing the effective interest method. For securities representing beneficialinterests in securitizations (i.e., residential mortgage-backed securities),unamortized premiums and discounts are recognized over the contractual life,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.

 

Interestincome on loans includes interest at stated coupon rates adjusted for accretionof purchase discounts and the amortization of purchase premiums. For corporateand commercial real estate loans, unamortized premiums and discounts arerecognized in interest income over the contractual life, adjusted for actualprepayments, of the loans using the effective interest method. For residentialmortgage loans, unamortized premiums and discounts are recognized over thecontractual life, adjusted for estimated prepayments using the effectiveinterest method.

 

Asof June 30, 2006, unamortized purchase premiums and unaccreted purchasediscounts on our investment portfolio totaled $33.8 million and $(48.7) million,respectively.

 

***Share-BasedPayment***

*** ***

Weaccount for share-based compensation issued to members of our Board ofDirectors and our Manager using the fair value based methodology in accordancewith SFAS No. 123(R). We do not have any employees, although we believethat members of our Board of Directors are deemed to be employees for purposesof interpreting and applying accounting principles relating to share-basedcompensation. We record as compensation costs the restricted common stock thatwe issued to members of our Board of Directors at estimated fair value as ofthe grant date and we amortize the cost into expense over the three-yearvesting period using the straight-line method. We recorded compensation costsfor restricted common stock and common stock options that we issued to ourManager at estimated fair value as of the grant date and we remeasure theamount on subsequent reporting dates to the extent that the restricted commonstock and/or common stock options have not vested. Unvested restricted commonstock is valued using observable secondary market prices. Unvested common stockoptions are valued using the Black-Scholes model and assumptions based onobservable market data for comparable companies. We amortize compensationexpense related to the restricted common stock and common stock options that wegranted to our Manager using the graded vesting attribution method inaccordance with SFAS No. 123(R).

 

Becausewe remeasure the amount of compensation costs associated with the unvestedrestricted common stock and unvested common stock options that we issued to ourManager as of each reporting period, our share-based compensation expensereported in our consolidated financial statements will change based on the marketprice of our common stock as of each remeasurement date and this may result inearnings volatility. For the three and six months ended June 30, 2006,share-based compensation totaled $5.1 million and $11.9 million, respectively.As of June 30, 2006, substantially all of the non-vested common stock optionsand restricted common stock issued that is subject to SFASNo. 123(R) is subject to remeasurement.

 

***Classificationsof Investment Securities***

*** ***

Ourinvestments in securities are classified as “available-for-sale” and arerecorded and reported on our consolidated balance sheet at estimated fair valuewith unrealized gains and losses reported in accumulated other comprehensiveincome (loss) on our consolidated balance sheet. We designate and classify ourinvestments in securities as available-for-sale because we may sell them priorto their maturity date. We do not designate and classify our investments insecurities as trading securities because we do not intend to trade them or sellthem in the near term. We determine the estimated fair value of our investmentsin securities using quoted market prices, dealers who make markets in thesecurities, and third-party pricing services. When we sell an investment security,the realized net gain or loss on the sale of the security is included in ourconsolidated statements of operations and we specifically identify the securitythat was sold and its specific cost basis when we compute the net realized gainor loss.

 

20

----

 

***Accountingfor Derivative Instruments and Hedging Activities***

*** ***

Ourpolicies permit us to enter into derivative contracts, including interest rateswaps, interest rate corridors, interest rate swaptions, interest ratestraddles, and credit and currency derivatives. We use interest ratederivatives to manage interest rate risk. We formally document relationshipsbetween our hedging instruments and our hedged transactions as of the inceptiondate of the hedge, including (i) our risk management objective and hedgestrategy, (ii) the risk that we are hedging, (iii) the hedginginstruments, consisting of the derivative instruments that comprise the hedge,(iv) the hedged transaction, consisting of the recognized or forecastedtransaction that we are hedging, (v) the method that we used to assess thehedge’s effectiveness on a retrospective and prospective basis, and(vi) the methodology that we will use to measure hedge ineffectiveness. Onthe date that we enter into an interest rate derivative transaction wedesignate the interest rate derivative as (i) a hedge of a forecastedtransaction or of the variability of cash flows related to a recognizedliability (“cash flow hedge”) or (ii) held for trading (“trading instrument”).Our interest rate swaptions are undesignated derivative contracts and accountedfor as trading instruments, and our interest rate swap and interest ratecorridor contracts are designated and accounted for as cash flow hedges. As ofJune 30, 2006, we have not entered into any interest rate derivativetransactions that are designated as a hedge of the estimated fair value of arecognized asset or liability or of an unrecognized firm commitment (“fairvalue hedge”).

 

Forour cash flow hedges, we record and report our hedge instruments at estimatedfair value on our balance sheet and record the changes in their estimated fairvalue in accumulated other comprehensive income (loss). Changes in theseamounts are reclassified to our statements of operations over the effectivehedge period as the hedged item affects earnings. Our cash flow hedgeinstrument must be “highly effective,” as defined in SFAS No. 133, inachieving offsetting changes in the hedged item attributable to the risk thatwe are hedging in order to qualify for initial and recurring hedge accountingtreatment. We recognize any hedge ineffectiveness related to our cash flowhedges as a component of interest expense during the period in which it occurs.Prior to the end of the specified cash flow hedge period, the effective portionof our hedge instrument gains and losses is recorded in other accumulatedcomprehensive income (loss). The estimated fair values of our hedge instrumentsare based on market prices provided by dealers that make markets in suchhedging instruments. For our cash flow hedges, we are required to discontinuehedge accounting prospectively when we determine that (i) the hedginginstruments are no longer effective in offsetting changes in the cash flows ofa hedged transaction, (ii) we determine that it is no longer probable thatthe forecasted transaction will occur, or (iii) the designation of thehedging instruments as hedges is no longer permitted or appropriate.

 

Weare not required to account for our derivative contracts using hedge accountingas described above. If we decide not to designate the derivative contracts ashedges or if we fail to fulfill the criteria necessary to qualify for hedgeaccounting, then the changes in the estimated fair values of our derivative contractswould affect periodic earnings immediately potentially resulting in theincreased volatility of our earnings. The qualification requirements for hedgeaccounting are complex and as a result we must evaluate, designate, andthoroughly document each hedge transaction at inception and performineffectiveness analysis and prepare related documentation at inception and ona recurring basis thereafter. As of June 30, 2006, the estimated fair value ofour derivatives totaled $129.4 million. As of June 30, 2006, the estimated fairvalue of interest rate derivatives accounted for as cash flow hedges totaledapproximately $127.4 million and the net unrealized gain on such cash flowhedges totaled approximately $118.0 million, which amount is recorded inaccumulated other comprehensive income in the consolidated statements ofchanges in stockholders’ equity.

 

***Impairments***

 

Weevaluate our investment portfolio for impairment as of each quarter end or morefrequently if we become aware of any material information that would lead us tobelieve that an investment may be impaired. We evaluate whether the investmentis considered impaired and whether the impairment is other-than-temporary. Ifwe make a determination that the impairment is other-

 

21

----

 

than-temporary, werecognize an impairment loss equal to the difference between the amortized costbasis and the estimated fair value of the investment. We consider many factorsin determining 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 June 30, 2006, we had aggregate unrealized losses on oursecurities classified as available-for-sale of approximately $63.5****million, which if not recovered may result in therecognition of future losses.

 

***Allowancefor Loan Losses***

*** ***

Wemaintain an allowance for loan losses at a level that we believe is adequatebased on an evaluation of known and inherent risks related to our loaninvestments. When determining the adequacy of the allowance for loan losses weconsider historical and industry loss experience, economic conditions andtrends, the estimated fair values of our loans, credit quality trends and otherfactors that we determine are relevant. To estimate the allowance for loanlosses, we first identify impaired loans. Loans are generally evaluated forimpairment individually, but loans purchased on a pooled basis with relativelysmaller balances and substantially similar characteristics may be evaluatedcollectively for impairment. We consider a loan to be impaired when, based oncurrent 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.

 

Currently,our residential mortgage loans are relatively homogeneous and the adequacy ofthe allowance for loan losses is based on a review of relevant factorsincluding, but not limited to, estimated fair values, industry statistics,current economic conditions, loan portfolio composition, delinquency trends andcredit losses realized to-date on underlying loans. Because our mortgage loanportfolio is not seasoned, we review these factors for similar portfolios ofmortgage loans that have comparable FICO® scores, loan-to-value ratios (“LTV”),loan balances, and geographical diversity and that were originated throughsimilar mortgage banking channels, and we use this information when assessingthe adequacy of the allowance for loan losses. Our investments in commercialreal estate mortgage loans and corporate loans are not homogeneous and weindividually review each of the loans for impairments and use relevantinformation in our analysis, including current estimated fair values, currentvaluation multiples, projected operating cash flow and projected liquidationcash flows.

 

**Recent AccountingPronouncements**

** **

InFebruary 2006, the FASB issued SFAS No. 155, *Accountingfor Certain Hybrid Financial Instruments*. Key provisions of SFASNo. 155 include: (1) a broad fair value measurement option forcertain hybrid financial instruments that contain an embedded derivative thatwould otherwise require bifurcation; (2) clarification that only thesimplest separations of interest payments and principal payments qualify for theexception afforded to interest-only strips and principal-only strips fromderivative accounting under paragraph 14 of SFAS No. 133 (therebynarrowing such exception); (3) a requirement that beneficial interests insecuritized financial assets be analyzed to determine whether they arefreestanding derivatives or whether they are hybrid instruments that containembedded derivatives requiring bifurcation; (4) clarification thatconcentrations of credit risk in the form of subordination are not embedded derivatives;and (5) elimination of the prohibition on a QSPE holding passivederivative financial instruments that pertain to beneficial interests that areor contain a derivative financial instrument. In general, these changes willreduce the operational complexity associated with bifurcating embeddedderivatives, and increase the number of beneficial interests in securitizationtransactions, including interest-only strips and principal-only strips,required to be accounted for in accordance with SFAS No. 133. SFAS No. 155is required to be adopted by us in the first quarter of 2007. We do not expectthat the adoption of SFAS No. 155 will have a material effect on ourconsolidated financial statements.

 

In June 2006, the FASB issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes – an interpretation of FASBStatement No. 109* (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109, *Accounting for IncomeTaxes*.  FIN 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. We are required to adopt FIN 48 in the first quarter of 2007 andwe currently assessing the impact that it will have on our consolidatedfinancial statements.

 

22

----

 

**Results of Operations**

** **

**For the Three and SixMonths Ended June 30, 2006 compared to the Three and Six Months Ended June 30,2005**

** **

*Summary*

* *

Ournet income for the three and six months ended June 30, 2006 totaled $34.9 million(or $0.44 per diluted share) and $65.3 million (or $0.82 per diluted share),respectively, as compared to net income of $8.5 million (or $0.21 per dilutedshare) and $14.6 million (or $0.36 per diluted share) for the three and sixmonths ended June 30, 2005. During the six months ended June 30, 2006, ourinvestment portfolio increased by 6.0% from $15.0 billion as of December 31,2005 to $15.9 billion as of June 30, 2006.

 

*NetInvestment Income*

* *

Thefollowing table presents the components of our net investment income for thequarters ended June 30, 2006 and 2005:

 

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

** **
| ** **                                                            |   | **For the three  months ended  June 30, 2006** |    | **For the three  months ended  June 30, 2005** |   | **For the six  months ended  June 30, 2006** | ** ** | **For the six****months ended  June 30, 2005** | ** ** |
|-----------------------------------------------------------------------|--------|----------------------------------------------------------|---------|----------------------------------------------------------|--------|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Investment  Income:                                                   |   |                                                     |    |                                                     |   |                                                   |       |                                                          |       |
| Residential  mortgage loans and securities interest income            |   | $                                                        | 155,402 |                                                     | $      | 49,380                                                 |       | $                                                             | 301,532    |   | $ | 74,434 |   |
| Corporate  loans and securities interest income                       |   | 61,511                                                   |    | 16,877                                                   |   | 111,925                                                |       | 26,309                                                        |       |
| Commercial  real estate loans and securities interest income          |   | 6,889                                                    |    | 2,562                                                    |   | 15,527                                                 |       | 3,474                                                         |       |
| Other  interest income                                                |   | 1,807                                                    |    | 943                                                      |   | 3,652                                                  |       | 1,197                                                         |       |
| Common  and preferred stock dividend income                           |   | 912                                                      |    | 934                                                      |   | 1,795                                                  |       | 1,467                                                         |       |
| Net  premium/discount (amortization) accretion                        |   | 306                                                      |    | (1,670                                                   | )      | 194                                                    |       | (2,309                                                        | )          |
| Total  investment income                                              |   | 226,827                                                  |    | 69,026                                                   |   | 434,625                                                |       | 104,572                                                       |       |
| Interest  Expense:                                                    |   |                                                     |    |                                                     |   |                                                   |       |                                                          |       |
| Repurchase  agreements interest expense                               |   | 97,704                                                   |    | 41,629                                                   |   | 203,766                                                |       | 60,179                                                        |       |
| Collateralized  loan obligation senior secured notes interest expense |   |  

20,420                                           |    |  

6,618                                            |   | 38,385                                                 |       | 8,516                                                         |       |
| Asset-backed  secured liquidity notes interest expense                |   | 62,322                                                   |    | —                                                   |   | 93,798                                                 |       | —                                                        |       |
| Secured  revolving credit facility interest expense                   |   | 2,119                                                    |    | —                                                   |   | 2,869                                                  |       | —                                                        |       |
| Demand  loan interest expense                                         |   | 573                                                      |    | —                                                   |   | 1,077                                                  |       | —                                                        |       |
| Junior  subordinated notes interest expense                           |   | 1,336                                                    |    | —                                                   |   | 1,368                                                  |       | —                                                        |       |
| Other  interest expense                                               |   | 633                                                      |    | 34                                                       |   | 1,574                                                  |       | 35                                                            |       |
| Interest  rate swap and corridor interest expense, net                |   | (10,013                                                  | )       | —                                                   |   | (11,180                                                | )          | —                                                        |       |
| Total  interest expense                                               |   | 175,094                                                  |    | 48,281                                                   |   | 331,657                                                |       | 68,730                                                        |       |
| Net  investment income                                                |   | $                                                        | 51,733  |                                                     | $      | 20,745                                                 |       | $                                                             | 102,968    |   | $ | 35,842 |   |

 

Aspresented in the table above, our net investment income increased by $31.0million and $67.1 million for the three and six months ended June 30, 2006,respectively, compared to the three and six months ended June 30, 2005. Thechange from 2005 to 2006 is primarily attributable to the increase in ourinvestment portfolio since June 30, 2005. As of June 30, 2006, we held $15.7billion in investments in loans and securities available-for-sale and hadborrowings outstanding totaling $14.2 billion. In comparison, as of June 30,2005, investments in loans and securities available-for-sale totaled $6.7billion and borrowings outstanding totaled $5.5 billion.  

 

23

----

 

*OtherIncome*

* *

Thefollowing table presents the components of other income for the three and sixmonths ended June 30, 2006 and 2005:

 

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

** **
| ** **                                                                     | ** ** | **For the three  months ended  June 30, 2006** | ** ** | **For the three  months ended  June 30, 2005** | ** ** | **For the six  months ended  June 30, 2006** | ** ** | **For the six  months ended  June 30, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Net realized and  unrealized gain (loss) on derivatives and foreign exchange:  |       |                                                     |       |                                                     |       |                                                   |       |                                                        |       |
| Interest rate  swaptions                                                       |       | $                                                        | 25         |                                                     | $          | (102                                                   | )          | $                                                           | 58         |   | $ | (194 | ) |
| Interest rate  swaps                                                           |       | (9                                                       | )          | 232                                                      |       | 152                                                    |       | 232                                                         |       |
| Credit default  swaps                                                          |       | 334                                                      |       | (118                                                     | )          | 76                                                     |       | 279                                                         |       |
| Foreign exchange  forwards                                                     |       | —                                                   |       | 2,158                                                    |       | —                                                 |       | 2,028                                                       |       |
| Total rate of  return swaps                                                    |       | 2,007                                                    |       | —                                                   |       | 1,707                                                  |       | —                                                      |       |
| Foreign exchange  translation                                                  |       | 942                                                      |       | (2,346                                                   | )          | 1,316                                                  |       | (2,394                                                      | )          |
| Total realized  and unrealized gain (loss) on derivatives and foreign exchange |       | 3,299                                                    |       | (176                                                     | )          | 3,309                                                  |       | (49                                                         | )          |
| Net realized  gain on investments                                              |       | 691                                                      |       | 790                                                      |       | 2,139                                                  |       | 1,151                                                       |       |
| Fee and other  income                                                          |       | 458                                                      |       | 1,245                                                    |       | 673                                                    |       | 1,595                                                       |       |
| Total other  income                                                            |       | $                                                        | 4,448      |                                                     | $          | 1,859                                                  |       | $                                                           | 6,121      |   | $ | 2,697 |   |

 

Aspresented in the table above, other income totaled $4.4 million and $6.1million for the three and six months ended June 30, 2006, respectively, ascompared to $1.9 million and $2.7 million for the three and six months endedJune 30, 2005, respectively. The increase in total other income from the priorperiod is primarily attributable to increased investment activity since June30, 2005.  

 

*Non-InvestmentExpenses*

 

Thefollowing table presents the components of our non-investment expenses for thethree and six months ended June 30, 2006 and 2005:

 

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

** **
| ** **                              | ** ** | **For the three  months ended  June 30, 2006** | ** ** | **For the three  months ended  June 30, 2005** | ** ** | **For the six  months ended  June 30, 2006** | ** ** | **For the six  months ended  June 30, 2005** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Related party  management compensation: |       |                                                     |       |                                                          |       |                                                   |       |                                                        |       |
| Base management  fees                   |       | $                                                        | 7,215      |                                                          | $          | 3,384                                                  |       | $                                                           | 14,373     |   | $ | 6,720 |   |
| Incentive fee                           |       | 1,595                                                    |       | —                                                        |       | 2,268                                                  |       | —                                                      |       |
| Share-based  compensation               |       | 4,968                                                    |       | 7,347                                                         |       | 11,577                                                 |       | 12,019                                                      |       |
| Related party  management compensation  |       | 13,778                                                   |       | 10,731                                                        |       | 28,218                                                 |       | 18,739                                                      |       |
| Professional  services                  |       | 548                                                      |       | 788                                                           |       | 1,495                                                  |       | 1,185                                                       |       |
| Loan servicing  expense                 |       | 3,720                                                    |       | 363                                                           |       | 7,716                                                  |       | 630                                                         |       |
| Insurance  expense                      |       | 274                                                      |       | 216                                                           |       | 498                                                    |       | 433                                                         |       |
| Directors  expenses                     |       | 375                                                      |       | 152                                                           |       | 748                                                    |       | 351                                                         |       |
| General and  administrative expenses    |       | 2,436                                                    |       | 858                                                           |       | 4,664                                                  |       | 1,477                                                       |       |
| Total  non-investment expenses          |       | $                                                        | 21,131     |                                                          | $          | 13,108                                                 |       | $                                                           | 43,339     |   | $ | 22,815 |   |

 

Aspresented in the table above, our non-investment expenses increased by $8.0million and $20.5 million for the three and six months ended June 30, 2006,respectively, compared to the three and six months ended June 30, 2005. Theincrease in non-investment expenses from the prior period is primarilyattributable to our growth since June 30, 2005. The significant components ofnon-investment expense are described below.

 

24

----

 

Managementcompensation to related parties consists of base management fees payable to ourManager pursuant to the Management Agreement, incentive management fees, andshare-based compensation related to restricted common stock and common stockoptions granted to our Manager. The base management fee payable was calculatedin accordance with the Management Agreement and is based on an annual rate of1.75% times “equity” as defined in the Management Agreement. Our Manager isalso entitled to an incentive fee provided that our quarterly “net income,” asdefined in the Management Agreement, before the incentive fee exceeds a definedreturn hurdle. We did not exceed the applicable hurdle during the three and sixmonths ended June 30, 2005.

 

Generaland administrative expenses consist of expenses incurred by our Manager on ourbehalf that are reimbursable to our Manager pursuant to the ManagementAgreement. We expect that our general and administrative expenses will continueto increase as our investment portfolio continues to increase. Professionalservices expenses consist of legal, accounting and other professional services.We expect that our recurring professional services expenses will continue toincrease as our investment portfolio continues to increase. Loan servicingexpense consists of servicing fees paid to third-party servicers.

 

*IncomeTax Provision*

* *

Wehave elected to be taxed as a REIT and intend to continue to comply with theprovisions of the Code with respect thereto. Accordingly, we are not subject tofederal income tax to the extent that our distributions to stockholders satisfythe REIT requirements and certain asset, income and ownership tests, andrecordkeeping requirements are fulfilled. Even though we qualify for federaltaxation as a REIT, we may be subject to some amount of federal, state, localand foreign taxes based on our taxable income.

 

KKRTRS Holdings, Inc., our domestic taxable REIT subsidiary, is taxed as aregular subchapter C corporation under the provisions of the Code. KKR TRSHoldings, Inc. was formed to make, from time to time, certain investmentsthat would not be REIT qualifying investments if made directly by us, and toearn income that would not be REIT qualifying income if earned directly by us.For the three and six months ended June 30, 2006, KKR TRS Holdings, Inc.had pre-tax net income of $0.3 million and $1.0 million, respectively, and theprovision for income taxes totaled $0.1 million and $0.4 million, respectively.As of June 30, 2006, KKR TRS Holdings, Inc. had an income tax receivableof $0.9 million and a deferred tax liability of $0.3 million.

 

KKRFinancial CLO 2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKRFinancial CDO 2005-1, Ltd., and KKR Financial CLO 2006-1, Ltd., are foreigntaxable REIT subsidiaries that were established to facilitate securitizationtransactions structured as secured financing transactions. They 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 three and six months ended June 30, 2006 were recorded; however,we will generally be required to include their current taxable income in ourcalculation of REIT taxable income.

 

25

----

 

**Financial Condition**

** **

**Summary**

** **

Thetables below summarize the carrying value, amortized cost, and estimated fairvalue of our investment portfolio as of June 30, 2006 and December 31, 2005,classified by interest rate type. Carrying value is the value that investmentsare recorded on our consolidated balance sheets and is estimated fair value forsecurities and amortized cost for loans held for investment and the lower ofamortized cost or market value for loans held for sale. Estimated fair valuesset forth in the tables below are based on dealer quotes and/or nationallyrecognized pricing services.

 

Thetable below summarizes our investment portfolio as of June 30, 2006 classifiedby interest rate type:

 

**InvestmentPortfolio(Amounts in thousands)**

** **
| ** **                                             | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  % by Fair Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|---------------------------------------------------|------------|
| **Floating  Rate:**                                    | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                        | ** ** |
| Residential ARM  Loans                                 |       | $                       | 1,779,419  |                    | $          | 1,779,419                      |       | $                                                 | 1,774,532  |   | 11.2 | % |
| Residential ARM  Securities                            |       | 4,387,857               |       | 4,378,482               |       | 4,387,857                      |       | 27.6                                              |       |
| Corporate Loans                                        |       | 2,440,722               |       | 2,440,722               |       | 2,449,724                      |       | 15.4                                              |       |
| Corporate Debt  Securities                             |       | 345,979                 |       | 336,374                 |       | 345,979                        |       | 2.2                                               |       |
| Commercial Real  Estate Loans                          |       | 232,515                 |       | 232,515                 |       | 232,294                        |       | 1.5                                               |       |
| Commercial Real  Estate Debt Securities                |       | 62,312                  |       | 62,503                  |       | 62,312                         |       | 0.4                                               |       |
| Total Floating  Rate                                   |       | 9,248,804               |       | 9,230,015               |       | 9,252,698                      |       | 58.3                                              |       |
| **Hybrid  Rate:**                                      | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                        | ** ** |
| Residential  Hybrid ARM Loans                          |       | 3,963,537               |       | 3,963,537               |       | 3,899,597                      |       | 24.6                                              |       |
| Residential  Hybrid ARM Securities                     |       | 1,997,875               |       | 2,048,441               |       | 1,997,875                      |       | 12.6                                              |       |
| Total Hybrid  Rate                                     |       | 5,961,412               |       | 6,011,978               |       | 5,897,472                      |       | 37.2                                              |       |
| **Fixed  Rate:**                                       | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                        | ** ** |
| Corporate Loans                                        |       | 37,737                  |       | 37,737                  |       | 38,013                         |       | 0.2                                               |       |
| Corporate Debt  Securities                             |       | 400,309                 |       | 395,791                 |       | 400,309                        |       | 2.5                                               |       |
| Commercial Real  Estate Loans                          |       | 78,477                  |       | 78,477                  |       | 78,138                         |       | 0.4                                               |       |
| Commercial Real  Estate Debt Securities                |       | 7,231                   |       | 6,714                   |       | 7,231                          |       | 0.1                                               |       |
| Total Fixed Rate                                       |       | 523,754                 |       | 518,719                 |       | 523,691                        |       | 3.2                                               |       |
| **Marketable  and Non-Marketable Equity Securities:**  | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                        | ** ** |
| Common and  Preferred Stock                            |       | 66,484                  |       | 68,608                  |       | 66,484                         |       | 0.4                                               |       |
| Non-Marketable  Equity Securities                      |       | 139,429                 |       | 139,429                 |       | 139,429                        |       | 0.9                                               |       |
| Total Marketable  and Non-Marketable Equity Securities |       | 205,913                 |       | 208,037                 |       | 205,913                        |       | 1.3                                               |       |
| Total                                                  |       | $                       | 15,939,883 |                    | $          | 15,968,749                     |       | $                                                 | 15,879,774 |   | 100.0 | % |

 

Asof June 30, 2006 the aggregate amortized cost value of the Company’s investmentportfolio exceeded the aggregate fair value of its portfolio by$89.1 million and, as of the same date, the Company had unrealized gainstotaling $118.0 million related to its cash flow hedges, as defined underSFAS No. 133. As of June 30, 2006, the aggregate net unamortized purchasediscount related to the Company’s investment portfolio was $14.9 million.

 

26

----

 

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

 

**InvestmentPortfolio(Amounts in thousands)**

** **
| ** **                                             | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|---------------------------------------------------|------------|
| **Floating  Rate:**                                    | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                     | ** ** | ** **                                        | ** ** |
| Residential ARM  Loans                                 |       | $                       | 2,175,929  |                    | $          | 2,175,929                      |       | $                                                 | 2,163,932  |   | 14.4 | % |
| 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 | % |

 

Asof December 31, 2005, the aggregate amortized cost value of the Company’sinvestment portfolio exceeded the aggregate fair value of its portfolio by$54.1 million and, as of the same date, the Company had unrealized gainstotaling $45.6 million related to its cash flow hedges, as defined underSFAS No. 133. As of December 31, 2005, the aggregate net unamortizedpurchase discount related to the Company’s investment portfolio was $6.7million.

 

**Asset Quality**

** **

*AssetQuality Review*

* *

Weevaluate and monitor the asset quality of our investment portfolio byperforming detailed credit reviews and by monitoring key credit statistics andtrends. We monitor the credit rating of our investment portfolio through theuse of both Moody’s and Standard & Poor’s ratings, and Moody’sweighted average rating factor, or WARF. WARF is the quantitative equivalent ofMoody’s traditional rating categories (e.g., Ba1, Ba2, etc.) and is used byMoody’s in its credit enhancement calculations for securitization transactions.By monitoring both Moody’s and Standard & Poor’s ratings and Moody’sWARF we can monitor trends and changes in the credit ratings of our investmentportfolio. For residential mortgage loans and residential mortgage-backedsecurities we monitor the credit quality of the underlying borrowers bymonitoring trends and changes in the underlying borrowers’ FICO® scores.Borrowers with lower FICO® scores default more frequently than borrowers withhigher FICO® scores. For residential and

 

27

----

 

commercial real estatemortgage loans and mortgage-backed securities we monitor trends and changes inLTV ratios. Increases in LTV ratios are likely to result in higher realizedcredit losses when borrowers default.

 

*SecuritiesAvailable-for-Sale*

* *

Thefollowing table summarizes the par value of our investment securities portfolioby investment class stratified by Moody’s and Standard & Poor’s ratingscategory as of June 30, 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                      |       | $                                    | 4,327,656  |                                         | $          | 1,984,254                       |       | $                                                      | —     |      | $          | — |   | $ | 6,311,910 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 18,411                               |       | 28,520                                       |       | —                          |       | —                                                 |       | 46,931    |       |
| A1/A+ through  A3/A-         |       | 13,273                               |       | 18,149                                       |       | —                          |       | —                                                 |       | 31,422    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 9,420                                |       | 9,689                                        |       | 21,444                          |       | —                                                 |       | 40,553    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 4,710                                |       | 3,889                                        |       | 287,000                         |       | 29,000                                                 |       | 324,599   |       |
| B1/B+ through  B3/B-         |       | 3,425                                |       | 2,593                                        |       | 254,815                         |       | —                                                 |       | 260,833   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 130,522                         |       | —                                                 |       | 130,522   |       |
| Non-Rated                    |       | 8,133                                |       | 6,482                                        |       | 56,000                          |       | 42,135                                                 |       | 112,750   |       |
| Total                        |       | $                                    | 4,385,028  |                                         | $          | 2,053,576                       |       | $                                                      | 749,781    |      | $          | 71,135 |   | $ | 7,259,520 |   |

 

Thefollowing table shows the par value of our investment securities portfolio byinvestment class stratified by Moody’s and Standard & Poor’s ratingscategory as of December 31, 2005:

 

**InvestmentSecurities(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 3,310,426  |                                         | $          | 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 mortgageloan portfolio totaled $5.7 billion as of June 30, 2006 and $6.4 billion as ofDecember 31, 2005. As of June 30, 2006 we owned one real estate propertyacquired through foreclosure.  Theoutstanding loan balance of $0.3 million (not included in the following table)was reclassified from loans to other assets on our balance sheet, and theestimated fair value of the real estate property exceeds the outstanding loanbalance and therefore we have not recorded a charge against our allowance forloan losses.  As of December 31,2005, we did not own any real estate properties that we had acquired throughforeclosure. 

 

As of June 30, 2006 wehad 13 loans that were 90 days or greater past due or in foreclosure and placedon non-accrual status.  During thequarter ended June 30, 2006 we did not recognize approximately $0.1 million ininterest income for loans in non-accrual status or that were classified as realestate owned.

 

28

----

 

The weighted averageoriginal FICO® score and weighted average original LTV ratio of our residentialARM loan portfolio were 737 and 69.0%, respectively, as of June 30, 2006. As ofDecember 31, 2005, the weighted average original FICO® score and weightedaverage LTV ratio of our residential ARM loan portfolio were 737 and 67.2%,respectively. As of June 30, 2006 our residential ARM loan investment portfoliodid not have any material concentrations in investor owned properties,multi-unit housing properties, condominium properties and/or cooperativeproperties. A material portion of our residential ARM loans are non-conformingmortgage loans, not due to credit quality, but because the mortgage loans havebalances that exceed the maximum balances necessary to qualify as a conformingmortgage loan. 

 

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of June 30, 2006 (dollar amounts in thousands):

 
| **Delinquency Status** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30  to 59 days              |       | 88                            |       | $                         | 33,681     |   |
| 60  to 89 days              |       | 12                            |       | 3,906                     |       |
| 90  days or more            |       | 1                             |       | 446                       |       |
| In  foreclosure             |       | 12                            |       | 3,192                     |       |
| Total                       |       | 113                           |       | $                         | 41,225     |   |

 

The following tablesummarizes the delinquency statistics of residential mortgage loans as ofDecember 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 three months ended June 30, 2006(amounts in thousands):

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

 

Our corporate loanportfolio totaled $2.4 billion as of June 30, 2006 and $1.9 billion as ofDecember 31, 2005. Our corporate loan portfolio consists of debtobligations of corporations, partnerships and other entities in the form offirst and second lien loans, mezzanine loans and bridge loans. As of June 30,2006 we classified seventeen corporate loans as held for sale.  Accordingly, these loans are recorded at thelower of cost or market on our consolidated balance sheet. Of the seventeenloans classified as held for sale, a gross loss of $0.2 million was recognized asthe carrying value of the loans exceeded fair value as of June 30, 2006 in theamount of $0.2 million.

 

We performed anallowance for loan losses analysis as of June 30, 2006 and December 31,2005, and we have made the determination that no allowance for loan losses wasrequired for our corporate loan portfolio as of June 30, 2006 orDecember 31, 2005. 

 

29

----

 

Thefollowing table summarizes the par value of our corporate loan portfoliostratified by Moody’s and Standard & Poor’s ratings category as ofJune 30, 2006 and December 31, 2005:

 

**CorporateLoans(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **As of  June 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|-------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                             | —     |                                        | $          | — |   |
| Aa1/AA+  through Aa3/AA-     |       | —                        |       | —                                      |       |
| A1/A+  through A3/A-         |       | —                        |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | 2,000                         |       | 2,000                                       |       |
| Ba1/BB+  through Ba3/BB-     |       | 837,722                       |       | 673,644                                     |       |
| B1/B+  through B3/B-         |       | 1,384,216                     |       | 1,095,368                                   |       |
| Caa1/CCC+  and lower         |       | 25,650                        |       | 21,547                                      |       |
| Non-rated                    |       | 231,226                       |       | 107,826                                     |       |
| Total                        |       | $                             | 2,480,814  |                                        | $          | 1,900,385 |   |

 

Ourcommercial real estate loan portfolio totaled $311.0 million and$521.7 million as of June 30, 2006 and December 31, 2005,respectively. Our commercial real estate loan portfolio consists of senior,mezzanine, and bridge loans that are secured by commercial real estate.

 

Weperformed an allowance for loan losses analysis as of June 30, 2006 andDecember 31, 2005, and we have made the determination that no allowancefor loan losses was required for our commercial real estate loan portfolio asof June 30, 2006 or December 31, 2005.

 

Thefollowing table summarizes the par value of our commercial real estate loanportfolio stratified by Moody’s and Standard & Poor’s ratings categoryas of June 30, 2006 and December 31, 2005:

 

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

** **
| **Ratings Category**    | ** ** | **As of  June 30, 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-     |       | 27,277                        |       | 60,929                                      |       |
| B1/B+  through B3/B-         |       | 75,000                        |       | 75,000                                      |       |
| Caa1/CCC+  and lower         |       | —                        |       | 50,000                                      |       |
| Non-rated                    |       | 209,700                       |       | 336,821                                     |       |
| Total                        |       | $                             | 311,977    |                                        | $          | 522,750 |   |

 

30

----

 

**Asset RepricingCharacteristics**

** **

*Summary*

* *

Thetable below summarizes the repricing characteristics of our investmentportfolio as of June 30, 2006 and December 31, 2005, and is classified byinterest rate type:

 

**InvestmentPortfolio(Amounts in thousands)**

** **
| ** **                              | ** ** | **As of June 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**           | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| Floating  Rate:                         |       |                              |       |                                            |       |   |   |   |   |
| Residential  ARM Loans                  |       | $                                 | 1,779,419  |                                            | 11.3       | % | $ | 2,175,929 |   | 14.5 | % |
| Residential  ARM Securities             |       | 4,378,482                         |       | 27.8                                            |       | 3,369,763 |   | 22.5 |   |
| Corporate  Loans                        |       | 2,440,722                         |       | 15.5                                            |       | 1,872,277 |   | 12.5 |   |
| Corporate  Debt Securities              |       | 336,374                           |       | 2.1                                             |       | 277,030 |   | 1.9 |   |
| Commercial  Real Estate Loans           |       | 232,515                           |       | 1.5                                             |       | 486,096 |   | 3.2 |   |
| Commercial  Real Estate Debt Securities |       | 62,503                            |       | 0.4                                             |       | 63,168 |   | 0.4 |   |
| Total  Floating Rate                    |       | 9,230,015                         |       | 58.6                                            |       | 8,244,263 |   | 55.0 |   |
| Hybrid  Rate:                           |       |                              |       |                                            |       |   |   |   |   |
| Residential  Hybrid ARM Loans           |       | 3,963,537                         |       | 25.2                                            |       | 4,252,893 |   | 28.4 |   |
| Residential  Hybrid ARM Securities      |       | 2,048,441                         |       | 13.0                                            |       | 2,197,020 |   | 14.7 |   |
| Total  Hybrid Rate                      |       | 6,011,978                         |       | 38.2                                            |       | 6,449,913 |   | 43.1 |   |
| Fixed  Rate:                            |       |                              |       |                                            |       |   |   |   |   |
| Corporate  Loans                        |       | 37,737                            |       | 0.2                                             |       | 25,000 |   | 0.2 |   |
| Corporate  Debt Securities              |       | 395,791                           |       | 2.5                                             |       | 202,748 |   | 1.4 |   |
| Commercial  Real Estate Loans           |       | 78,477                            |       | 0.5                                             |       | 35,646 |   | 0.2 |   |
| Commercial  Real Estate Debt Securities |       | 6,714                             |       | 0.0                                             |       | 19,833 |   | 0.1 |   |
| Total  Fixed Rate                       |       | 518,719                           |       | 3.2                                             |       | 283,227 |   | 1.9 |   |
| Total                                   |       | $                                 | 15,760,712 |                                            | 100.0      | % | $ | 14,977,403 |   | 100.0 | % |

 

Thetable above excludes marketable equity securities with a fair value of $66.5million and amortized cost of $68.6 million, and non-marketable equitysecurities with a fair value of $139.4 million and amortized cost of $139.4million as of June 30, 2006.  Alsoexcluded are marketable equity securities with a fair value of $47.0 millionand amortized cost of $47.2 million, and non-marketable equity securities witha fair value of $52.5 million and amortized cost of $52.5 million as ofDecember 31, 2005

* *

*ResidentialARM Securities*

* *

Asof June 30, 2006, substantially all of our residential ARM securities werecomprised of one-month LIBOR floating rate securities that reprice monthly andwere subject to a weighted average maximum net interest rate of 11.88% which ismaterially above the then current weighted average net coupon of 6.19%. Ourrepricing risk on our portfolio of residential ARM securities increasesmaterially if interest rates continue to increase to a level where the weightedaverage coupon rate approaches the weighted average maximum net interest rateof 11.88% because the weighted average coupon is subject to a maximum rate, orcap, which is approximately equal to the weighted average maximum interest rateof 11.88%.

 

Asof December 31, 2005, substantially all of our residential ARM securitieswere comprised of one-month LIBOR floating rate securities that reprice monthlyand were subject to a weighted average maximum net interest rate of 11.63%which is materially above the then current weighted average net coupon of4.62%. Our repricing risk on our portfolio of residential ARM securities increasesmaterially if interest rates continue to increase to a level where the weightedaverage coupon rate approaches the weighted average maximum net interest rateof 11.63% because the weighted average coupon is subject to a maximum rate, orcap, which is approximately equal to the weighted average maximum interest rateof 11.63%.

 

31

----

 

*ResidentialHybrid ARM Securities*

* *

Asof June 30, 2006, all of our residential hybrid ARM securities had underlyingmortgage loans that were originated as 5/1 hybrid ARM loans. As of June 30,2006, we owned 100% of the securities that represent 100% of the beneficialinterest in the 5/1 hybrid ARM loans underlying our portfolio of hybrid ARMsecurities. When the underlying residential hybrid mortgage loans convert fromfixed rate to floating rate, the underlying mortgage loans will have aninterest rate based on one-year LIBOR or one-year constant maturity treasuryindex, or CMT, depending upon if the underlying mortgage loan is a LIBOR- orCMT-based mortgage loan. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and(ii) the weighted average post-roll date net margin. As of June 30, 2006all of the mortgage loans underlying our residential hybrid ARM securities hada post-roll date index reset frequency of one year with 34% based on six-monthor one-year LIBOR and 66% 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, the weightedaverage net coupon rate approaches the weighted average post roll date maximumnet interest rate of 9.43% because the post roll date weighted average netcoupon is subject to a maximum rate, or cap, which is approximately equal tothe weighted average post roll date maximum net interest rate of 9.43%. Theweighted average net coupon on the portfolio of residential hybrid securitiesis 4.18% as of June 30, 2006. As of June 30, 2006, the weighted average monthsuntil roll date for the mortgage loans underlying our residential hybrid ARMsecurities was 30.

 

Asof December 31, 2005, all of our residential hybrid ARM securities hadunderlying mortgage loans that were originated as 5/1 hybrid ARM loans. As ofDecember 31, 2005, we owned 100% of the securities that represent 100% ofthe beneficial interest in the 5/1 hybrid ARM loans underlying our portfolio ofhybrid ARM securities.  As ofDecember 31, 2005 all of the mortgage loans underlying our residentialhybrid ARM securities had a post-roll date index reset frequency of one yearwith 35% based on six-month or one-year LIBOR and 65% based on one-yearCMT.  Our repricing risk on our portfolioof residential hybrid ARM loans increases materially if interest rates continueto increase 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 is4.13% as of December 31, 2005. As of December 31, 2005, the weightedaverage months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 36.

 

*ResidentialARM Loans*

* *

Asof June 30, 2006, all of our residential ARM loans were comprised of one-monthLIBOR floating rate loans that reprice monthly and were subject to a weightedaverage maximum net interest rate of****11.92%, whichis well above the then current weighted average net coupon of****6.02%. Our repricing risk on our portfolio of residentialARM loans increases materially if interest rates continue to increase to alevel where the weighted average net coupon rate approaches the weightedaverage maximum interest rate of 11.92% because the weighted average coupon issubject to a maximum rate, or cap, which is approximately equal to the weightedaverage maximum interest rate of 11.92%.

 

Asof December 31, 2005, all of our residential ARM loans were comprised ofone-month LIBOR floating rate loans that reprice monthly and were subject to aweighted average maximum net interest rate of****11.90%,which is well above the then current weighted average net coupon of****5.05%. Our repricing risk on our portfolio

 

32

----

 

of residential ARM loansincreases materially if interest rates continue to increase to a level wherethe weighted average net coupon rate approaches the weighted average maximuminterest rate of 11.90% because the weighted average coupon is subject to amaximum rate, or cap, which is approximately equal to the weighted averagemaximum interest rate of 11.90%.

 

*ResidentialHybrid ARM Loans*

* *

As of June 30, 2006, allof our residential hybrid ARM loans were originated as either 3/1 or 5/1 hybridARM loans. When the loans convert from fixed rate to floating rate, theunderlying mortgage loans will have an interest rate based on one-year LIBOR orone-year CMT. On the date that the residential hybrid ARM loans convert from afixed rate to a floating rate loan, which we refer to as the roll date, ourportfolio of residential hybrid ARM loans will have a weighted average couponthat is the sum of (i) the post-roll date index, and (ii) theweighted average post-roll date net margin. As of June 30, 2006 all of ourresidential hybrid ARM loans had a post-roll date index reset frequency ofone-year with 43% based on six-month or one-year LIBOR and 57% based onone-year CMT. Our repricing risk on our portfolio of residential hybrid ARMloans increases materially if interest rates continue to increase to a levelwhere, subsequent to the roll date, the weighted average net coupon rateapproaches the weighted average post-roll date maximum net interest rate of10.12%****because the post-roll date weightedaverage net coupon is subject to a maximum rate, or cap, which is approximatelyequal to the weighted average post-roll date maximum net interest rate of10.12%. The weighted average net coupon on the portfolio of residential hybridloans is 4.85% as of June 30, 2006. As of June 30, 2006, the weighted averagemonths until roll date for the mortgage loans underlying our residential hybridARM securities was 39.

 

As of December 31,2005, all of our residential hybrid ARM loans were originated as either 3/1 or5/1 hybrid ARM loans.  As ofDecember 31, 2005 all of our residential hybrid ARM loans had a post-rolldate index reset frequency of one-year with 43% based on six-month or one-yearLIBOR and 57% based on one-year CMT.  Ourrepricing risk on our portfolio of residential hybrid ARM loans increasesmaterially if interest rates continue to increase to a level where, subsequentto the roll date, the weighted average net coupon rate approaches the weightedaverage post-roll date maximum net interest rate of 10.13%****becausethe post-roll date weighted average net coupon is subject to a maximum rate, orcap, which is approximately equal to the weighted average post-roll datemaximum net interest rate or 10.13%. The weighted average net coupon on theportfolio of residential hybrid loans is 4.85% as of December 31, 2005. Asof December 31, 2005, the weighted average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 44.

 

*CorporateLoans and Securities*

* *

All of our floating ratecorporate loans and securities have index reset frequencies of less than twelvemonths with the majority of the loans resetting at least quarterly. Theweighted average coupon on our floating rate corporate loans and securities was8.03% and 7.12% as of June 30, 2006 and December 31, 2005, respectively.As of June 30, 2006 and December 31, 2005, the weighted average years tomaturity of our floating rate corporate loans and securities was 6.2 yearsand 6.3 years, respectively.

 

As of June 30, 2006, ourfixed rate corporate debt securities had a weighted average coupon of 9.44% anda weighted average years to maturity of****6.4****years, as compared to 10.58% and 8.7 years,respectively, as of December 31, 2005.

 

*CommercialReal Estate Loans and Securities*

* *

All of our floating ratecommercial real estate loans and securities have index reset frequencies ofless than twelve months. The weighted average coupon on our floating ratecommercial real estate loans and securities was 8.27% and 8.70% as of June 30,2006 and December 31, 2005, respectively. As of June 30, 2006 and

 

33

----

 

December 31, 2005,the weighted average years to maturity of our floating rate commercial realestate loans and securities was****4.0** **years and 3.7 years, respectively.

 

As of June 30, 2006 ourfixed rate commercial real estate loans and securities had a weighted averagecoupon of 8.00% and a weighted average years to maturity of 7.9 years, ascompared to 7.95% and 7.7 years, respectively, as of December 31, 2005.

 

**Portfolio Purchases**

** **

We purchased$1.7 billion and $3.5 billion during the three and six months ended June30, 2006, respectively, compared to $1.4 billion and $5.4 billion par amount ofinvestments during the three and six months ended June 30, 2005, respectively.

 

The table belowsummarizes our investment portfolio purchases for the periods indicated andincludes the par amount, or face amount, of the securities and loans that werepurchased:  

 

**InvestmentPortfolio Purchases(Amounts in thousands)**

 
| ** **                              | ** ** | **Three months ended  June 30, 2006** | ** ** | **Three months ended  June 30, 2005** | ** ** | **Six months ended  June 30, 2006** | ** ** | **Six months ended  June 30, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                              | ** ** | **Par Amount**                   | ** ** | **%**                                 | ** ** | **Par Amount**                 | ** ** | **%**                               | ** ** | **Par Amount** | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                             |       |                                  |       |                                  |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| Residential ARM  Securities             |       | $                                     | 800,491    |                                  | 47.5       | %                                   | $          | 73,423                              |       | 5.3 | % | $ | 1,864,267 |   | 53.0 | % | $ | 739,205 |   | 13.8 | % |
| Residential  Hybrid ARM Securities      |       | —                                |       | —                                |       | 299,040                             |       | 21.9                                |       | — |   | — |   | 2,935,532 |   | 54.7 |   |
| Corporate Debt  Securities              |       | 212,247                               |       | 12.6                                  |       | 106,500                             |       | 7.8                                 |       | 340,016 |   | 9.7 |   | 218,505 |   | 4.1 |   |
| Commercial Real  Estate Debt Securities |       | —                                |       | —                                |       | —                              |       | —                              |       | — |   | — |   | 10,000 |   | 0.2 |   |
| Total Securities  Principal Balance     |       | 1,012,738                             |       | 60.1                                  |       | 478,963                             |       | 35.0                                |       | 2,204,283 |   | 62.7 |   | 3,903,242 |   | 72.8 |   |
| Loans:                                  |       |                                  |       |                                  |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| Residential ARM  Loans                  |       | 26,054                                |       | 1.5                                   |       | 189,781                             |       | 13.9                                |       | 125,552 |   | 3.6 |   | 436,501 |   | 8.1 |   |
| Corporate Loans                         |       | 647,619                               |       | 38.4                                  |       | 592,150                             |       | 43.3                                |       | 1,186,502 |   | 33.7 |   | 916,701 |   | 17.1 |   |
| Commercial Real  Estate Loans           |       | —                                |       | —                                |       | 106,750                             |       | 7.8                                 |       | — |   | — |   | 106,750 |   | 2.0 |   |
| Total Loans  Principal Balance          |       | 673,673                               |       | 39.9                                  |       | 888,681                             |       | 65.0                                |       | 1,312,054 |   | 37.3 |   | 1,459,952 |   | 27.2 |   |
| Grand Total  Principal Balance          |       | 1,686,411                             |       | 100.0                                 | %          | 1,367,644                           |       | 100.0                               | %          | $ | 3,516,337 |   | 100.0 | % | $ | 5,363,194 |   | 100.0 | % |
|                                         |            |                                       |            |                                       |            |                                     |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The table above excludespurchases of $16.8 million (purchase cost) of marketable equity securities and$40.7 million of non-marketable equity securities during the three months endedJune 30, 2006, and $27.2 million (purchase cost) of marketable equitysecurities and $91.6 million (purchase cost) of non-marketable equitysecurities during the six months ended June 30, 2006.  The table also excludes $8.8 million(purchase cost) and $24.7 million (purchase cost) of marketable equitysecurities during the three and six months ended June 30, 2005, respectively.

 

**Stockholders’ Equity**

** **

Our stockholders’ equityat each of June 30, 2006 and December 31, 2005 totaled $1.7 billion.Included in our stockholders’ equity as of June 30, 2006 and December 31,2005, is accumulated other comprehensive income totaling****$89.1million and $18.3 million, respectively.

 

Our averagestockholders’ equity and return on average stockholders’ equity for the threeand six months ended June 30, 2006 were $1.7 billion and 8.1%, and $1.7 billionand 7.8%, respectively.  Our averagestockholders’ equity and return on average stockholders’ equity for the threeand six months ended June 30, 2005 were $0.8 billion and 4.6%, and $0.8 billionand 3.9%, respectively.  Return onaverage stockholders’ equity is defined as net income divided by weightedaverage stockholders’ equity.

 

Our book value percommon share as of June 30, 2006 and December 31, 2005 was $21.58 and $20.59,respectively, and were computed based on 80,374,061 shares issued andoutstanding as June 30, 2006 and December 31, 2005, respectively.

 

On August 2, 2006, ourBoard of Directors declared a cash distribution of $0.49 per share for thequarter ended June 30, 2006 to stockholders of record on August 16, 2006.The distribution is payable on August 30, 2006. The aggregate amount of thedistribution,****$39.4 million, exceeded netincome for the quarter by $4.5 million.

 

34

----

 

**Liquidity and CapitalResources**

** **

We manage our liquiditywith the intention of providing the continuing ability to fund our operationsand fulfill our commitments on a timely and cost-effective basis. We believethat our liquidity level is in excess of that necessary to sufficiently enableus to meet our anticipated liquidity requirements including, but not limitedto, 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. As of June 30, 2006, we owed our Manager $5.3 million forthe payment of management fees and reimbursable expenses pursuant to theManagement Agreement.

 

An increase inprepayment rates substantially above our expectations could, however, cause atemporary liquidity shortfall due to the timing of the necessary margin callson the financing arrangements and the actual receipt of the cash related toprincipal 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 time insufficient to satisfy ourliquidity requirements, we may have to sell assets or issue debt or additionalequity securities.

 

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

 

The decisions byinvestors and lenders to enter into equity and financing transactions with uswill depend upon a number of factors, including our historical and projectedfinancial performance, compliance with the terms of our current creditarrangements, industry and market trends, the availability of capital and ourinvestors’ and lenders’ policies and rates applicable thereto, and the relativeattractiveness of alternative investment or lending opportunities.

 

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

 

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

 

35

----

 

**Sources of Funds**

 

*SecuritizationTransactions*

* *

On March 30, 2006, weclosed our second $5.0 billion asset-backed secured liquidity note facility.This facility provides us with an alternative source of funding our residentialmortgage-backed securities by issuing asset-backed secured liquidity notes thatare rated A-1+, P-1, and F1+, by Standard & Poor’s, Moody’s and Fitch Inc,respectively. Issuances of asset-backed secured liquidity notes are recorded asborrowings on our Consolidated Balance Sheet. At June 30, 2006, $2.7 billionwas outstanding under this facility and a total of $7.3 billion outstandingunder both our asset-backed secured liquidity note facilities.

 

In preparation forfuture securitization transactions, during the year ended December 31,2005 we formed KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”), KKRFinancial CLO 2006-1, Ltd. (“CLO 2006-1”), and KKR Financial CLO2006-2, Ltd. (“CLO 2006-2”). These entities will be used to provide securedfinancing principally for the purchase of corporate and commercial real estateloans and securities. CLO 2006-1 has executed a $500.0 million warehousefacility, in the form of a repurchase agreement. At June 30, 2006, there was$498.9 million outstanding under the repurchase facility that bears interest ata rate of 30-day LIBOR plus 0.65%. Additionally, CLO 2006-1 had $116.9million outstanding under a repurchase agreement separate from the repurchasefacility as of June 30, 2006. CDO 2005-1 has executed a $300.0 millionwarehouse facility, in the form of a repurchase agreement. At June 30, 2006there was $186.9 million outstanding under this facility that bearsinterest at a rate of 30-day LIBOR plus 1.10%. CLO 2006-2 has executed a $450.0million warehouse facility, in the form of a repurchase agreement. At June 30,2006 there were no borrowings outstanding under this facility. Any borrowingswould bear interest at a rate of 30-day LIBOR plus 0.65%.

 

*RepurchaseAgreements*

* *

As of June 30, 2006, wehad $5.1 billion outstanding on repurchase facilities with ten counterpartieswith a weighted average effective rate of 5.47% and a weighted averageremaining term to maturity of 27****days. Becausewe borrow under repurchase agreements based on the estimated fair value of ourpledged investments, and because changes in interest rates can negativelyimpact the valuation of our pledged investments, our ongoing ability to borrowunder our repurchase facilities may be limited and our lenders may initiatemargin calls in the event interest rates change or the value of our pledgedsecurities decline as a result of adverse changes in interest rates or creditspreads.

 

*SecuredCredit Facility*

* *

During June 2006, wereplaced our existing $275.0 million secured revolving credit facility with anew three year $375.0 million senior secured revolving credit facility. We havethe option to increase the size of this new facility up to $550.0 million solong as no default or event of default (as defined in such credit facility) hasoccurred and subject to addition of new lenders, increases in the commitmentsof existing lenders, or a combination thereof.****Thenew senior secured revolving credit facility matures in June 2009 and consistsof two tranches.****Outstanding borrowings under thesenior secured revolving credit facility bear interest at either (i) analternate base rate per annum equal to the greater of (a) the prime rate ineffect on such day, and (b) the federal funds in effect on such day plus 0.50%,or (ii) an interest rate per annum equal to the LIBOR rate for the applicableinterest period plus 0.50% for borrowings under tranche A of the facility and0.75% for borrowings under tranche B of the facility. As of June 30, 2006 wehad $112.6 million in borrowings outstanding under this facility.

 

36

----

 

*Junior Subordinated Notes*

 

During March 2006, weformed KKR Financial Capital Trust I (the “Trust”) for the sole purpose ofissuing trust preferred securities. On March 28, 2006, the Trust issuedpreferred securities to unaffiliated investors for gross proceeds of $50.0million and common securities to us for $1.6 million. The combined proceedswere invested by the Trust in $51.6 million of junior subordinated notes issuedby us. The junior subordinated notes are the sole assets of the Trust and matureon April 30, 2036, but are callable on or after April 30, 2011. Interest ispayable quarterly at a fixed rate of 7.64% (ten-year LIBOR plus 2.45%) throughMarch 2016 and thereafter at a floating rate equal to three-month LIBOR plus2.65%.

 

During June 2006, theCompany formed KKR Financial Capital Trust II (“Trust II”) for the sole purposeof issuing trust preferred securities. On June 2, 2006, Trust II 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 II in $51.6 million of junior subordinatednotes issued by the Company. The junior subordinated notes are the sole assetsof Trust II and mature on July 30, 2036, but are callable on or after July 30,2011. Interest is payable quarterly at a fixed rate of 8.09% (ten-year LIBORplus 2.45%) through July 2016 and thereafter at a floating rate equal tothree-month LIBOR plus 2.65%.

 

*Off-BalanceSheet Commitments*

* *

As of June 30, 2006, wehad committed to purchase corporate loans with aggregate commitments totaling $146.9 million.In a typical corporate loan or commercial real estate loan syndication, thereis a delay between the time we are informed of our allocable portion of suchloan and the actual funding of such loan.

 

Asof June 30, 2006, we had purchased or participated in corporate loan delayeddraw transactions with aggregate commitments totaling $17.3 million. In adelayed draw transaction, we have made available to the borrower a statedamount to be drawn as needed within a specified future period of time.

 

**REIT Matters**

** **

As of June 30, 2006, webelieve that we qualified as a REIT under the provisions of the Code. The Coderequires that at the end of each calendar quarter at least 75% of our totalassets 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 June 30, 2006, we believe that we were in compliance with such requirements.As of June 30, 2006, we also believe that we met all of the REIT requirementsregarding the ownership of our common stock and the distributions of ourtaxable income.

 

To maintain our statusas a REIT for federal income tax purposes, we are required to declare and paydividends amounting to at least 90% of our taxable income for each year. In addition,for each taxable year, to avoid certain federal excise taxes, we are requiredto declare and pay dividends amounting to certain designated percentages of ourtaxable income by the end of such taxable year. Because we expect to makedistributions based on taxable income, we expect that our distributions may attimes be more or less than our reported earnings computed in accordance withGAAP.

 

37

----

 

Total taxable income andREIT taxable income are non-GAAP financial measurements, and do not purport tobe an alternative to reported net income determined in accordance with GAAP asa measure of operating performance or to cash flows from operating activitiesdetermined in accordance with GAAP as a measure of liquidity. Total taxableincome is the aggregate amount of taxable income generated by us and by ourdomestic and foreign taxable REIT subsidiaries. REIT taxable income excludesthe undistributed taxable income of our domestic taxable REIT subsidiary, whichis not included in REIT taxable income until distributed to us. There is norequirement that our domestic taxable REIT subsidiary distribute its earningsto us. REIT taxable income, however, includes the taxable income of our foreigntaxable REIT subsidiaries because we will generally be required to recognizeand report their taxable income on a current basis. These non-GAAP financialmeasurements are important because we are structured as a REIT and the Coderequires that we pay substantially all of our taxable income in the form ofdistributions to our stockholders. The non-GAAP financial measurements of totaltaxable income and REIT taxable income are critical in the determination of theamount of the minimum distributions that we must pay to our stockholders so asto comply with the rules set forth in the Code. Because not all companiesuse identical calculations, this presentation of total taxable income and REITtaxable income may not be comparable to other similarly titled measuresprepared and reported by other companies. The table below reconciles thedifferences between reported net income and total taxable income and REITtaxable income for the quarters ended June 30, 2006 and 2005:

 

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

 
| ** **                                                                   | ** ** | **Estimated  for the  three months ended  June 30, 2006** | ** ** | **Three  months ended  June 30, 2005** | ** ** | **Estimated  for the  six months ended  June 30, 2006** | ** ** | **Six  months ended  June 30, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                   | ** ** | **Amount**                                                | ** ** | **Per  Share**                         | ** ** | **Amount**                                              | ** ** | **Per  Share**                       | ** ** | **Amount** | ** ** | **Per  Share** | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income**                                                     |       | $                                                         | 34,931     |                                   | $          | 0.44                                                    |       | $                                    | 8,502      |   | $ | 0.21 |   | $ | 65,319 |   | $ | 0.82 |   | $ | 14,618 |   | $ | 0.36 |   |
| Interest income  and expense                                                 |       | 3,199                                                     |       | 0.04                                   |       | (21                                                     | )          | —                               |       | 5,292 |   | 0.07 |   | 89 |   | — |   |
| Share-based compensation                                                     |       | 5,143                                                     |       | 0.06                                   |       | 7,334                                                   |       | 0.18                                 |       | 11,926 |   | 0.15 |   | 12,080 |   | 0.30 |   |
| Tax gains on  sales of assets to affiliates                                  |       | 670                                                       |       | 0.01                                   |       | 52                                                      |       | —                               |       | 1,558 |   | 0.02 |   | 4,305 |   | 0.11 |   |
| Realized and  unrealized derivative (losses) and gains                       |       |  

(1,955                                            | )          |  

(0.02                          | )          | 119                                                     |       | —                               |       | (539 | ) | (0.01 | ) | (369 | )  | (0.01 | ) |
| Foreign currency  translation (gains) and losses                             |       |  

(826                                              | )          |  

(0.01                          | )          | 2,344                                                   |       | 0.06                                 |       | (1,200 | ) | (0.02 | ) | 2,536 |   | 0.06 |   |
| Book/tax year end  difference adjustment for CLOs/CDOs                       |       |  

—                                            |       |  

—                         |       | —                                                  |       | —                               |       | 8,168 |   | 0.10 |   | — |   | — |   |
| Other                                                                        |       | 227                                                       |       | —                                 |       | 57                                                      |       | —                               |       | 431 |   | 0.01 |   | 109 |   | — |   |
| Income tax  expense                                                          |       | 119                                                       |       | —                                 |       | 994                                                     |       | 0.02                                 |       | 431 |   | 0.01 |   | 1,106 |   | 0.03 |   |
| **Total  taxable income**                                                    |       | 41,508                                                    |       | 0.52                                   |       | 19,381                                                  |       | 0.47                                 |       | 91,386 |   | 1.15 |   | 34,474 |   | 0.85 |   |
| Undistributed  taxable (income) and loss of domestic taxable REIT subsidiary |       |  

176                                               |       |  

—                         |       | (2,486                                                  | )          | (0.06                                | )          | (2,008 | ) | (0.03 | ) | (2,265 | ) | (.06 | ) |
| **REIT  taxable income**                                                     |       | $                                                         | 41,684     |                                   | $          | 0.52                                                    |       | $                                    | 16,895     |   | $ | 0.41 |   | $ | 89,378 |   | $ | 1.12 |   | $ | 32,209 |   | $ | 0.79 |   |
| **Number  of common shares outstanding:**                                    | ** ** | ** **                                                | ** ** | ** **                             | ** ** | ** **                                              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average  diluted common shares outstanding during the period        |       |  

79,410                                            |       |                                   |       | 40,994                                                  |       |                                 |       | 79,237 |   |   |   | 40,689 |   |   |   |

 

Our Board of Directorshas adopted a policy to distribute to our stockholders amounts required tomaintain our status as a REIT and to avoid federal excise taxes, in each caseas discussed 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. Pursuant to this policy, on August 2, 2006, our Board of Directorsauthorized a cash distribution of $0.49 per common share to our stockholders ofrecord on August 16, 2006. This distribution payable on August 30, 2006. Theaggregate amount of the distribution is $39.4 million. Neither the paymentof this distribution nor the existence of

 

38

----

 

our distribution policyguarantees that we will make future distributions to our stockholders of anyparticular level, or at all. In addition, the amount of this distribution doesnot constitute any kind of projection as to the amount of future distributions,if any.

 

**Exemption fromRegulation under the Investment Company Act**

** **

We intend to operate ourbusiness so as to be excluded from regulation under the Investment Company Act.Because we conduct some of our business through wholly-owned subsidiaries, wemust ensure not only that we qualify for an exclusion or exemption fromregulation under the Investment Company Act, but also that each of oursubsidiaries so qualifies.

 

For KKR Financial Corp.itself, we will be relying on a provision designed for companies that do not issueredeemable securities and are primarily engaged in the business of purchasingor otherwise acquiring mortgages and other liens on and interests in realestate.

 

The Securities andExchange Commission (“SEC”) has not promulgated rules to address preciselywhat is required for a company to be considered “primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate.” A series of no-action letters issued by the Divisionof Investment Management (the “Division”) of the SEC, however, reflects theview that at least 55% of a company’s assets must consist of mortgage loans andother assets that are considered the functional equivalent of mortgage loansfor purposes of the Investment Company Act (collectively, “qualifying realestate assets”), and an additional 25% of a company’s assets must consist ofreal estate-related assets, leaving no more than 20% of the company’s assets inmiscellaneous assets. These no-action letters also indicate what types ofassets can be considered qualifying real estate assets. No-action lettersissued by the Division are not binding except as they relate to the companiesto whom they are addressed, so investors should be aware that the Division maychange its position regarding what assets might constitute qualifying realestate assets at any time. If the Division were to change its position, wemight be required to change our investment strategy to comply with any newguidance provided by the Division. We cannot predict whether such a changewould be adverse to us.

 

Based on the no-actionletters issued by the Division, we classify our investment in residentialmortgage loans as qualifying real estate assets, as long as the loans are“fully secured” by an interest in real estate. That is, if the loan-to-valueratio of the loan is equal to or less than 100%, then we consider the mortgageloan a qualifying real estate asset. We do not consider loans withloan-to-value ratios in excess of 100% to be qualifying real estate assets forthe 55% test, but only real estate-related assets for the 25% test.

 

We also consider agencywhole pool certificates to be qualifying real estate assets. An agency wholepool certificate is a certificate issued or guaranteed as to principal andinterest by federally chartered entities such as the Federal National MortgageAssociation, better known as “Fannie Mae,” the Federal Home Loan MortgageCorporation, better known as “Freddie Mac,” and, in the case of the GovernmentNational Mortgage Association, better known as “Ginnie Mae,” by the U.S.government, that represents the entire beneficial interest in the underlyingpool of mortgage loans. By contrast, an agency certificate that represents lessthan the entire beneficial interest in the underlying mortgage loans is notconsidered to be a qualifying real estate asset for purpose of the 55% test,but constitutes a real estate-related asset for purposes of the 25% test.

 

Most non-agencymortgage-backed securities do not constitute qualifying real estate assets forpurposes of the 55% test, because they represent less than the entirebeneficial interest in the related pool of mortgage loans. The Division,however, has indicated in a series of no-action letters that in certaincircumstances a company’s investment in non-agency mortgage-backed securitiesis the “functional equivalent” of owning the underlying mortgage loans. We ownmortgage-backed securities that we classify as qualifying real estate assetsbecause we believe that we own the functional equivalent of the underlyingmortgage loans.

 

In several suchinstances, we own all of the securities issued by the related securitizationtrust. There are no other owners of the securities, and thus we view ourinvestment, economically, as an investment in mortgage loans rather than aninvestment in mortgage-backed securities. For these transactions, we classifyour entire investment as an investment in qualifying real estate assets forpurposes of the 55% test.

 

39

----

 

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

 

We will use this sameanalysis to determine whether to classify investments we make in the future asqualifying real estate assets. If we acquire securities that, collectively, areexpected to receive all of the principal and interest paid on the related poolof underlying mortgage loans (less fees, such as servicing and trustee fees,and expenses of the securitization), and we have foreclosure rights withrespect to those mortgage loans, then we will consider those securities,collectively, to be qualifying real estate assets. If another entity acquiresany of the securities that are expected to receive cash flow from theunderlying mortgage loans, then we will consider whether we have the unilateralright to foreclose on the underlying loans and whether our investment is a firstloss position to decide whether it should be classified as a qualifying realestate asset. If we own more than one subordinate class, then, to determine theclassification of the subordinate classes that we own other than the first lossclass, we would consider whether such classes are contiguous with the firstloss class (with no other classes absorbing losses after the first loss classand before any other subordinate classes that we own), whether we own theentire amount of each such class and whether we would continue to have theunilateral right to foreclose in connection with each such class if the moresubordinate classes were no longer outstanding. If the answers to any of thesequestions is no, then we would not classify that particular class, or classessenior to that class, as a qualifying real estate asset.

 

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

 

We believe that we havesatisfied the tests with respect to our assets, measured on an unconsolidatedbasis, since the first anniversary of our initial private placement of ourcommon stock in August 2004. It is not entirely settled, however, that thetests are to be measured on an unconsolidated basis. To the extent the SECprovides further guidance on how to measure assets for these tests, we willadjust our measurement techniques.

 

In addition to monitoringour assets to qualify for the exclusion from regulation as an investmentcompany, we also must ensure that each of our subsidiaries qualifies for itsown exclusion or exemption. Some of our subsidiaries rely on the exemptionprovided if (i) the securities of the subsidiary are owned exclusively bypersons who at the time of acquisition of the securities are “qualifiedpurchasers” as that term is defined in the Investment Company Act and(ii) none of the non-real estate subsidiaries is making or proposing tomake a public offering of its securities. Other subsidiaries may qualify, ontheir own, for the exclusion designed for companies primarily engaged in thebusiness of purchasing or otherwise acquiring mortgages and other liens on andinterests in real estate, the same exclusion from regulation that we rely uponfor our exclusion from regulation. To the extent that we form subsidiaries inthe future, we must ensure that they qualify for their own separate exclusionfrom regulation as an investment 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.

 

40

----

 

**Quantitative andQualitative Disclosures About Market Risk**

** **

**Market Risks**

 

*CurrencyRisks*

* *

From time to time, wemay make investments that are denominated in a foreign currency through whichwe may be subject to foreign currency exchange risk.

 

*InflationRisks*

* *

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.

 

*InterestRate Risk*

* *

We believe that ourprimary market risk is interest rate risk. Interest rate risk is defined as thesensitivity of our current and future earnings to interest rate volatility,variability of spread relationships, the difference in repricing intervalsbetween our assets and liabilities and the effect that interest rates may haveon our cash flows and the prepayment rates experienced on our investments thathave imbedded borrower optionality. The objective of interest rate risk managementis to achieve earnings, preserve capital and achieve liquidity by minimizingthe negative impacts of changing interest rates, asset and liability mix, andprepayment activity.

 

We are exposed to basisrisk between our investments and our borrowings. Our floating rate investmentsand our variable 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 riskimpacts our interest income, interest expense, prepayments, and the fair valueof our investments, interest rate derivatives, and liabilities. We manageinterest rate risk and make interest rate risk decisions by evaluating ourprojected earnings under selected interest rate scenarios. We also use staticmeasures of interest rate risk including duration. During periods of increasinginterest rates we are biased to purchase investments that are floating rate andwe have had that bias since our inception. We manage our interest rate riskusing various techniques ranging from the purchase of floating rate investmentsto the use of interest rate derivatives. We generally fund our variable rateinvestments with variable rate borrowings with similar interest rate resetfrequencies. We fund our fixed rate and our hybrid investments with short-termvariable rate borrowings and we may use interest rate derivatives to hedge thevariability of the cash flows associated with our existing or forecastedvariable rate borrowings. Hedging activities are complex and accounting forinterest rate derivatives as fair value or cash flow hedges in accordance withSFAS No. 133 is difficult. We may not be able to execute certain hedgingstrategies because we are a REIT and there are complex rules regarding howour hedges impact our compliance with the REIT requirements.

 

Prepayments will impactthe average lives of our fixed rate and hybrid investments and, as a result, weare exposed to the risk that the amount of variable rate borrowings that wehave swapped from floating rate to fixed rate is materially different than weexpected because the average life of the fixed rate or hybrid investment haseither extended or contracted. If the difference is material, we may have toadjust the amount of our interest rate derivative position and such actioncould generate a loss if we terminated any of the interest rate derivatives orit may negatively impact our future earnings if we have to increase ourinterest rate derivative positions because the average lives of our investmentshave extended.

 

41

----

 

The periodic andlifetime interest rate caps contained in our residential ARM loans andsecurities may limit the repricing of our residential ARM loans and securitiesand, as a result, we are exposed to the risk that repricing of our investmentsis limited by the respective caps and our variable rate borrowings do not haveany similar such caps. As a result our income on the investments that aresubject to the periodic and lifetime cap would remain constant while our costof financing using variable rate debt would increase. The periodic and lifetimeinterest rate caps may negatively impact future net interest margins and thefair values of our residential ARM loan and security investments.

 

The following tablesummarizes the estimated net fair value of our derivative instruments held atJune 30, 2006 and December 31, 2005 (amounts in thousands):

 

**DerivativeFair Value**

 
| ** **                     | ** ** | **As of  June 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|--------------------------------|------------|-------------------------------|------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**          | ** ** | ** **                    | ** ** | ** **                                  | ** ** |
| Interest  rate corridors       |       | $                             | 22,464     |                                        | $          | 14,762 |   |
| Interest  rate swaps           |       | 104,949                       |       | 40,796                                      |       |
| **Free-Standing Derivatives:** | ** ** | ** **                    | ** ** | ** **                                  | ** ** |
| Interest  rate swaptions       |       | 226                           |       | 879                                         |       |
| Interest  rate swaps           |       | —                        |       | 198                                         |       |
| Credit  default swaps          |       | (19                           | )     | 71                                          |       |
| Total  rate of return swaps    |       | 1,780                         |       | 727                                         |       |
| Net  fair value                |       | $                             | 129,400    |                                        | $          | 57,433 |   |

 

*RiskManagement*

* *

To the extent consistentwith maintaining our REIT status, we seek to manage our interest rate riskexposure to protect our investment portfolio and related borrowings against theeffects of major interest rate changes. We generally seek to manage ourinterest rate risk by:

 

•       Changing themix between our floating rate investments and our fixed rate investments;

 

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

 

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

 

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

 

**Item 3.**                          Quantitativeand Qualitative Disclosures About Market Risk

** **

See discussion ofquantitative and qualitative disclosures about market risk in “Quantitative andQualitative Disclosures About Market Risk” section of Management’s Discussionand Analysis of Financial Condition and Results of Operations.

 

42

----

 

**Item 4.**                          Controls andProcedures

** **

Under the supervisionand with the participation of our management, including our principal executiveofficer and principal financial officer, we conducted an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended, as of the end of the periodcovered by this report (the “Evaluation Date”). Based on this evaluation, ourprincipal executive officer and principal financial officer concluded as of theEvaluation Date that our disclosure controls and procedures were effective suchthat the information relating to us, including our consolidated subsidiaries,required to be disclosed in our Securities and Exchange Commission (“SEC”)reports (i) is recorded, processed, summarized and reported within thetime periods specified in SEC rules and forms, and (ii) isaccumulated and communicated to our management, including our principalexecutive and principal financial officer, as appropriate to allow timelydecisions regarding required disclosure.

 

As previously disclosedin our registration statement on Form S-11 (RegistrationNo. 333-124103), in connection with its audit of our consolidatedfinancial statements for the period ended December 31, 2004, ourindependent registered public accounting firm, on March 8, 2005 identifiedto us three matters involving our internal controls over financial reportingthat it considered to be reportable conditions under standards established bythe American Institute of Certified Public Accountants, which reportableconditions in its judgment constituted material weaknesses. Under thesestandards, in each of these areas the design or operation of our internalcontrols did not reduce to a relatively low level the risk that misstatementscaused by error or fraud in amounts that would be material may occur and not bedetected within a timely period.

 

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

 

We are activelyremediating the identified reportable conditions. Specifically, subsequent toMarch 8, 2005, we hired individuals to fill the positions of ChiefAccounting Officer; Controller; Treasurer; Assistant Controller; and FinancialAnalysis Manager and during the second quarter of 2006 our Director of Tax wasappointed Chief Financial Officer and replaced our Chief Operating Officer in thisrole. We are also enhancing our internal control structure to ensure propersegregation of duties and the timely recording of transactions and timelypreparation of reconciliations as we continue to prepare for compliance withSection 404 of the Sarbanes-Oxley Act of 2002. Due to the recentlyannounced one-year delay in the required compliance schedule fornon-accelerated filers, we will be required to issue a management report on ourassessment of internal controls over financial reporting in our Annual Reporton Form 10-K for the year ended December 31, 2006.

 

There were no otherchanges in our internal control over financial reporting identified inconnection with the foregoing evaluation that occurred during the three monthsended June 30, 2006 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

43

----

 

**PART II. OTHER INFORMATION**

 

**Item1.****                         *****Legal Proceedings***

** **

None.

 

**Item2*.******                         ******Unregistered Sales of Equity Securities and Use of Proceeds***

** **

None.

 

**Item3.****                         *****Defaults Upon Senior Securities***

** **

None.

 

**Item4.****                         *****Submission of Matters to a Vote of Security Holders***

** **

None.

 

**Item5.****                         *****Other Information***

** **

(a) On August 2, 2006,the Company’s Board of Directors, upon the recommendation of the Board’sNominating and Corporate Governance Committee, voted to amend the Company’sBylaws to increase the size of the Board from eleven members to twelve membersand the Board filled the vacancy created by such increase by voting to electTracy Collins as a new director to serve until her successor has been dulyelected and qualified.  Ms. Collins wasalso appointed to serve as a member of the Audit Committee and the CompensationCommittee.  There is no other arrangementor understanding between Ms. Collins and any other person pursuant to which shewas selected to become a member of the Board, nor are there any transactionsbetween the Company and Ms. Collins that are reportable under Item 404(a) ofRegulation S-K. 

 

A copy of the Amended and restated Bylaw is attached to this Form 10-Qas Exhibit 3.

 

**Item6.****                         *****Exhibits***

 
| 3*    |   | Amended and Restated  Bylaws of the Registrant                                                                                                                                                                              |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10*   |   | Credit Agreement Dated  as of June 23, 2006 among KKR Financial Corp. and KKR TRS Holdings, Inc. as  the Borrowers, Bank of America, N.A., as Administrative Agent and Swingline  Lender and The Other Lenders Party Hereto |
| 31.1* |   | Chief Executive Officer  Certification of the Quarterly Financial Statements                                                                                                                                                |
| 31.2* |   | Chief Financial Officer  Certification of the Quarterly Financial Statements                                                                                                                                                |
| 32*   |   | Certification Pursuant  to 18 U.S.C. Section 1350                                                                                                                                                                           |

 

----

*                    Filedherewith.

 

44

----

 

**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, KKR Financial Corp. has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                         |       | KKR Financial  Corp.                                                  |
|-------------------------|------------|-----------------------------------------------------------------------|
|                    |       |                                                                  |
| **Signature**           | ** ** | **Title**                                                             |
| ** **              | ** ** |                                                                  |
| /s/ SATURNINO S. FANLO  |       | Chief Executive  Officer (Principal Executive Officer)                |
| **Saturnino S. Fanlo**  | ** ** | ** **                                                            |
| ** **              | ** ** | ** **                                                            |
| /s/ JEFFREY B. VAN HORN |       | Chief Financial  Officer (Principal Financial and Accounting Officer) |
| **Jeffrey B. Van Horn** |       |                                                                  |
| ** **              |       |                                                                  |
| Date: August 2,  2006   |       |                                                                  |

 

45

----