**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

**FORM 10-Q**

| x                                                            | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **For the quarterly period ended:  September 30, 2005** |
| **OR**                                                       |
| o                                                            | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe transition period from                  to                  **

**Commissionfile number 001-32542**

**KKR FINANCIAL CORP.**(Exact name of registrant as specified in its governing instruments)

----

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

 

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

----

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities and Exchange Act of 1934 during the preceding 12 months and (2) hasbeen subject to such filing requirements for the past90 days. Yes x  No o

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

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Securities Exchange Act of1934). Yes o  No x

The number of shares of the registrant’s common stockoutstanding as of September 30, 2005 was 80,374,063.

 

----

**PART I.FINANCIAL INFORMATION**

**Item 1. Financial Statements (Unaudited)**

**KKR Financial Corp. and Subsidiaries****Condensed ConsolidatedBalance Sheets****(Unaudited)****(Amounts in thousands,except share information)**

| ** **                                                                                                                                                                                                     | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                     | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                     |       | $                            | 62,078     |                        |       | $ | 7,219 |   |   |
| Restricted cash  and cash equivalents                                                                                                                                                                          |       | 83,286                       |       |                        | 1,321      |   |   |
| Securities  available-for-sale                                                                                                                                                                                 |       | 419,066                      |       |                        | 167,058    |   |   |
| Securities  available-for-sale, pledged as collateral                                                                                                                                                          |       | 4,877,621                    |       |                        | 1,484,222  |   |   |
| Loans, net of  allowance of $1,300 and $0 as of September 30, 2005 and  December 31, 2004, respectively                                                                                              |       | 7,221,803                    |       |                        | 682,757    |   |   |
| Derivative assets                                                                                                                                                                                              |       | 35,445                       |       |                        | 223        |   |   |
| Interest  receivable                                                                                                                                                                                           |       | 46,118                       |       |                        | 2,694      |   |   |
| Principal  receivable                                                                                                                                                                                          |       | 284                          |       |                        | —     |   |   |
| Deferred tax asset                                                                                                                                                                                             |       | —                       |       |                        | 228        |   |   |
| Other assets                                                                                                                                                                                                   |       | 22,306                       |       |                        | 1,618      |   |   |
| **Total assets**                                                                                                                                                                                               |       | $                            | 12,768,007 |                        |       | $ | 2,347,340 |   |   |
| **Liabilities**                                                                                                                                                                                                |       |                         |       |                        |       |   |   |
| Repurchase  agreements                                                                                                                                                                                         |       | $                            | 10,231,010 |                        |       | $ | 1,558,274 |   |   |
| CLO senior notes  payable                                                                                                                                                                                      |       | 773,000                      |       |                        | —     |   |   |
| Demand loan                                                                                                                                                                                                    |       | 40,511                       |       |                        | 27,875     |   |   |
| Accounts payable,  accrued expenses and other liabilities                                                                                                                                                      |       | 75,640                       |       |                        | 1,157      |   |   |
| Accrued interest  payable                                                                                                                                                                                      |       | 25,097                       |       |                        | 771        |   |   |
| Payable to  manager and related party liabilities                                                                                                                                                              |       | 3,413                        |       |                        | 1,765      |   |   |
| Income tax  liability                                                                                                                                                                                          |       | 1,654                        |       |                        | —     |   |   |
| Derivative  liabilities                                                                                                                                                                                        |       | 1,089                        |       |                        | 750        |   |   |
| **Total liabilities**                                                                                                                                                                                          |       | 11,151,414                   |       |                        | 1,590,592  |   |   |
| **Stockholders’ Equity**                                                                                                                                                                                  |       |                         |       |                        |       |   |   |
| Preferred stock,  $0.01 par value, 50,000,000 shares authorized and  none issued and outstanding at September 30, 2005 and  December 31, 2004                                                        |       | —                       |       |                        | —     |   |   |
| Common stock,  $0.01 par value, 250,000,000 shares authorized and 80,374,063 shares issued  and outstanding at September 30, 2005 and 41,004,492 shares issued and  outstanding at December 31, 2004 |       | 804                          |       |                        | 410        |   |   |
| Additional paid-in-capital                                                                                                                                                                                     |       | 1,675,379                    |       |                        | 779,740    |   |   |
| Deferred  compensation                                                                                                                                                                                         |       | (46,120                      | )          |                        | (18,413    | ) |   |
| Accumulated other  comprehensive income (loss)                                                                                                                                                                 |       | (13,182                      | )          |                        | 1,720      |   |   |
| Accumulated  deficit                                                                                                                                                                                           |       | (288                         | )          |                        | (6,709     | ) |   |
| **Total stockholders’ equity**                                                                                                                                                                            |       | 1,616,593                    |       |                        | 756,748    |   |   |
| **Total  liabilities and stockholders’ equity**                                                                                                                                                           |       | $                            | 12,768,007 |                        |       | $ | 2,347,340 |   |   |

 

See notes to condensed consolidated financial statements.

2

----

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

| ** **                                                                    | ** ** | **Three months ended  September 30, 2005** | ** ** | **Nine months ended  September 30, 2005** | ** ** | **For the Period from  August 12, 2004  (Inception) through  September 30, 2004** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| **Net investment income:**                                                    |       |                                                           |       |                                                          |       |                                                                                                                      |       |   |   |   |   |   |   |
| Securities  interest income                                                   |       |                                                           | $          | 50,917                                                        |       |                                                                                                                      |       | $ | 120,835 |   |   |   | $ | — |   |   |
| Loan interest  income                                                         |       |                                                           | 63,869     |                                                          |       |                                                                                                                      | 95,859     |   |   |   | — |   |   |
| Dividend income                                                               |       |                                                           | 985        |                                                          |       |                                                                                                                      | 2,452      |   |   |   | — |   |   |
| Other interest  income                                                        |       |                                                           | 816        |                                                          |       |                                                                                                                      | 2,013      |   |   |   | 1,466 |   |   |
| Total investment  income                                                      |       |                                                           | 116,587    |                                                          |       |                                                                                                                      | 221,159    |   |   |   | 1,466 |   |   |
| Interest expense                                                              |       |                                                           | (77,532    | )                                                             |       |                                                                                                                      | (146,262   | ) |   |   | — |   |   |
| Provision for  loan losses                                                    |       |                                                           | (1,300     | )                                                             |       |                                                                                                                      | (1,300     | ) |   |   | — |   |   |
| Net investment  income                                                        |       |                                                           | 37,755     |                                                          |       |                                                                                                                      | 73,597     |   |   |   | 1,466 |   |   |
| **Other income:**                                                             |       |                                                           |       |                                                          |       |                                                                                                                      |       |   |   |   |   |   |   |
| Net realized and  unrealized gain (loss) on  derivatives and foreign exchange |       |                                                           | 13         |                                                          |       |                                                                                                                      | (36        | ) |   |   | — |   |   |
| Net realized gain  on investments                                             |       |                                                           | 1,730      |                                                          |       |                                                                                                                      | 2,881      |   |   |   | — |   |   |
| Fee and other  income                                                         |       |                                                           | 136        |                                                          |       |                                                                                                                      | 1,731      |   |   |   | — |   |   |
| Total other  income                                                           |       |                                                           | 1,879      |                                                          |       |                                                                                                                      | 4,576      |   |   |   | — |   |   |
| **Non-investment  expenses:**                                                 |       |                                                           |       |                                                          |       |                                                                                                                      |       |   |   |   |   |   |   |
| Management  compensation to related party                                     |       |                                                           | 14,331     |                                                          |       |                                                                                                                      | 33,070     |   |   |   | 3,801 |   |   |
| Professional  services                                                        |       |                                                           | 1,432      |                                                          |       |                                                                                                                      | 2,617      |   |   |   | 221 |   |   |
| Loan servicing expense                                                        |       |                                                           | 1,369      |                                                          |       |                                                                                                                      | 1,999      |   |   |   | — |   |   |
| Insurance expense                                                             |       |                                                           | 275        |                                                          |       |                                                                                                                      | 708        |   |   |   | 119 |   |   |
| Directors  expenses                                                           |       |                                                           | 368        |                                                          |       |                                                                                                                      | 719        |   |   |   | 99 |   |   |
| General and  administrative expenses                                          |       |                                                           | 2,630      |                                                          |       |                                                                                                                      | 4,107      |   |   |   | 656 |   |   |
| Total non-investment  expenses                                                |       |                                                           | 20,405     |                                                          |       |                                                                                                                      | 43,220     |   |   |   | 4,896 |   |   |
| Income (loss)  before income tax expense                                      |       |                                                           | 19,229     |                                                          |       |                                                                                                                      | 34,953     |   |   |   | (3,430 | ) |   |
| Income tax  expense                                                           |       |                                                           | 775        |                                                          |       |                                                                                                                      | 1,881      |   |   |   | — |   |   |
| Net income (loss)                                                             |       |                                                           | $          | 18,454                                                        |       |                                                                                                                      |       | $ | 33,072 |   |   |   | $ | (3,430 | ) |   |
| Net income (loss) per  common share:                                          |       |                                                           |       |                                                          |       |                                                                                                                      |       |   |   |   |   |   |   |
| Basic                                                                         |       |                                                           | $          | 0.24                                                          |       |                                                                                                                      |       | $ | 0.63 |   |   |   | $ | (0.09 | ) |   |
| Diluted                                                                       |       |                                                           | $          | 0.24                                                          |       |                                                                                                                      |       | $ | 0.62 |   |   |   | $ | (0.09 | ) |   |
| Weighted-average  number of common shares outstanding:                        |       |                                                           |       |                                                          |       |                                                                                                                      |       |   |   |   |   |   |   |
| Basic                                                                         |       |                                                           | 77,486     |                                                          |       |                                                                                                                      | 52,681     |   |   |   | 39,796 |   |   |
| Diluted                                                                       |       |                                                           | 78,492     |                                                          |       |                                                                                                                      | 53,519     |   |   |   | 39,796 |   |   |
| Distributions declared  per common share                                      |       |                                                           | $          | —                                                        |       |                                                                                                                      |       | $ | 0.65 |   |   |   | $ | — |   |   |

 

See notes to condensed consolidated financial statements.

3

----

**KKR Financial 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** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|----------------------------|------------|-----------------------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| **Balance at January 1, 2005**                                 |       |                              | 41,004     |                                  |       |                             | $          | 410                        |       |                                                      | $          | 779,740                  |       |                                  | $          | (18,413                               | )          |   |   | $ | 1,720 |   |   |   | $ | (6,709 | ) |   |   | $ | — |   |   |   | $ | 756,748 |   |   |
| Net income                                                     |       |                              |       |                                  |       |                             |       |                       |       |                                                      |       |                     |       |                                  |       |                                  |       |   |   |   | 33,072 |   |   |   | 33,072 |   |   |   | 33,072 |   |   |
| Net change in unrealized gain on cash flow hedges         |       |                              | —     |                                  |       |                             | —     |                       |       | —                                                    |       |                     | —     |                                  |       |                                  | 23,886     |   |   |   | — |   |   |   | 23,886 |   |   |   | 23,886 |   |   |
| Net change in unrealized loss on securities available-for-sale |       |                              | —     |                                  |       |                             | —     |                       |       | —                                                    |       |                     | —     |                                  |       |                                  | (38,788    | ) |   |   | — |   |   |   | (38,788 | ) |   |   | (38,788 | ) |   |
| Comprehensive income                                           |       |                              | —     |                                  |       |                             | —     |                       |       | —                                                    |       |                     | —     |                                  |       |                                  | —     |   |   |   | — |   |   |   | $ | 18,170 |   |   |   | — |   |   |
| Common stock distributions                                     |       |                              | —     |                                  |       |                             | —     |                       |       | —                                                    |       |                     | —     |                                  |       |                                  | —     |   |   |   | (26,651 | ) |   |   |   |   |   |   | (26,651 | ) |   |
| Issuance of common stock, net of expenses                      |       |                              | 37,472     |                                  |       |                             | 375        |                       |       | 848,442                                                   |       |                     | —     |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 848,817 |   |   |
| Issuance of restricted common stock                            |       |                              | 1,903      |                                  |       |                             | 19         |                       |       | 42,386                                                    |       |                     | (42,405    | )                                     |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | — |   |   |
| Amortization of restricted common stock                        |       |                              | —     |                                  |       |                             | —     |                       |       | 5,883                                                     |       |                     | 12,024     |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 17,907 |   |   |
| Forfeiture of restricted common stock                          |       |                              | (5         | )                                     |       |                             | —     |                       |       | (13                                                       | )          |                     | —     |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | (13 | ) |   |
| Amortization of common stock options                           |       |                              | —     |                                  |       |                             | —     |                       |       | (1,059                                                    | )          |                     | 2,674      |                                  |       |                                  | —     |   |   |   | — |   |   |   |   |   |   |   | 1,615 |   |   |
| **Balance  at September 30, 2005**                             |       |                              | 80,374     |                                  |       |                             | $          | 804                        |       |                                                      | $          | 1,675,379                |       |                                  | $          | (46,120                               | )          |   |   | $ | (13,182 | ) |   |   | $ | (288 | ) |   |   |   |   |   |   | $ | 1,616,593 |   |   |

 

See notes to condensedconsolidated financial statements.

 

4

 

----

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

| ** **                                                                            | ** ** | **Nine months ended  September 30, 2005** | ** **  | **For the Period from  August 12, 2004  (Inception) through  September 30, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| **Cash flows from operating  activities:**                                            |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Net income (loss)                                                                     |       |                                                          | $           | 33,072                                                                                                                    |       |   |   | $ | (3,430 | ) |   |
| Adjustments to reconcile  net income (loss) to cash provided by operating activities: |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Unrealized gain on derivatives                                                        |       |                                                          | (890        | )                                                                                                                         |       |   | — |   |   |
| Unrealized loss on equity shorts                                                      |       |                                                          | 32          |                                                                                                                      |       |   |   |   |   |
| Increase in allowance for loan losses                                                 |       |                                                          | 1,300       |                                                                                                                      |       |   | — |   |   |
| Share-based compensation                                                              |       |                                                          | 19,509      |                                                                                                                      |       |   | 1,989 |   |   |
| Net gain on sale of securities available-for-sale                                     |       |                                                          | (1,140      | )                                                                                                                         |       |   | — |   |   |
| Net gain on sale of loans                                                             |       |                                                          | (1,773      | )                                                                                                                         |       |   | — |   |   |
| Depreciation and amortization                                                         |       |                                                          | 4,683       |                                                                                                                      |       |   | — |   |   |
| Deferred tax expense                                                                  |       |                                                          | 341         |                                                                                                                      |       |   | — |   |   |
| Changes in assets and  liabilities:                                                   |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Interest receivable                                                                   |       |                                                          | (43,424     | )                                                                                                                         |       |   | (876 | ) |   |
| Other assets                                                                          |       |                                                          | (21,382     | )                                                                                                                         |       |   | (823 | ) |   |
| Payable to manager and related party liabilities                                      |       |                                                          | 1,648       |                                                                                                                      |       |   | 1,357 |   |   |
| Accounts payable, accrued expenses and other  liabilities                             |       |                                                          | 49,132      |                                                                                                                      |       |   | 2,676 |   |   |
| Accrued interest payable                                                              |       |                                                          | 24,326      |                                                                                                                      |       |   | — |   |   |
| Net cash provided by operating activities                                             |       |                                                          | 65,434      |                                                                                                                      |       |   | 893 |   |   |
| **Cash flows from investing  activities:**                                            |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Purchase of securities available-for-sale                                             |       |                                                          | (4,973,742  | )                                                                                                                         |       |   | — |   |   |
| Principal payments on securities available-for-sale                                   |       |                                                          | 990,259     |                                                                                                                      |       |   | — |   |   |
| Proceeds from sale of securities available-for-sale                                   |       |                                                          | 325,328     |                                                                                                                      |       |   | — |   |   |
| Purchase of loans                                                                     |       |                                                          | (7,009,666  | )                                                                                                                         |       |   | — |   |   |
| Principal payments on loans                                                           |       |                                                          | 372,723     |                                                                                                                      |       |   | — |   |   |
| Proceeds from sale of loans                                                           |       |                                                          | 96,536      |                                                                                                                      |       |   | — |   |   |
| Net additions to restricted cash and cash equivalents                                 |       |                                                          | (81,965     | )                                                                                                                         |       |   | — |   |   |
| Purchase of property and equipment                                                    |       |                                                          | (480        | )                                                                                                                         |       |   | — |   |   |
| Net cash used in investing activities                                                 |       |                                                          | (10,281,007 | )                                                                                                                         |       |   | — |   |   |
| **Cash flows from financing  activities:**                                            |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Net proceeds from issuance of common shares                                           |       |                                                          | 848,817     |                                                                                                                      |       |   | 755,511 |   |   |
| Proceeds from borrowings:                                                             |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Repurchase agreements                                                                 |       |                                                          | 71,582,429  |                                                                                                                      |       |   | — |   |   |
| CLO senior notes payable                                                              |       |                                                          | 773,000     |                                                                                                                      |       |   | — |   |   |
| Demand loan                                                                           |       |                                                          | 12,636      |                                                                                                                      |       |   | — |   |   |
| Repayments of borrowing from repurchase agreements                                    |       |                                                          | (62,909,693 | )                                                                                                                         |       |   | — |   |   |
| Purchase of derivatives                                                               |       |                                                          | (10,106     | )                                                                                                                         |       |   | — |   |   |
| Payment of distributions on common stock                                              |       |                                                          | (26,651     | )                                                                                                                         |       |   | — |   |   |
| Net cash provided by financing activities                                             |       |                                                          | 10,270,432  |                                                                                                                      |       |   | 755,511 |   |   |
| **Net increase in cash and cash equivalents**                                         |       |                                                          | 54,859      |                                                                                                                      |       |   | 756,404 |   |   |
| **Cash and cash equivalents at beginning of period**                                  |       |                                                          | 7,219       |                                                                                                                      |       |   | — |   |   |
| **Cash and cash equivalents at end of period**                                        |       |                                                          | $           | 62,078                                                                                                                    |       |   |   | $ | 756,404 |   |   |
| **Supplemental cash flow  information:**                                              |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Interest expense paid in cash                                                         |       |                                                          | $           | 121,937                                                                                                                   |       |   |   | $ | — |   |   |
| **Non-cash investing and  financing activities:**                                     |       |                                                          |        |                                                                                                                      |       |   |   |   |   |
| Unsettled securities trades                                                           |       |                                                          | $           | 26,860                                                                                                                    |       |   |   | $ | 22,000 |   |   |
| Issuance of restricted common stock                                                   |       |                                                          | $           | 42,405                                                                                                                    |       |   |   | $ | 24,395 |   |   |
| Transfer of loans  from held for investment to held for sale                          |       |                                                          | $           | 32,000                                                                                                                    |       |   |   | $ | — |   |   |

 

See notes to condensed consolidated financial statements.

5

----

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

**Note 1.**        Organization

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

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

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

**Note 2.**        Summaryof Significant Accounting Policies

**Basis of Presentation**

The accompanying condensed consolidated financialstatements have been prepared in conformity with accounting principlesgenerally accepted in the United States of America (“GAAP”). The consolidatedfinancial statements include the accounts of the Company and its taxable REITsubsidiaries: KKR TRS Holdings, Inc. (“KKR TRS”); KKR Financial CLO 2005-1, Ltd.(“CLO 2005-1”); KKR Financial CLO 2005-2, Ltd. (“CLO 2005-2”);KKR Financial CLO 2005-3, Ltd. (“CLO 2005-3”); KKR FinancialCLO 2006-1, Ltd. (“CLO 2006-1”); KKR Financial Market Value CLO 2005-1,Ltd. (“MV CLO 2005-1”); KKR Financial CDO 2005-1, Ltd. (“CDO2005-1”); and KKR Financial CDO 2006-1, Ltd. (“CDO 2006-1”).KKR TRS was formed to make, from time to time, certain investments that wouldnot be REIT qualifying investments if made directly by the Company, and to earnincome that would not be REIT qualifying income if earned directly by theCompany. CLO 2005-1, CLO 2005-2, CLO 2005-3, CLO 2006-1,and MV CLO 2005-1 are entities established to complete collateralizedloan obligation (“CLO”) secured financing transactions. CDO 2005-1 andCDO 2006-1 are entities established to complete collateralized debtobligation (“CDO”) secured financing transactions. The consolidated financialstatements also include the accounts of the Company’s qualified REITsubsidiaries: KKR Financial Mortgage Corp. (“KKR Mortgage”); KKR QRS #1, Inc. (“KKRQRS”); and KKR Pacific Funding Trust and KKR Pacific Funding DepositorCorporation (collectively, “KKR Pacific”). KKR Mortgage was formed to sell,from time to time, the Company’s whole loan mortgage pools in residentialmortgage-backed securitization (“RMBS”) transactions. KKR QRS was formed tohold the residual interests in RMBS transactions 

6

----

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

**Note 2.**        Summary of SignificantAccounting Policies (Continued)

structured as real estatemortgage investment conduits (“REMICs”) for tax purposes. KKR Pacific wasformed to finance the Company’s RMBS investments through the issuance ofsecured liquidity notes. The term “Company” refers to these entitiescollectively, unless otherwise noted. The entities consolidated by the Companyare either wholly owned subsidiaries or entities established to completesecured financing transactions that are considered to be variable interestentities and for which the Company is the primary beneficiary. For additionalinformation, see “Consolidation” below.

The interim consolidated financialstatements presented herein are unaudited; however, in the opinion of theCompany’s management, all adjustments, consisting only of normal recurringaccruals, necessary for a fair presentation of the Company’s consolidated financialposition, results of operations and cash flows have been included. The natureof the Company’s business is such that the results of any interim period arenot necessarily indicative of results of a full year.

**Consolidation**

The Company consolidates all entities in which itholds a greater than 50 percent voting interest. The Company alsoconsolidates all variable interest entities (“VIEs”) for which it is consideredto be the primary beneficiary pursuant to Financial Accounting Standards BoardInterpretation No. 46R, *Consolidationof Variable Interest Entities—an interpretation of ARB No. 51*,as revised (“FIN 46R”). In general, FIN 46R requires an enterprise toconsolidate a VIE when the enterprise holds a variable interest in the VIE andis deemed to be the primary beneficiary of the VIE. An enterprise is theprimary beneficiary if it absorbs a majority of the VIE’s expected losses,receives a majority of the VIE’s expected residual returns, or both.

CLO 2005-1, CLO 2005-2, CLO 2005-3,CLO 2006-1, MV CLO 2005-1, CDO 2005-1, and CDO 2006-1are VIEs and are not considered to be qualifying special-purpose entitiesas defined by Statement of Financial Accounting Standards No. 140, *Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities* (“SFAS No. 140”). TheCompany has determined it is the primary beneficiary of these entities and hasincluded the accounts of these entities in these condensed consolidatedfinancial statements.

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

**Cash and Cash Equivalents**

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

**RestrictedCash and Cash Equivalents**

Restricted cash and cashequivalents represent amounts that are held by third parties under certain ofthe Company’s financing and derivative transactions.

**Securities Available-for-Sale**

The Company classifies its investments in securitiesas available-for-sale as the Company may sell them prior to maturity and doesnot hold them principally for the purpose of selling them in the near term. 

7

----

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

**Note 2.**        Summary of SignificantAccounting Policies (Continued)

These investments arecarried at estimated fair value, with unrealized gains and losses reported inaccumulated other comprehensive income (loss). Estimated fair values are basedon quoted market prices, when available, or on estimates provided byindependent pricing sources or dealers who make markets in such securities.Upon the sale of a security, the realized net gain or loss is included inincome on a specific identification basis.

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

**SecuritiesInterest Income Recognition**

Interest income onsecurities is accrued as earned using the effective yield method, whichincludes the accretion of purchase discounts or amortization of purchasepremiums and the stated coupon interest payments. Actual prepayment and creditloss experience is reviewed quarterly and effective yields are recalculatedwhen differences arise between prepayments and credit losses originally anticipatedcompared to amounts actually received plus anticipated future prepayments.

**Loans**

The Company purchasespools of residential mortgage whole loans and participations in corporateleveraged loans and commercial real estate loans in the primary and secondarymarket. Loans are held for investment and the Company initially records loansat their purchase prices. The Company subsequently accounts for loans based ontheir outstanding principal plus or minus unaccreted purchase discounts andunamortized purchase premiums. In certain instances, where the creditfundamentals underlying a particular loan have materially changed in such amanner that the Company’s expected return on investment may decrease, the Companymay elect to sell a loan held for investment due to adverse changes in creditfundamentals. Once the determination has been made by the Company that it willno longer hold the loan for investment, the Company accounts for the loan atthe lower of amortized cost or estimated fair value.

**Loan Interest Income Recognition**

Interest income on loansincludes interest at stated coupon rates adjusted for accretion of purchasediscounts and the amortization of purchase premiums. Purchase premiums areamortized and purchase discounts are accreted into income using the effectiveyield method, adjusted for prepayments.

**Allowanceand Provision for Loan Losses**

The Company maintains an allowance for loan losses ata level that management considers adequate based on an evaluation of known andinherent risks in the loan portfolio, including historical and industry 

8

----

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

**Note 2.**        Summary of SignificantAccounting Policies (Continued)

loss experience, economicconditions and trends, estimated fair values and the quality of collateral,estimated fair values of the loans and other relevant factors.

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

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

**Property and Equipment**

Property, consisting ofleasehold improvements and equipment, is carried at cost less depreciation andamortization and is reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of the assets might not be recoverable.Equipment is depreciated using the straight-line method over the estimateduseful lives of the respective assets of three years. Leasehold improvementsare amortized on a straight-line basis over the shorter of their estimated usefullives or lease terms. Property and equipment, net of accumulated depreciationand amortization, are included in other assets.

**Borrowings**

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

**Derivative Financial Instruments**

The Company recognizes all derivatives on theconsolidated balance sheet at estimated fair value. In accordance with SFAS No. 133,*Accounting for Derivative Instruments andHedging Activities*, as amended and interpreted (“SFAS No. 133”),the Company designates and documents each derivative contract as one of thefollowing at the time the contract is executed: (i) a hedge of a recognizedasset or liability or an 

9

----

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

**Note 2.**        Summary of SignificantAccounting Policies (Continued)

unrecognized firmcommitment; (ii) a hedge of a forecasted transaction or of the variabilityof cash flows to be received or paid related to a recognized asset orliability; (iii) a hedge of a net investment in a foreign operation; or (iv) aderivative instrument not designated as a hedging instrument.

In accordance with SFAS No. 133,the Company designates certain of its derivative instruments as cash flowhedges and formally documents its hedge relationships, including identificationof the hedging instruments and the hedged items, as well as its risk managementobjectives and strategies for undertaking the hedge transaction, at the timethe derivative contract is executed. The Company assesses the effectiveness ofthe hedge both at inception and on an on-going basis and determines whether thehedge is highly effective in offsetting changes in cash flows of the hedgeditem. The Company records the effective portion of changes in the estimatedfair value in accumulated other comprehensive income (loss) and subsequentlyreclassifies the related amount of accumulated other comprehensive income(loss) to earnings when the hedging relationship is terminated. If it isdetermined that a derivative has ceased to be a highly effective hedge, theCompany will discontinue hedge accounting for such transaction. For derivativesthat are not designated as hedges (“free-standing derivatives”), all changes inestimated fair value are recognized in the consolidated statements ofoperations.

**Foreign Currency**

The Company makesinvestments in non-U.S. dollar-denominated securities and loans. As aresult, the Company is subject to the risk of fluctuation in the exchange ratebetween the U.S. dollar and the foreign currency in which it makes aninvestment. In order to reduce the currency risk, the Company may hedge theapplicable foreign currency. All investments denominated in foreign currencyare converted to the U.S. dollar using prevailing exchange rates on the balancesheet date. Income, expenses, gains and losses on investments denominated inforeign currency are converted to the U.S. dollar using the prevailing exchangerates on the dates when they are recorded. Foreign exchange gains and lossesare recorded in the consolidated statements of operations.

**Manager Compensation**

The Company’s ManagementAgreement provides for the payment of a base management fee to the Manager, aswell as an incentive fee if the Company’s financial performance exceeds certainbenchmarks. See Note 10 for further discussion of the specific terms ofthe computation and payment of the incentive fee. The base management fee andthe incentive fee are accrued and expensed during the period for which they areearned by the Manager.

**Share-Based Payments**

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

10

----

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

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

**Income Taxes**

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

KKR TRS, CLO 2005-1,CLO 2005-2, CLO 2005-3, CLO 2006-1, MV CLO 2005-1, CDO2005-1, and CDO 2006-1 are not consolidated for federal income taxpurposes. For financial reporting purposes, current and deferred taxes areprovided for on the portion of earnings recognized by the Company with respectto its interest in KKR TRS, a domestic taxable REIT subsidiary, because it istaxed as a regular subchapter C corporation under the provisions of the Code.Deferred income tax assets and liabilities are computed based on temporarydifferences between the GAAP consolidated financial statements and the federalincome tax basis of assets and liabilities that existed on each consolidatedbalance sheet date. CLO 2005-1, CLO 2005-2, CLO 2005-3,CLO 2006-1, MV CLO 2005-1, CDO 2005-1, and CDO 2006-1,the Company’s foreign taxable REIT subsidiaries, are organized as exemptedcompanies incorporated with limited liability under the laws of the CaymanIslands, and are generally exempt from federal and state income tax at thecorporate 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-month and nine-month periods ended September 30, 2005are required; however, the Company will generally be required to include theircurrent taxable income in its calculation of REIT taxable income.

**Earnings Per Share**

In accordance with SFAS No. 128,*Earnings per Share*, the Companypresents both basic and diluted earnings (loss) per share (“EPS”) in itsconsolidated financial statements and footnotes thereto. Basic earnings (loss)per share (“Basic EPS”) excludes dilution and is computed by dividing netincome or loss allocable to common stockholders by the weighted average numberof common shares, including vested restricted common shares, outstanding forthe period. Diluted earnings per share (“Diluted EPS”) reflects the potentialdilution of common stock options and unvested restricted common stock, if theyare not anti-dilutive. See Note 3 for earnings per share computation.

**Use of Estimates**

In preparing theconsolidated financial statements, management is required to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the balance sheet dates andrevenues and expenses for the periods presented in the statement of operations.Actual results could differ from those estimates and assumptions. Significantestimates in the consolidated financial statements include interest incomerecognition from investments in securities and loans, valuation of securitiesand loans, valuation and designation of derivative instruments, share-basedpayments, and prepayment rates for certain securities and loans.

11

----

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

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

**RecentAccounting Pronouncements**

On November 3, 2005,the Financial Accounting Standards Board, or FASB, issued FASB Staff Position(“FSP”) 115-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments*.This FSP provides authoritative guidance regarding determining when aninvestment is considered impaired, whether that impairment is other-than-temporary,and the measurement of an impairment loss. This FSP also includes accountingconsideration subsequent to the recognition of an other-than-temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. The Company does notexpect the adoption of the FSP to have a material effect on its consolidatedfinancial statements.

**Note 3.**        Earningsper Share

TheCompany calculates basic net income per share by dividing net income for theperiod by the weighted-average shares of its common stock outstanding forthe period. Diluted net income per share takes into account the effect ofdilutive instruments, such as common stock options and unvested restrictedcommon stock, but uses the average share price for the period in determining thenumber of incremental shares that are to be added to the weighted-averagenumber of shares outstanding. The following table presents a reconciliation ofbasic and diluted net income per share for the three and nine-month periodsended September 30, 2005 (amounts in thousands, except per shareinformation):

| ** **                                                                | ** ** | **Three months ended  September 30, 2005** | ** ** | **Nine months ended  September 30, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **Basic:**                                                                |       |                                                           |       |                                                          |       |   |   |   |   |
| Net income                                                                |       |                                                           | $          | 18,454                                                        |       |   |   | $ | 33,072 |   |   |
| Weighted-average  number of shares outstanding                            |       |                                                           | 77,486     |                                                          |       |   | 52,681 |   |   |
| Basic net income  per share                                               |       |                                                           | $          | 0.24                                                          |       |   |   | $ | 0.63 |   |   |
| **Diluted:**                                                              |       |                                                           |       |                                                          |       |   |   |   |   |
| Net income                                                                |       |                                                           | $          | 18,454                                                        |       |   |   | $ | 33,072 |   |   |
| Weighted-average  number of shares outstanding                            |       |                                                           | 77,486     |                                                          |       |   | 52,681 |   |   |
| Plus: Incremental  shares from assumed conversion of dilutive instruments |       |                                                           | 1,006      |                                                          |       |   | 838 |   |   |
| Adjusted weighted-average  number of shares outstanding                   |       |                                                           | 78,492     |                                                          |       |   | 53,519 |   |   |
| Diluted net income per  share                                             |       |                                                           | $          | 0.24                                                          |       |   |   | $ | 0.62 |   |   |

 

For the period fromInception through September 30, 2004, the Company incurred a net loss of$0.09 per share. Inclusion of unvested common stock options and unvestedrestricted common stock in the diluted loss per share calculation would reducethe net loss per share amount; therefore, they are considered anti-dilutive. Asa result, the Company’s diluted loss per share is equivalent to its basic lossper share for such period.

12

----

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

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

Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of September 30, 2005, which are carried atestimated fair value (amounts in thousands):

| **Description**                         | ** ** | ** ** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Estimated  Fair Value** | ** ** |
|-----------------------------------------|------------|------------|------------|---------------------|------------|------------------------------|------------|---------------------------------|------------|--------------------------------|------------|
| Residential  mortgage-backed securities |       | $          | 4,850,806  |                |       | $                            | 9,180      |                            |       |                           | $          | (44,679 | ) |   | $ | 4,815,307 |   |
| Commercial mortgage-backed  securities  |       | 71,781     |       |                | 144        |                         |       |                            | —     |                           |       | 71,925 |   |
| Asset-backed  securities                |       | 40,000     |       |                | 588        |                         |       |                            | —     |                           |       | 40,588 |   |
| Corporate  securities                   |       | 318,342    |       |                | 2,828      |                         |       |                            | (5,423     | )                              |       | 315,747 |   |
| Common and  preferred stock             |       | 52,826     |       |                | 865        |                         |       |                            | (571       | )                              |       | 53,120 |   |
| Total                                   |       | $          | 5,333,755  |                |       | $                            | 13,605     |                            |       |                           | $          | (50,673 | ) |   | $ | 5,296,687 |   |

 

Thefollowing table summarizes the Company’s securities classified asavailable-for-sale as of December 31, 2004, which are carried at estimatedfair value (amounts in thousands):

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

 

All securities in an unrealized loss position at September 30,2005 and December 31, 2004 have been in an unrealized loss position forless than one year. The Company’s review of such securities indicates that thedecrease in estimated fair value was not due to permanent changes in theunderlying credit fundamentals or in the amount of principal and interestexpected to be received. In addition, the Company has the financial wherewithaland management has the intention to hold the securities for a period of timesufficient for a recovery in the estimated fair value. Therefore, managementdoes not believe any of the securities held are other-than-temporarily impairedat September 30, 2005 or December 31, 2004.

During the three andnine-month periods ended September 30, 2005, the Company’s gross realizedgains from the sales of securities was $0.3 million and $1.1 million,respectively. The Company did not have any gross realized losses from the salesof securities during the three and nine-month periods ended September 30,2005 and did not sell any securities during the period from August 12,2004 (Inception) through September 30, 2004.

**Note 5.**        Loans

As of September 30,2005 a commercial real estate loan with an amortized cost of $20.0 million(fair value of $20.0 million) and a corporate loan with an amortized cost of$12.0 million (fair value of 

13

----

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

**Note 5.   Loans (Continued)**

$12.1 million), were classified as held for saleby the Company. Accordingly, these loans are recorded at the lower of cost ormarket on the Company’s consolidated balance sheet. No loans were classified asheld for sale as of December 31, 2004. The following table summarizes theCompany’s loans as of September 30, 2005 (amounts in thousands):

| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** **    | **Net  Amortized  Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|---------------|--------------------------|------------|
| Loans held for  investment:                               |       |          |       |                                |          |                     |       |   |   |
| Corporate loans                                           |       | $             | 1,611,127  |                                |          | $                        | (2,659     | ) |   | $ | 1,608,468 |   |
| Residential  mortgage loans                               |       | 5,192,189     |       |                                | 19,319        |                     |       | 5,211,508 |   |
| Commercial real  estate loans                             |       | 372,050       |       |                                | (923          | )                        |       | 371,127 |   |
| Allowance for  loan losses for residential mortgage loans |       | (1,300        | )          |                                | —        |                     |       | (1,300 | ) |
| Total loans held for investment                           |       | 7,174,066     |       |                                |   15,737 |                     |       | 7,189,803 |   |
| Loans held for  sale                                      |       | 32,000        |       |                                | —        |                     |       | 32,000 |   |
| Total loans, net  of allowance for loan losses            |       | $             | 7,206,066  |                                |          | $                        | 15,737     |   |   | $ | 7,221,803 |   |

 

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

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

 

Thefollowing table summarizes the delinquency statistics of residential mortgageloans as of September 30, 2005 (dollar amounts in thousands):

| **Delinquency Status** | ** ** | ** ** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|------------|------------|-------------------------------|------------|---------------------------|------------|
| Current                     |       |       | 10,434     |                          |       |                      | $          | 5,184,863 |   |   |
| 30 to 59 days               |       |       | 17         |                          |       |                      | 7,326      |   |   |
| 60 to 89 days               |       |       | —     |                          |       |                      | —     |   |   |
| 90 days or more             |       |       | —     |                          |       |                      | —     |   |   |
| In foreclosure              |       |       | —     |                          |       |                      | —     |   |   |
| Total                       |       |       | 10,451     |                          |       |                      | $          | 5,192,189 |   |   |

 

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

During September 2005, the Gulf Coast region ofthe United States was severely impacted by Hurricane Katrina. The Company’sprincipal source of exposure to the hurricane is through propertiescollateralizing its residential mortgage loans. The impact of the hurricane onthe Company is difficult to 

14

----

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

**Note 5.   Loans (Continued)**

predict and is based onmany factors including the extent of damage to properties collateralizingresidential mortgage loans, the extent to which damage is not covered byinsurance, and the extent to which the economic conditions of borrowers hasbeen impacted in such a way as to affect the ability of borrowers to repaytheir loans. The ultimate impact of the hurricane on the Company is yet to bedetermined and the Company is working with its third-party loan servicers andthird-party property inspection vendors to assess the damage. The Company expectsthat losses will be realized related to the hurricane; accordingly, the Companyhas recorded a provision for loan losses of $1.3 million related to itsresidential mortgage loan portfolio. The Company does not believe that thehurricane has had a material impact on its corporate or commercial real estateloan portfolio.

As of September 30, 2005 and December 31,2004, the Company had not recorded an allowance for loan losses for itscommercial real estate or corporate loan portfolios. In reviewing the Company’sportfolio of commercial real estate and corporate loans and the observablesecondary market prices, the Company did not identify any loans that exhibitcharacteristics indicating that an impairment had occurred.

As of December 31, 2004, the Company had notrecorded an allowance for loan losses for its residential mortgage loanportfolio. In reviewing the Company’s portfolio of residential mortgage loansand the observable secondary market prices, the Company did not identify anyloans that exhibit characteristics indicating that an impairment had occurred.

During the quarter ended September 30, 2005, theCompany purchased $3.9 billion of securities in connection with threesecuritization transactions backed by $3.7 billion of residential hybrid ARMloans and $0.2 billion of residential ARM loans. In all three of the securitizationtransactions, the Company purchased all of the securities issued, including thesubordinate classes. Of the $3.9 billion of securities purchased, approximately$3.8 billion, or 96%, were rated AAA by Standard & Poor’s. Each of thespecial-purpose entities that issued the securities are not consideredqualifying special-purpose entities as defined by SFAS No. 140 and are treatedas VIEs under FIN 46R. The Company has determined that it is the primarybeneficiary of each of the special purpose entities that issued the securities;accordingly, the Company recorded its investments as loans and not securities.

During September 2005, the Company securitized$959.2 million of residential ARM loans and retained all of the securities issuedin the securitization transaction, including the subordinate classes. Of the$959.2 million of securities issued, approximately $908.8 million, or 95%, wererated AAA by Standard & Poor’s. While the Company transferred theloans to a separate bankruptcy-remote legal entity, the Company did not accountfor the transaction as a sale as the securitization transaction did not meetthe criteria for sales treatment under SFAS No. 140. Accordingly, theCompany did not record a gain or loss in connection with the securitizationtransaction and accounts for the transferred assets as loans on itsconsolidated balance sheet. The loans transferred in this securitization areowned by a special purpose entity and collateralize the issued securities, andas a result, those loans are not available to the Company, its creditors orstockholders.

As of September 30, 2005, residential mortgageloans with an estimated fair value of $5.1 billion (amortized cost of$5.2 billion) and corporate loans collateralizing the retained tranches ofCLO 2005-1 with an estimated fair value of $128.0 million (amortized cost of$128.0 million) were pledged as collateral for borrowings under repurchaseagreements. At December 31, 2004, residential mortgage loans with anestimated fair value of $233.9 million (amortized cost of $233.1 million) and acommercial real estate loan with an estimated fair value of $50.3 million(amortized cost of $50.0 million) were pledged as collateral 

15

----

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

**Note 5.   Loans (Continued)**

for borrowings underrepurchase agreements. The amounts pledged as collateral under repurchaseagreements as of September 30, 2005 and December 31, 2004, excludeloans owned by CLO 2005-1, CLO 2005-2, and CDO 2005-1, whichare described below.

As of September 30,2005, corporate loans with an estimated fair value of $891.5 million(amortized cost of $882.9 million) and commercial real estate loans with anestimated fair value of $20.3 million (amortized cost of$20.0 million) were owned by CLO 2005-1. At September 30, 2005,corporate loans with an estimated fair value of $537.0 million (amortizedcost of $530.0 million) and commercial real estate loans with an estimatedfair value of $20.3 million (amortized cost of $20.0 million) were ownedby CLO 2005-2. Additionally, at September 30, 2005, commercial realestate loans with an estimated fair value of $316.3 million (amortizedcost of $316.2 million) were owned by CDO 2005-1. See Note 6for Borrowings.

**Note 6.**        Borrowings

The Company leverages its portfolio of securities andloans through the use of repurchase agreements, warehouse facilities,short-term demand loans, and securitization transactions structured as securedfinancings. Each of the borrowing vehicles used by the Company bear interest atfloating rates based on a spread above the London InterBank Offered Rate (“LIBOR”)or commercial paper rates.

Certaininformation with respect to the Company’s borrowings as of September 30,2005 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** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------|------------|
| Repurchase  agreements            |       | $                           | 9,510,959  |                                   |       | 3.89                                                       | %          |                                    |       | 24 |   |   | $ | 9,893,155 |   |
| Demand loan                       |       | 40,511                      |       |                                   | 4.44       |                                                       |       |                                    | 1          |   |   | 45,995 |   |
| CLO 2005-1  senior notes          |       | 773,000                     |       |                                   | 3.72       |                                                       |       |                                    | 26         |   |   | 996,216 |   |
| CLO 2005-2  repurchase agreements |       | 532,187                     |       |                                   | 4.45       |                                                       |       |                                    | 1          |   |   | 620,096 |   |
| CDO 2005-1  repurchase agreements |       | 187,864                     |       |                                   | 4.89       | %                                                          |       |                                    | 18         |   |   | 290,149 |   |
| Total                             |       | $                           | 11,044,521 |                                   |       |                                                       |       |                                    |       |   |   |   | $ | 11,845,611 |   |

 

Certain information withrespect to the Company’s borrowings as of December 31, 2004 is summarizedin the following table (amounts in thousands):

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

 

16

----

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

**Note 6.**        Borrowings(Continued)

In March 2005, the Company closed CLO 2005-1,a $1.0 billion CLO transaction that provides financing for investmentsconsisting of corporate loans and certain other loans and securities. Theinvestments that are owned by CLO 2005-1 collateralize the CLO 2005-1debt, and as a result, those investments are not available to KKR Financial,its creditors or stockholders. CLO 2005-1 issued a total of$773.0 million of senior notes at par to investors. In addition, KKRFinancial retained $148.0 million of rated mezzanine notes and$85.5 million of unrated subordinated notes issued by CLO 2005-1.

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

During February 2005 the Company formed CLO 2005-2and began borrowing from a warehouse facility, in the form of a repurchaseagreement, to purchase corporate loans and certain other loans and securities. Therepurchase facility bears interest at a rate of 30-day LIBOR plus 0.65%and as of September 30, 2005, there was $532.2 million outstanding.During April 2005 the Company formed CDO 2005-1 and began borrowingon a warehouse facility, in the form of a repurchase agreement, to purchasecommercial real estate debt obligations. The repurchase facility bears interestat a rate of 30-day LIBOR plus 1.10% and as of September 30, 2005,there was $187.9 million outstanding.

The Company’s CLO and the CDO transactions areaccounted for by the Company as secured borrowings as defined in SFAS No. 140.

During June 2005, the Company entered into a$275.0 million secured revolving credit facility. This revolving creditfacility matures on June 30, 2006, and, as of September 30, 2005, theCompany had no borrowings outstanding. The revolving credit facility bearsinterest at 30-day LIBOR plus 1.00%.

On September 30,2005, the Company closed a $5 billion asset-backed commercial paper facility. Thisfacility will provide the Company with an alternative source of funding its residentialreal estate securities by issuing secured liquidity notes that are rated A-1+,P-1, and F1+, by Standard and Poor’s, Moody’s Investors Service, or Moody’s,and Fitch Inc, respectively. Issuances of secured liquidity notes will berecorded as borrowings on the Company’s consolidated balance sheet. As of September 30,2005, no borrowings were outstanding under this facility.

**Note 7.**        DerivativeFinancial Instruments

The Company may use derivative financial instrumentsto hedge all or a portion of the interest rate risk associated with itsborrowings. Certain of the techniques used to hedge exposure to interest ratefluctuations may also be used to protect against declines in the market valueof assets that result from general trends in debt markets or from fluctuationsin currency values, to the extent the Company makes non-U.S. dollar-denominatedinvestments. The principal objective of such arrangements is to minimize therisks and/or costs associated with the Company’s operating and financialstructure as well as to hedge specific anticipated transactions. Thecounterparties to these contractual arrangements are major financialinstitutions with which the Company and its affiliates may also have otherfinancial relationships. In the event of nonperformance by the counterparties,the Company is potentially exposed to losses. However, 

17

----

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

**Note 7.   Derivative Financial Instruments(Continued)**

because of the high creditratings of the counterparties the Company has entered into derivativetransactions with, the Company does not anticipate that any of thecounterparties will fail to fulfill their obligations.

The tablebelow summarizes the estimated net fair value of the derivative instruments asof September 30, 2005 and December 31, 2004 (amounts in thousands):

| ** **                      | ** ** | **As of  September 30, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| **Cash Flow Hedges:**           |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate corridors         |       |                                         | $          | 12,699                                      |       |   |   | $ | — |   |   |
| Interest rate swaps             |       |                                         | 21,186     |                                        |       |   | — |   |   |
| **Free-Standing  Derivatives:** |       |                                         |       |                                        |       |   |   |   |   |
| Interest rate swaptions         |       |                                         | 162        |                                        |       |   | 223 |   |   |
| Interest rate swaps             |       |                                         | 78         |                                        |       |   | — |   |   |
| Credit default swaps            |       |                                         | 47         |                                        |       |   | (625 | ) |   |
| Total rate of return swaps      |       |                                         | 184        |                                        |       |   | — |   |   |
| Foreign exchange contracts      |       |                                         | —     |                                        |       |   | (125 | ) |   |
| Net fair value                  |       |                                         | $          | 34,356                                      |       |   |   | $ | (527 | ) |   |

 

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

Thecomponents of accumulated other comprehensive income (loss) were as follows(amounts in thousands):

| ** **                                                      | ** ** | **As of  September 30, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized  (losses) gains on available-for-sale securities |       |                                         | $          | (37,068                                     | )          |   |   | $ | 1,720 |   |   |
| Net unrealized  gains on cash flow hedges                       |       |                                         | 23,886     |                                        |       |   | — |   |   |
| Accumulated other  comprehensive income (loss)                  |       |                                         | $          | (13,182                                     | )          |   |   | $ | 1,720 |   |   |

 

The changes in the componentsof other comprehensive loss were as follows (amounts in thousands):

| ** **                                                     | ** ** | **Three months  ended  September  30, 2005** | ** ** | **Nine months  ended  September 30, 2005** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Unrealized gains  on securities available-for-sale:            |       |                                                             |       |                                                      |       |   |   |   |   |
| Unrealized holding losses arising during period                |       |                                                             | $          | (30,023                                                   | )          |   |   | $ | (37,648 | ) |   |
| Reclassification adjustments for gains realized in  net income |       |                                                             | (325       | )                                                         |       |   | (1,140 | ) |   |
| Unrealized losses  on securities available-for-sale            |       |                                                             | (30,348    | )                                                         |       |   | (38,788 | ) |   |
| Unrealized gains  on cash flow hedges                          |       |                                                             | 27,430     |                                                      |       |   | 23,886 |   |   |
| Other comprehensive loss                                       |       |                                                             | $          | (2,918                                                    | )          |   |   | $ | (14,902 | ) |   |

 

**Note 9.**        StockOptions and Restricted Stock

The Company has adopted a stock incentive plan (the “2004Stock Incentive Plan”) that provides for the grant of qualified incentivecommon stock options that meet the requirements of Section 422 of the 

18

----

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

**Note 9.   Stock Options and Restricted Stock(Continued)**

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.

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

The following tablesummarizes restricted common stock transactions:

| ** **                                         | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested  shares as of August 19, 2004**    |       | 1,193,867   |       |          | 15,000     |      |       | 1,208,867 |   |
| Issued                                             |       | —      |       |          | —     |      |       | — |   |
| Vested                                             |       | —      |       |          | —     |      |       | — |   |
| Forfeited                                          |       | —      |       |          | —     |      |       | — |   |
| **Unvested  shares as of December 31, 2004**  |       | 1,193,867   |       |          | 15,000     |      |       | 1,208,867 |   |
| Issued                                             |       | 1,875,000   |       |          | 28,321     |      |       | 1,903,321 |   |
| Vested                                             |       | (397,956    | )          |          | (10,000    | )         |       | (407,956 | ) |
| Forfeited                                          |       | —      |       |          | (5,000     | )         |       | (5,000 | ) |
| **Unvested shares as of  September 30, 2005** |       | 2,670,911   |       |          | 28,321     |      |       | 2,699,232 |   |

 

The shares of restricted common stock granted to thedirectors were valued using the fair market value at the time of grant, whichwas $20.00 and $24.90 per share, for the shares of restricted common stockgranted in 2004 and 2005, respectively. Pursuant to SFAS No. 123(R), theCompany is required to value any unvested shares of restricted common stockgranted to the Manager at the current market price. The Company valued theunvested restricted common stock at $22.24 and $20.00 per share at September 30,2005 and December 31, 2004, respectively.

19

----

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

**Note 9.   Stock Options and Restricted Stock (Continued)(Continued)**

The following tablesummarizes common stock option transactions:

| ** **                                     | ** ** | **Number  of Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Outstanding  as of August 19, 2004**    |       | 1,989,779                   |       |                                           | $          | 20.00 |   |   |
| Granted                                        |       | —                      |       |                                           | —     |   |   |
| Exercised                                      |       | —                      |       |                                           | —     |   |   |
| Forfeited                                      |       | —                      |       |                                           | —     |   |   |
| **Outstanding  as of December 31, 2004**  |       | 1,989,779                   |       |                                           | $          | 20.00 |   |   |
| Granted                                        |       | —                      |       |                                           | —     |   |   |
| Exercised                                      |       | —                      |       |                                           | —     |   |   |
| Forfeited                                      |       | —                      |       |                                           | —     |   |   |
| **Outstanding as of  September 30, 2005** |       | 1,989,779                   |       |                                           | $          | 20.00 |   |   |

 

Noneof the common stock options outstanding were exercised at September 30,2005, and December 31, 2004, respectively. As of September 30, 2005,663,260 common stock options were exercisable and no common stock options wereexercisable as of December 31, 2004. The common stock options are valuedusing the Black-Scholes model using the following assumptions:

| ** **     | ** ** | **As of  September 30, 2005** | ** ** | **As of  September 30, 2004** | ** ** |
|----------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| Expected life  |       | 8.9 years                               |       | 9.9 years                               |       |
| Discount rate  |       | 4.43%                                   |       | 4.33%                                   |       |
| Volatility     |       | 20%                                     |       | 20%                                     |       |
| Dividend yield |       | 9%                                      |       | 9%                                      |       |

 

The estimated fair valueof the common stock options was $1.46 and $0.88 at September 30, 2005 and September 30,2004, respectively. For the three-month and nine-month periods ended September 30,2005 and the period from August 12, 2004 (Inception) through September 30,2004, the components of share-based compensation expense are as follows(amounts in thousands):

| ** **                                      | ** ** | **Three months  ended  September 30, 2005** | ** ** | **Nine months  ended  September 30, 2005** | ** ** | **Period from  August 12, 2004  (Inception) through  September 30, 2004** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| Options granted  to Manager                     |       |                                                       | $          | 38                                                        |       |                                                                                                    |       | $ | 1,615 |   |   |   | $ | 146 |   |   |
| Restricted shares  granted to Manager           |       |                                                       | 7,191      |                                                      |       |                                                                                                    | 17,634     |   |   |   | 1,843 |   |   |
| Restricted shares  granted to certain directors |       |                                                       | 199        |                                                      |       |                                                                                                    | 260        |   |   |   | — |   |   |
| Total shared based  compensation expense        |       |                                                       | $          | 7,428                                                     |       |                                                                                                    |       | $ | 19,509 |   |   |   | $ | 1,989 |   |   |

 

**Note 10.** Management Agreement and Related PartyTransactions

The Manager manages the Company’s day-to-dayoperations, subject to the direction and oversight of the Company’s Board ofDirectors. The Management Agreement was executed on August 12, 2004. Theinitial term expires on December 31, 2006 and shall be automaticallyrenewed for a one-year term on each anniversary date thereafter. Following theinitial term, the Management Agreement may be terminated 

20

----

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

**Note 10.** Management Agreement and Related Party Transactions(Continued)

upon the affirmative voteof at least two-thirds of the Company’s independent directors, or by a vote ofthe holders of a majority of the outstanding shares of the Company’s commonstock.

The Management Agreement provides, among other things,that the Company pays to the Manager, in exchange for managing the day-to-dayoperations of the Company, certain fees and reimbursements, consisting of abase management fee, an incentive fee, and reimbursement for out-of-pocket andcertain other costs incurred by the Manager and on behalf of the Company. Allrent incurred by the Manager is paid by the Company and the Company is a partyto the lease.

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

For the three and nine-month periods ended September 30,2005, the Company incurred $7.1 million and $13.8 million, respectively,in base management fees. In addition, the Company recognized share-basedcompensation expense related to common stock options and restricted commonstock granted to the Manager of $7.2 million and $19.3 million forthe three and nine-month periods ending September 30, 2005, respectively(see Note 9). The Company also reimbursed the Manager $1.5****million and $3.2 million, respectively, for expensesfor the three and nine-month periods ended September 30, 2005. The Companyincurred base management fees and reimbursed the Manager for expenses of$1.8 million and $0.6 million, respectively, for the period fromInception through September 30, 2004. In addition, the Company recognizedshare-based compensation expense related to common stock options andrestricted common stock granted to the Manager of $2.0 million for theperiod from Inception through September 30, 2004. Base management feesincurred and share-based compensation expense relating to common stockoptions and restricted common stock granted to the Manager are included inmanagement compensation to related party on the consolidated statement ofoperations. Expenses incurred by the Manager and reimbursed by the Company arereflected in the respective consolidated statement of operations non-investmentexpense category based on the nature of the expense.

No incentive fees wereearned or paid to the Manager during the three and nine-month periods ended September 30,2005 or during the period from Inception to September 30, 2004.

**Note 11.** Subsequent Events

On November 2, 2005,the Company’s Board of Directors declared a cash distribution for the quarterended September 30, 2005 on the Company’s common stock of $0.32 per share.The distribution will be payable on November 30, 2005 to stockholders ofrecord as of the close of business on November 16, 2005.

On November 2, 2005, the independent Directors of theCompany’s Board of Directors approved the Company’s recommendation to co-investon a pari passu basis with Kohlberg Kravis Roberts & Co. L.P., in threeseparate private equity transactions. The Company’s aggregate investment willtotal $42.5 million and the investments are scheduled to close during the forthquarter of 2005.

21

----

**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.*

**Executive Overview**

We are a specialty finance company that invests inmultiple asset classes and uses leverage to generate competitive leveragedrisk-adjusted returns subject to maintaining our status as a REIT, and ourexemption from regulation under the Investment Company Act of 1940, as amended(the “Investment Company Act”). Our objective is to provide competitive returnsto our investors through a combination of dividends and capital appreciation.As part of our multi-asset class strategy, we seek to investopportunistically in those asset classes that can generate competitiveleveraged risk-adjusted returns. The implementation of our multi-assetclass strategy diversifies our investment portfolio. 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 debtsecurities; (iii) commercial real estate loans and debt securities;(iv) asset-backed securities; and (v) equity securities. Wealso make opportunistic investments in other asset classes from time to time.Our investment guidelines do not impose any limitations on the amount of ourinvestments in any specific asset class. Our income is generated primarily fromthe difference between the interest and dividend income earned on ourinvestments and the cost of our borrowings, less operating expenses.

We were organized as a Maryland corporation onJuly 7, 2004 and commenced operations on August 12, 2004(“Inception”). We are managed by KKR Financial Advisors LLC (the “Manager”)pursuant to a management agreement (the “Management Agreement”). The Manager isan affiliate of Kohlberg Kravis Roberts & Co. L.P. The Company istaxed as a real estate investment trust (“REIT”) and is required to comply withthe provisions of the Internal Revenue Code of 1986, as amended (the “Code”)with respect thereto.

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

We commenced our investment activities by making ourfirst investment on September 30, 2004. Assuming no material changes inmarket conditions or our business strategy, our objective is to have fullydeployed our capital, including the proceeds from our IPO, on a fully leveragedbasis during the second quarter of 2006. We used the proceeds from our IPO toreduce short-term borrowings and intend to fund future investments principallythrough borrowings until such time that we fully deploy our capital on a fullyleveraged basis. Provided that market conditions and market opportunities arefavorable, we may undertake to raise additional equity capital subsequent tothe deployment of our existing capital and leverage.

During September 2005the Gulf Coast region of the United States was severely impacted by HurricaneKatrina. Our principal sources of exposure related to the effect of thehurricane is through 

22

----

propertiescollateralizing our residential mortgage loans. We are working with ourthird-party loan servicers and other third-party property inspection vendors toassess the damage.

**Forward Looking Statements**

Certain informationcontained in this Quarterly Report on Form 10-Q constitutes “forward-looking”statements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934 that are based onour current expectations, estimates and projections. Pursuant to thosesections, we may obtain a “safe harbor” for forward-looking statements byidentifying those and by accompanying those statements with cautionarystatements, which identify factors that could cause actual results to differfrom those expressed in the forward-looking statements. Statements thatare 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,” andsimilar words identify forward-looking statements. Such statements arenot guarantees of future performance, events or results and involve potentialrisks and uncertainties. Accordingly, actual results and the timing of certainevents could differ materially from those addressed in forward-lookingstatements due to a number of factors including, but not limited to, changes ininterest rates and market values, changes in prepayment rates, general economicconditions, and other factors not presently identified. Other factors that mayimpact our actual results are discussed in our Registration Statement on Form S-11(File No. 333-124103) under the section titled “Risk Factors”. We donot undertake, and specifically disclaim, any obligation to publicly releasethe result of any revisions that may be made to any forward-lookingstatements to reflect the occurrence of anticipated or unanticipated events orcircumstances after the date of such statements.

**Critical Accounting Policies**

Our consolidated financialstatements are prepared by management in conformity with accounting principlesgenerally accepted in the United States of America (“GAAP”). Refer to theCritical Accounting Policies section of our Form S-11 for a detaileddescription of our significant accounting policies. Our significant accountingpolicies are fundamental to understanding our financial condition and resultsof operations because some of these policies require that we make significantestimates and assumptions that may affect the value of our assets or liabilitiesand financial results. We believe that certain of our policies are criticalbecause they require us to make difficult, subjective, and complex judgmentsabout matters that are inherently uncertain. The critical policies summarizedbelow relate to revenue recognition, other-than-temporary impairments,allowance for loan losses, accounting for derivative instruments and hedgingactivities, classification of investment securities, and share-basedcompensation. We have reviewed these critical accounting policies with ourBoard of Directors and our Audit Committee.

*Revenue Recognition*

We account for interestincome on our investments using the effective yield method. For investmentspurchased at par, the effective yield is the contractual coupon rate on theinvestment. If the investment is purchased at a discount or at a premium, theeffective yield is computed based on the contractual interest rate increasedfor the accretion of purchase discounts or decreased for the amortization ofpurchase premiums. The effective yield method requires that we make estimatesof future prepayment rates for our investments that can be contractuallyprepaid prior to their contractual maturity date so that the purchase discountcan be accreted, or the purchase premium can be amortized, over the estimatedremaining life of the investment. The prepayment estimates that we use directlyimpact the estimated remaining lives of our investments. We review and adjustour prepayment estimates as of each quarter end or more frequently if we becomeaware of any material information that would lead us to believe that anadjustment is 

23

----

necessary.As of September 30, 2005, unamortized purchase premiums and unaccretedpurchase discounts on our investment portfolio totaled $33.2 million and $39.6 million,respectively.

*Impairments*

We evaluate our investmentportfolio for impairment as of each quarter end or more frequently if we becomeaware of any material information that would lead us to believe that aninvestment may be impaired. We evaluate whether the investment is consideredimpaired and whether the impairment is other-than-temporary. If we make adetermination that the impairment is other-than-temporary, we recognize animpairment loss equal to the difference between the amortized cost basis andthe estimated fair value of the investment. We consider many factors indetermining whether the impairment of an investment is other-than-temporary,including but not limited to the length of time the security has had a declinein estimated fair value below its amortized cost, the amount of the loss, theintent and our financial ability to hold the investment for a period of timesufficient for a recovery in its estimated fair value, recent events specificto the issuer or industry, external credit ratings and recent downgrades insuch ratings. As of September 30, 2005, we had aggregate unrealized losseson our securities classified as available-for-sale of approximately$50.7 million, which if not recovered may result in the recognition offuture losses.

*Allowance for LoanLosses*

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

Currently, our residentialmortgage loans are relatively homogeneous and the adequacy of the allowance forloan losses is based on a review of relevant factors including, but not limitedto, estimated fair values, industry statistics, current economic conditions,loan portfolio composition, delinquency trends and credit losses realizedto-date on underlying loans. Because our mortgage loan portfolio is notseasoned we review these factors for similar portfolios of mortgage loans thathave comparable FICO® scores, loan-to-value ratios (“LTV”), loan balances, andgeographical diversity and that were originated through similar mortgagebanking channels, and we use this information when assessing the adequacy ofthe allowance for loan losses. Our investments in commercial real estatemortgage loans and corporate loans are not homogeneous and we individuallyreview each of the loans for impairments and use relevant information in ouranalysis including current estimated fair values, current valuation multiples,projected operating cash flow and projected liquidation cash flows.

*Accounting forDerivative Instruments and Hedging Activities*

Our policies permit us to enter into derivativecontracts, including interest rate swaps, interest rate corridors, interestrate swaptions, and credit and currency derivatives. We use interest ratederivatives to manage interest rate risk. We formally document relationshipsbetween our hedging instruments and our 

24

----

hedged transactions as ofthe inception date of the hedge, including (i) our risk managementobjective and hedge strategy, (ii) the risk that we are hedging, (iii) thehedging instruments, consisting of the derivative instruments that comprise thehedge, (iv) the hedged transaction, consisting of the recognized orforecasted transaction that we are hedging, (v) the method that we used toassess the hedge’s effectiveness on a retrospective and prospective basis, and (vi) themethodology that we will use to measure hedge ineffectiveness. On the date thatwe enter into an interest rate derivative transaction we designate the interestrate derivative as (i) a hedge of a forecasted transaction or of thevariability of cash flows related to a recognized liability (“cash flow hedge”)or (ii) held for trading (“trading instrument”). Our interest rateswaptions are undesignated derivative contracts and accounted for as tradinginstruments, and our interest rate swap and interest rate corridor contractsare designated and accounted for as cash flow hedges. We have not entered intoany interest rate derivative transactions that are designated as a hedge of theestimated fair value of a recognized asset or liability or of an unrecognizedfirm commitment (“fair value hedge”).

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

We are not required toaccount for our derivative contracts using hedge accounting as described above.If we decide not to designate the derivative contracts as hedges or if we failto fulfill the criteria necessary to qualify for hedge accounting, then thechanges in the estimated fair values of our derivative contracts would affectperiodic earnings immediately potentially resulting in the increased volatilityof our earnings. The qualification requirements for hedge accounting arecomplex and as a result we must evaluate, designate, and thoroughly documenteach hedge transaction at inception and perform ineffectiveness analysis andprepare related documentation at inception and on a recurring basis thereafter.As of September 30, 2005, the estimated fair value of our derivativestotaled $34.4 million. As of September 30, 2005, the estimated fair valueof interest rate derivatives accounted for as cash flow hedges totaledapproximately $33.9 million and the net change in unrealized gain on suchcash flow hedges totaled approximately $23.9 million, which amount isrecorded in accumulated other comprehensive income (loss) in the consolidatedstatements of changes in stockholders’ equity.

*Classifications ofInvestment Securities*

Our investments insecurities are classified as “available-for-sale” and are recorded and reportedon our consolidated balance sheet at estimated fair value with unrealized gainsand losses reported in accumulated other comprehensive income (loss) on our consolidatedbalance sheet. We designate and classify our investments in securities asavailable-for-sale because we may sell them prior to their maturity date. We donot designate and classify our investments in securities as trading securitiesbecause we do not intend to trade them or sell them in the near term. Wedetermine the estimated fair value of our 

25

----

investmentsin securities using quoted market prices, dealers who make markets in thesecurities, and third-party pricing services. When we sell an investmentsecurity, the realized net gain or loss on the sale of the security is includedin our consolidated statements of operations and we specifically identify thesecurity that was sold and its specific cost basis when we compute the netrealized gain or loss. As of September 30, 2005, securities classified asavailable-for-sale totaled $5.3 billion.

*Share-BasedPayment*

We account for share-based compensation issuedto members of our Board of Directors and our Manager using the fair value basedmethodology in accordance with SFAS No. 123(R). We do not have anyemployees, although we believe that members of our Board of Directors aredeemed to be employees for purposes of interpreting and applying accountingprinciples relating to share-based compensation. We record ascompensation costs the restricted common stock that we issued to members of ourboard of directors at estimated fair value as of the grant date and we amortizethe cost into expense over the three-year vesting period using the straight-linemethod. We recorded compensation costs for restricted common stock and commonstock options that we issued to our Manager at estimated fair value as of thegrant date and we remeasure the amount on subsequent reporting dates to theextent that the restricted common stock and/or common stock options have notvested. Unvested restricted common stock is valued using observable secondarymarket prices. Unvested common stock options are valued using the Black-Scholesmodel and assumptions based on observable market data for comparable companies.We amortize compensation expense related to the restricted common stock andcommon stock options that we granted to our Manager using the graded vestingattribution method in accordance with SFAS No. 123(R).

Because we remeasure theamount of compensation costs associated with the unvested restricted commonstock and unvested common stock options that we issued to our Manager as ofeach reporting period, our share-based compensation expense reported in ourconsolidated financial statements will change based on the estimated fair valueof our common stock and this may result in earnings volatility. For the threeand nine-month periods ended September 30, 2005, share-based compensationtotaled $7.4 million and $19.5 million, respectively.

**RecentlyAdopted Accounting Pronouncements**

On November 3, 2005,the Financial Accounting Standards Board, or FASB, issued FASB Staff Position(“FSP”) 115-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments*.This FSP provides authoritative guidance regarding determining when aninvestment is considered impaired, whether that impairment is other-than-temporary,and the measurement of an impairment loss. This FSP also includes accountingconsideration subsequent to the recognition of an other-than-temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. We do not expect theadoption of the FSP to have a material effect on its consolidated financialstatements.

**Results of Operations**

**Forthe three-month and nine-month periods ended September 30, 2005**

*Summary*

Our net income for thethree-month and nine-month periods ended September 30, 2005 totaled $18.5million (or $0.24 per diluted share) and $33.1 million (or $0.62 per dilutedshare), respectively. During the three-month period ended September 30,2005, our investment portfolio increased by 76% from $7.1 billion as of June 30,2005 to $12.5 billion as of September 30, 2005. For the nine-month periodended September 30, 2005, our investment portfolio increased by 443% from$2.3 billion as of December 31, 2004.

26

----

*Net InvestmentIncome*

Net investment income forthe three-month and nine-month periods ended September 30, 2005, was$37.8 million and $73.6 million, respectively. Investment income,primarily consisting of interest and dividend income from investments insecurities and loans, totaled $116.6 million and $221.2 million for thethree and nine-month periods ended September 30, 2005, respectively. Forthe three-month period ended September 30, 2005, investment incomeprimarily consisted of $80.1 million of interest income on residentialadjustable rate mortgages, or ARM, securities, residential hybrid ARMsecurities and residential mortgage loans, $28.9 million of interestincome on corporate loans and corporate debt securities, $7.5 million ofinterest income on commercial real estate loans and debt securities and$0.1 million of dividends on common and preferred stock, with totalinvestment income offset by $0.8 million of net purchase price premiumamortization. For the nine-month period ended September 30, 2005,investment income primarily consisted of $154.6 million of interest incomeon residential ARM securities, residential hybrid ARM securities andresidential mortgage loans, $55.3 million of interest income on corporateloans and corporate debt securities, $12.4 million of interest income oncommercial real estate loans and debt securities and $0.1 million ofdividends on common and preferred stock, with total investment income offset by$3.2 million of net purchase price premium amortization. For thethree-month and nine-month periods ended September 30, 2005, interestexpense on our borrowings totaled $77.5 million and $146.3 million,respectively. For the three-month period ended September 30, 2005,interest expense, including amortization of fees and expenses, related to ourborrowings consisted of $65.4 million related to repurchase agreements,$0.6 million related to interest rate swaps, and $11.5 million related tonotes payable under our CLOs. For the nine-month period ended September 30,2005, interest expense, including amortization of fees and expenses, related toour borrowings consisted of $123.0 million related to repurchaseagreements, $0.6 million related to interest rate swaps, and $22.7 millionrelated to notes payable under our CLOs. Provision for loan losses for thethree and nine-month periods ended September 30, 2005 was $1.3 million. Theprovision for losses was recorded as a reserve of the Company’s exposure topotential losses resulting from the effects of Hurrican Katrina. See furtherdiscussion under Asset Quality.

*Net InvestmentGains and Losses*

Net investment gains andother income totaled $1.9 million for the three-month period ended September 30,2005 and was primarily comprised of $1.7 million of gains realized on the saleof investments and $0.1 million of fee and other income. For thenine-month period ended September 30, 2005, net investment gains and otherincome totaled $4.6 million and was primarily comprised of $2.9 millionof gains realized on the sale of investments and $1.7 million of fee and otherincome.

27

----

*Non-InvestmentExpenses*

Non-investment expenses totaled $20.4 million and$43.2 million for the three and nine-month periods endedSeptember 30, 2005, respectively. For the three-month period endedSeptember 30, 2005 management compensation to related party totaled$14.3 million and consisted of $7.1 million of base management feespayable to our Manager pursuant to the Management Agreement and$7.2 million of share-based compensation related to restrictedcommon stock and common stock options granted to our Manager. For thenine-month period ended September 30, 2005, management compensationtotaled $33.1 million and consisted of $13.8 million of basemanagement fees payable to our Manager pursuant to the Management Agreement and$19.3 million of shared-based compensation related to restrictedcommon stock and common stock options granted to our Manager. The basemanagement fee payable was calculated in accordance with the ManagementAgreement and is based on an annual rate of 1.75% times “equity” as defined inthe Management Agreement. Our Manager is also entitled to an incentive feeprovided that our quarterly “net income”, as defined in the ManagementAgreement, before the incentive fee exceeds a defined return hurdle. We did notexceed the applicable hurdle during the three and nine-month periods endedSeptember 30, 2005; accordingly, no incentive fee was earned or paid.

General and administrativeexpenses totaled $2.6 million and $4.1 million, respectively, for thethree-month and nine-month periods ended September 30, 2005, andconsisted of expenses incurred by our Manager on our behalf that arereimbursable to our Manager pursuant to the Management Agreement. General andadministrative expenses for the three and nine-month periods ended September 30,2005, include a non-recurring lease termination charge totaling $0.8 million. Professionalservices expenses totaled $1.4 million and $2.6 million, respectively,for the three and nine-month periods ended September 30, 2005 and consistof legal, accounting and other professional services. We expect that ourrecurring professional services expenses will continue to increase as ourinvestment portfolio continues to increase. Loan servicing expenses totaled$1.4 million and $2.0 million, respectively, for the three and nine-monthperiods ended September 30, 2005, and consist of fixed servicing fees paidto third-party servicers. We expect that loan servicing expenses will continueto increase as our residential loan portfolio increases.

*Income TaxProvision*

We have elected to be taxed as a REIT and are requiredto comply with the provisions of the Code with respect thereto. Accordingly, weare not subject to federal income tax to the extent that our distributions tostockholders satisfy the REIT requirements and certain asset, income andownership tests, and recordkeeping requirements are fulfilled. Even though wequalify for federal taxation as a REIT, we may be subject to some amount offederal, state and local taxes based on our taxable income.

KKR TRS Holdings, Inc., our domestic taxable REITsubsidiary, is taxed as a regular subchapter C corporation under the provisionsof the Code. KKR TRS Holdings, Inc. was formed to make, from time to time,certain investments that would not be REIT qualifying investments if madedirectly by us, and to earn income that would not be REIT qualifying income ifearned directly by us. For the three and nine month periods ended September 30,2005, KKR TRS Holdings, Inc. had pre-tax net income of $1.6 millionand $4.3 million, respectively, that was primarily related to thederivative transactions discussed under “Net Investment Gains and Losses” aboveand the provision for income taxes totaled $0.8 million and$1.9 million, for the three and nine-month periods ended September 30,2005, respectively. As of September 30, 2005, KKR TRS Holdings, Inc.had an income tax liability of $1.7 million.

KKR Financial CLO 2005-1, Ltd.,KKR Financial CLO 2005-2, Ltd., KKR Financial CLO 2005-3, Ltd.,KKR Financial CLO 2006-1, Ltd., KKR Financial Market Value CLO 2005-1,Ltd., KKR Financial CDO 2005-1, Ltd., and KKR CDO 2006-1, Ltd.are foreign taxable REIT subsidiaries that were established to facilitatesecuritization transactions structured as secured financing transactions. They 

28

----

areorganized as exempted companies incorporated with limited liability under thelaws of the Cayman Islands, and are generally exempt from federal and stateincome tax at the corporate entity level because they restrict their activitiesin the United States to trading in stock and securities for their own account.Therefore, despite their status as taxable REIT subsidiaries, they generallywill not be subject to corporate income tax on their earnings, and noprovisions for income taxes for the three and nine month periods ended September 30,2005 have been recorded; however, we will generally be required to includetheir current taxable income in our calculation of REIT taxable income.

**Forthe period from August 12, 2004 (Inception) through September 30,2004**

*Summary*

Our net loss for theperiod totaled $3.4 million or $0.09 per share, which was principally due tolimited investment income resulting from the implementation of our ramp-up,which began on August 12, 2004, when we closed the private placement ofour common stock. Our investment portfolio totaled $22.0 million as of September 30,2004.

*Net InvestmentIncome*

Net investment income forthe period totaled $1.5 million, consisted of interest income on cash andcash equivalents. There was no interest expense on our borrowings.

*Non-InvestmentExpenses*

Non-investment expensestotaled $4.9 million. Management compensation totaled $3.8 million andconsisted of $1.8 million of base management fees payable to our Managerpursuant to the Management Agreement and $2.0 million of share-basedcompensation related to restricted common stock and common stock optionsgranted to our Manager. The base management fee payable was calculated inaccordance with the Management Agreement and is based on an annual rate of1.75% times “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 period;accordingly, no incentive fee was earned or paid. Professional servicesexpenses totaled $0.2 million and consist of legal, accounting and otherprofessional services. We expect that our recurring professional servicesexpenses will continue to increase as our investment portfolio continues toincrease. Insurance expenses totaled $0.1 million and consist of insurancepremium expense for directors and officers insurance. Board of director expensestotaled $0.1 million and consist of board of director fees, board ofdirector committee fees, amortization of restricted common stock granted tocertain members of our Board of Directors and related expense reimbursementspaid to the members of our Board of Directors. Other general and administrativeexpenses totaled $0.7 million and consist of expenses incurred by ourManager on our behalf that are reimbursable to our Manager pursuant to theManagement Agreement.

*Income Tax Provision*

KKR TRS Holdings, Inc.,our domestic taxable REIT subsidiary, is taxed as a regular subchapter Ccorporation under the provisions of the Code. KKR TRS Holdings, Inc. wasformed to make, from time to time, certain investments that would not be REITqualifying investments if made directly by us, and to earn income that wouldnot be REIT qualifying income if earned directly by us. KKR TRS Holdings, Inc.had no operations for the period from August 12, 2004 through September 30,2004. Therefore, despite its status as a taxable REIT subsidiary, no provisionfor income taxes has been recorded for this period.

29

----

**Financial Condition**

**Summary**

The tables below summarize the carrying value,amortized cost, and estimated fair value of our investment portfolio as of September 30,2005 and December 31, 2004, classified by interest rate type. Carryingvalue is the value that investments are recorded on our consolidated balancesheets and is estimated fair value for securities and amortized cost for loansheld for investment and the lower of amortized cost or market value for loansheld for sale. Estimated fair values set forth in the tables below are based ondealer quotes and/or nationally recognized pricing services.

The table below summarizesour investment portfolio as of September 30, 2005 classified by interestrate type:

**Investment Portfolio(Amounts in thousands)**

| ** **                                    | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix %  by Fair Value** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| **Floating  Rate:**                           |       |                    |       |                    |       |                           |       |                                                   |       |   |   |   |   |   |   |
| Residential ARM  Loans                        |       |                    | $          | 1,579,769               |       |                           |       | $                                                      | 1,579,769  |   |   | $ | 1,576,220 |   |   | 12.7 | % |   |
| Residential ARM  Securities                   |       |                    | 2,532,718  |                    |       |                           | 2,529,423  |                                                   |       | 2,532,718 |   |   | 20.3 | % |   |
| Corporate Loans                               |       |                    | 1,595,468  |                    |       |                           | 1,595,468  |                                                   |       | 1,611,569 |   |   | 13.0 | % |   |
| Corporate Debt  Securities                    |       |                    | 250,853    |                    |       |                           | 252,282    |                                                   |       | 250,853 |   |   | 2.0 | % |   |
| Commercial Real  Estate Loans                 |       |                    | 355,586    |                    |       |                           | 355,586    |                                                   |       | 355,925 |   |   | 2.9 | % |   |
| Commercial Real  Estate Debt Securities  |       |                    | 52,045     |                    |       |                           | 51,995     |                                                   |       | 52,045 |   |   | 0.4 | % |   |
| Total Floating Rate                           |       |                    | 6,366,439  |                    |       |                           | 6,364,523  |                                                   |       | 6,379,330 |   |   | 51.3 | % |   |
| **Hybrid  Rate:**                             |       |                    |       |                    |       |                           |       |                                                   |       |   |   |   |   |   |   |
| Residential  Hybrid ARM Loans                 |       |                    | 3,631,739  |                    |       |                           | 3,631,739  |                                                   |       | 3,593,785 |   |   | 28.9 | % |   |
| Residential  Hybrid ARM Securities            |       |                    | 2,282,589  |                    |       |                           | 2,321,383  |                                                   |       | 2,282,589 |   |   | 18.3 | % |   |
| Total Hybrid Rate                             |       |                    | 5,914,328  |                    |       |                           | 5,953,122  |                                                   |       | 5,876,374 |   |   | 47.2 | % |   |
| **Fixed  Rate:**                              |       |                    |       |                    |       |                           |       |                                                   |       |   |   |   |   |   |   |
| Corporate Loans                               |       |                    | 25,000     |                    |       |                           | 25,000     |                                                   |       | 25,000 |   |   | 0.2 | % |   |
| Corporate Debt  Securities                    |       |                    | 105,482    |                    |       |                           | 106,060    |                                                   |       | 105,482 |   |   | 0.8 | % |   |
| Commercial Real  Estate Loans                 |       |                    | 35,541     |                    |       |                           | 35,541     |                                                   |       | 35,890 |   |   | 0.3 | % |   |
| Commercial Real  Estate Debt Securities  |       |                    | 19,880     |                    |       |                           | 19,786     |                                                   |       | 19,880 |   |   | 0.2 | % |   |
| Total Fixed Rate                              |       |                    | 185,903    |                    |       |                           | 186,387    |                                                   |       | 186,252 |   |   | 1.5 | % |   |
| Total                                         |       |                    | $          | 12,466,670              |       |                           |       | $                                                      | 12,504,032 |   |   | $ | 12,441,956 |   |   | 100.0 | % |   |

 

The table above excludes common and preferred stockwith an estimated fair value of $53.1 million and an amortized cost of$52.8 million as of September 30, 2005. As of September 30,2005, the aggregate amortized cost value of our investment portfolio exceededthe aggregate fair value of our portfolio by $61.8 million and, as of thesame date, we had unrealized gains totaling $23.9 million related to our cashflow hedges, as defined under SFAS No. 133. As of September 30, 2005,the aggregate net unamortized purchase discount related to our investmentportfolio was $6.4 million.

30

----

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

**Investment Portfolio(Amounts in thousands)**

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

 

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

**Asset Quality**

*Hurricane Katrina*

During September 2005,the Gulf Coast region of the United States was severely impacted by HurricaneKatrina. Our principal source of exposure to the hurricane is throughproperties collateralizing our residential mortgage loans. The impact of thehurricane is difficult to predict and is based on many factors including the extentof damage to properties collateralizing residential mortgage loans, the extentto which damage is not covered by insurance, and the extent to which theeconomic conditions of borrowers has been impacted in such a way as to affectthe ability of borrowers to repay their loans. The ultimate impact of thehurricane is yet to be determined and we are working with our third-party loanservicers and other third-party property inspection vendors to assess thedamage. Based on our expectation that losses will be realized from thehurricane, we have recorded a provision for loan losses of $1.3 million relatedto our residential mortgage loan portfolio. We do not believe that thehurricane has had a material impact on our corporate or commercial real estateloan portfolio.

*Asset QualityReview*

We evaluate and monitorthe asset quality of our investment portfolio by performing detailed creditreviews and by monitoring key credit statistics and trends. We monitor thecredit rating of our investment portfolio through the use of both Moody’sInvestors Services, Inc., or Moody’s, and Standard & Poor’sRatings Service, or Standard & Poor’s ratings, and Moody’s weightedaverage rating factor, or WARF. 

31

----

WARF isthe quantitative equivalent of Moody’s traditional rating categories (e.g.,Ba1, Ba2, etc.) and is used by Moody’s in its credit enhancement calculationsfor securitization transactions. By monitoring both Moody’s and Standard &Poor’s ratings and Moody’s WARF we can monitor trends and changes in the creditratings of our investment portfolio. For residential mortgage loans andresidential mortgage-backed securities we monitor the credit quality ofthe underlying borrowers by monitoring trends and changes in the underlyingborrowers’ FICO® scores. Borrowers with lower FICO® scores default morefrequently than borrowers with higher FICO® scores. For residential andcommercial real estate mortgage loans and mortgage-backed securities wemonitor trends and changes in LTV ratios. Increases in LTV ratios are likely toresult in higher realized credit losses when borrowers default.

*SecuritiesAvailable-for-Sale*

The following tablesummarizes the amortized cost of our investment securities portfolio byinvestment class stratified by Moody’s and Standard & Poor’s ratingscategory as of September 30, 2005:

**Investment Securities(Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       |       | $          | 2,470,157                            |       |                                         | $          | 2,258,395                       |       | $                                                      | —     |      |       | $ | — |   |   | $ | 4,728,552 |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | 21,497     |                                 |       | 28,327                                       |       | —                          |       |                                                   | —     |      |       | 49,824 |   |
| A1/A+ through  A3/A-         |       |       | 15,498     |                                 |       | 17,944                                       |       | —                          |       |                                                   | —     |      |       | 33,442 |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | 10,999     |                                 |       | 8,813                                        |       | 85,452                          |       |                                                   | 38,488     |      |       | 143,752 |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 4,668      |                                 |       | 3,612                                        |       | 107,761                         |       |                                                   | 25,000     |      |       | 141,041 |   |
| B1/B+ through  B3/B-         |       |       | 2,796      |                                 |       | 2,042                                        |       | 132,069                         |       |                                                   | —     |      |       | 136,907 |   |
| Caa1/CCC+ and  lower         |       |       | —     |                                 |       | —                                       |       | 33,060                          |       |                                                   | 8,293      |      |       | 41,353 |   |
| Non-Rated                    |       |       | 3,808      |                                 |       | 2,250                                        |       | —                          |       |                                                   | —     |      |       | 6,058 |   |
| Total                        |       |       | $          | 2,529,423                            |       |                                         | $          | 2,321,383                       |       | $                                                      | 358,342    |      |       | $ | 71,781 |   |   | $ | 5,280,929 |   |

 

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

**Investment Securities(Amounts in thousands)**

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

 

32

----

*Loans*

Our residential ARM loan portfolio totaled$1.6 billion as of September 30, 2005, representing an increase of700.0% from $0.2 billion as of December 31, 2004. As of September 30,2005 and December 31, 2004, none of the residential ARM loans that weowned were in default and we did not own any real estate properties that we hadacquired through foreclosure. The weighted average original FICO® score andweighted average original LTV ratio of our residential ARM loan portfolio were736 and 67.7%, respectively, as of September 30, 2005. As of December 31,2004, the weighted average original FICO® score and weighted average LTV ratioof our residential ARM loan portfolio were 744 and 63.5%, respectively. As ofSeptember 30, 2005, our residential ARM loan investment portfolio did nothave any material concentrations in investor owned properties, multi-unithousing properties, condominium properties and/or cooperative properties. Amaterial portion of our residential ARM loans are non-conforming mortgageloans, not due to credit quality, but because the mortgage loans have balancesthat exceed the maximum balances necessary to qualify as a conforming mortgageloan.

Our residential hybrid ARM loan portfolio totaled $3.6billion as of September 30, 2005 and $0 as of December 31, 2004. Weperformed an allowance for loan losses analysis as of September 30, 2005and December 31, 2004, and we made the determination to record anallowance of $1.3 million for loan losses as of September 30, 2005. Asof September 30, 2005, none of the residential hybrid ARM loans that weowned were in default and we did not own any real estate properties that we hadacquired through foreclosure. The weighted average original FICO® score andweighted average LTV ratio of our residential hybrid ARM loan portfolio were736  and 69.4%, respectively, as of September 30,2005. As of September 30, 2005, our residential hybrid ARM loan 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.

Our corporate loan portfolio totaled $1.6 billionas of September 30, 2005, representing an increase of 300.0% from$0.4 billion as of December 31, 2004. Our corporate loan portfolioconsists of debt obligations of corporations, partnerships and other entitiesin the form of first and second lien loans, mezzanine loans and bridge loans.As of September 30, 2005 and December 31, 2004, none of the corporateloans in our investment portfolio were delinquent. We performed an allowancefor loan losses analysis as of September 30, 2005 and December 31,2004, and we have made the determination that no allowance for loan losses wasrequired for our corporate loan portfolio as of September 30, 2005 or December 31,2004.

33

----

The following table summarizesthe amortized cost of our corporate loans portfolio stratified by Moody’s andStandard & Poor’s ratings category as of September 30, 2005 and December 31,2004:

**Corporate Loans(Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **As of  September 30, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       |       | $          | —                                       |       |                                        |       | $ | — |   |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | —     |                                         |       |                                        | —     |   |   |
| A1/A+ through A3/A-          |       |       | —     |                                         |       |                                        | —     |   |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | —     |                                         |       |                                        | —     |   |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | 574,106    |                                         |       |                                        | 216,822    |   |   |
| B1/B+ through  B3/B-         |       |       | 932,283    |                                         |       |                                        | 182,815    |   |   |
| Caa1/CCC+ and  lower         |       |       | 21,138     |                                         |       |                                        | —     |   |   |
| Non-Rated                    |       |       | 92,941     |                                         |       |                                        | —     |   |   |
| Total                        |       |       | $          | 1,620,468                                    |       |                                        |       | $ | 399,637 |   |   |

 

Our commercial real estate loan portfolio totaled$391.1** **million and $50.0 million asof September 30, 2005 and December 31, 2004, respectively. Ourcommercial real estate loan portfolio consists of senior, mezzanine, and bridgeloans that are secured by commercial real estate. As of September 30, 2005none of the commercial real estate loans in our investment portfolio weredelinquent.

We performed an allowance for loan losses analysis asof September 30, 2005 and December 31, 2004, and we have made thedetermination that no allowance for loan losses was required for our commercialreal estate loan portfolio as of September 30, 2005 or December 31,2004.

The following table summarizesthe amortized cost of our commercial real estate loans portfolio stratified byMoody’s and Standard & Poor’s ratings category as of September 30,2005 and December 31, 2004:

**Commercial Real Estate Loans(Amounts in thousands)**

| **Ratings Category**    | ** ** | ** ** | ** ** | **As of  September 30, 2005** | ** ** | **As of  December 31, 2004** | ** ** |
|------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       |       | $          | —                                       |       |                                        |       | $ | — |   |   |
| Aa1/AA+ through  Aa3/AA-     |       |       | —     |                                         |       |                                        | —     |   |   |
| A1/A+ through  A3/A-         |       |       | —     |                                         |       |                                        | —     |   |   |
| Baa1/BBB+ through  Baa3/BBB- |       |       | —     |                                         |       |                                        | —     |   |   |
| Ba1/BB+ through  Ba3/BB-     |       |       | —     |                                         |       |                                        | —     |   |   |
| B1/B+ through  B3/B-         |       |       | —     |                                         |       |                                        | —     |   |   |
| Caa1/CCC+ and  lower         |       |       | 50,000     |                                         |       |                                        | 50,000     |   |   |
| Non-Rated                    |       |       | 341,127    |                                         |       |                                        | —     |   |   |
| Total                        |       |       | $          | 391,127                                      |       |                                        |       | $ | 50,000 |   |   |

 

34

----

**Asset Repricing Characteristics**

*Summary*

The table below summarizesthe repricing characteristics of our investment portfolio as of September 30,2005 and December 31, 2004, and is classified by interest rate type:

**Investment Portfolio(Amounts in thousands)**

| ** **                              | ** ** | **As of September 30, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                          | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| Floating Rate:                          |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential ARM  Loans                  |       |                                             | $          | 1,579,769                                       |       |   |   | 12.6 | % |   |   | $ | 233,120 |   |   |   | 10.1 | % |   |
| Residential ARM  Securities             |       |                                             | 2,529,423  |                                            |       |   | 20.2 |   |   |   | 1,581,824 |   |   |   | 68.8 |   |   |
| Corporate Loans                         |       |                                             | 1,595,468  |                                            |       |   | 12.8 |   |   |   | 394,387 |   |   |   | 17.1 |   |   |
| Corporate Debt  Securities              |       |                                             | 252,282    |                                            |       |   | 2.0 |   |   |   | 16,578 |   |   |   | 0.7 |   |   |
| Commercial Real  Estate Loans           |       |                                             | 355,586    |                                            |       |   | 2.9 |   |   |   | 50,000 |   |   |   | 2.2 |   |   |
| Commercial Real  Estate Debt Securities |       |                                             | 51,995     |                                            |       |   | 0.4 |   |   |   | 12,000 |   |   |   | 0.5 |   |   |
| Total Floating Rate                     |       |                                             | 6,364,523  |                                            |       |   | 50.9 |   |   |   | 2,287,909 |   |   |   | 99.4 |   |   |
| Hybrid Rate:                            |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential  Hybrid ARM Loans           |       |                                             | 3,631,739  |                                            |       |   | 29.0 |   |   |   | — |   |   |   | — |   |   |
| Residential  Hybrid ARM Securities      |       |                                             | 2,321,383  |                                            |       |   | 18.6 |   |   |   | — |   |   |   | — |   |   |
| Total Hybrid Rate                       |       |                                             | 5,953,122  |                                            |       |   | 47.6 |   |   |   | — |   |   |   | — |   |   |
| Fixed Rate:                             |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Corporate Loans                         |       |                                             | 25,000     |                                            |       |   | 0.2 |   |   |   | 5,250 |   |   |   | 0.2 |   |   |
| Corporate Debt  Securities              |       |                                             | 106,060    |                                            |       |   | 0.8 |   |   |   | 8,000 |   |   |   | 0.4 |   |   |
| Commercial Real  Estate Loans           |       |                                             | 35,541     |                                            |       |   | 0.3 |   |   |   | — |   |   |   | — |   |   |
| Commercial Real  Estate Debt Securities |       |                                             | 19,786     |                                            |       |   | 0.2 |   |   |   | — |   |   |   | — |   |   |
| Total Fixed Rate                        |       |                                             | 186,387    |                                            |       |   | 1.5 |   |   |   | 13,250 |   |   |   | 0.6 |   |   |
| Total                                   |       |                                             | $          | 12,504,032                                      |       |   |   | 100.0 | % |   |   | $ | 2,301,159 |   |   |   | 100.0 | % |   |

 

The table above excludescommon and preferred stock with an estimated fair value of $53.1 millionand an amortized cost of $52.8 million****as of September 30,2005 and preferred stock with an estimated fair value of $31.7 million andan amortized cost of $31.1 million as of December 31, 2004.

*Residential ARMSecurities*

As of September 30,2005, substantially all of our residential ARM securities were comprised ofone-month LIBOR floating rate securities that reprice monthly and were subject toa weighted average maximum net interest rate of 11.45% which is materiallyabove the then current weighted average net coupon of 4.26%. Our repricing riskon our portfolio of residential ARM securities increases materially if interestrates continue to increase to a level where the weighted average coupon rateapproaches the weighted average maximum net interest rate of 11.45% because theweighted average coupon is subject to a maximum rate, or cap, which isapproximately equal to the weighted average maximum interest rate of 11.45%.

*Residential HybridARM Securities*

As of September 30,2005, all of our residential hybrid ARM securities had underlying mortgageloans that were originated as 5/1 hybrid ARM loans. As of September 30,2005, we owned 100% of the securities that represent 100% of the beneficialinterest in the 5/1 hybrid ARM loans underlying our portfolio of 

35

----

hybridARM securities. When the underlying residential hybrid mortgage loans convertfrom fixed rate to floating rate, the underlying mortgaged loans will have aninterest rate based on one-year LIBOR or one-year constant maturity treasuryindex, or CMT, depending upon if the underlying mortgage loan is a LIBOR-or CMT-based mortgage loan. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and (ii) theweighted average post-roll date net margin. As of September 30, 2005 allof the mortgage loans underlying our residential hybrid ARM securities had apost-roll date index reset frequency of one year with 34%****basedon 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, theweighted average net coupon rate approaches the weighted average post roll datemaximum net interest rate of 9.43% because the post roll date weighted averagenet coupon is subject to a maximum rate, or cap, which is approximately equalto the weighted average post roll date maximum net interest rate or 9.43%. Theweighted average coupon on the portfolio of residential hybrid securities is 4.18%as of September 30, 2005. As of September 30, 2005, the weighted averagemonths until roll date for the mortgage loans underlying our residential hybridARM securities was 40.00. We did not own any residential hybrid ARM securitiesas of December 31, 2004.

*Residential ARMLoans*

As of September 30,2005, all of our residential ARM loans were comprised of one-month LIBORfloating rate loans that reprice monthly and were subject to a weighted averagemaximum net interest rate of 11.99%, which is well above the then currentweighted average net coupon of 4.61%. Our repricing risk on our portfolio ofresidential ARM loans increases materially if interest rates continue toincrease to a level where the weighted average net coupon rate approaches theweighted average maximum interest rate of 11.99% because the weighted averagecoupon is subject to a maximum rate, or cap, which is approximately equal tothe weighted average maximum interest rate of 11.99%.

*Residential HybridARM Loans*

As of September 30,2005, all of our residential hybrid ARM loans were originated as 5/1 hybrid ARMloans. When the loans convert from fixed rate to floating rate, the underlyingmortgage loans will have an interest rate based on one-year LIBOR or one-yearCMT. On the date that the residential hybrid ARM loans convert from a fixedrate to a floating rate loan, which we refer to as the roll date, our portfolioof residential hybrid ARM loans will have a weighted average coupon that is thesum of (i) the post-roll date index, and (ii) the weighted averagepost-roll date net margin. As of September 30, 2005 all of our residentialhybrid ARM loans had a post-roll date index reset frequency of one-year with39.7%****based on six-month or one-year LIBORand 60.3%****based on one-year CMT. Our repricingrisk on our portfolio of residential hybrid ARM loans increases materially ifinterest rates continue to increase to a level where, subsequent to the rolldate, the weighted average net coupon rate approaches the weighted average post-rolldate maximum net interest rate of 10.06% because the post-roll date weightedaverage net coupon is subject to a maximum rate, or cap, which is approximatelyequal to the weighted average post-roll date maximum net interest rate or10.06%. The weighted average net coupon on the portfolio of residential hybridloans is 4.78% as of September 30, 2005. As of September 30, 2005, theweighted average months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 45.85. We did not own any residentialhybrid ARM securities as of December 31, 2004.

*Corporate Loans andSecurities*

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

36

----

floating rate corporateloans and securities was 6.48% and 4.93% as of September 30, 2005 and December 31,2004, respectively. As of September 30, 2005, and December 31, 2004,the weighted average years to maturity of our floating rate corporate loans andsecurities was 6.4 years and 6.0 years, respectively.

As of September 30,2005, our fixed rate corporate debt securities had a weighted average coupon of10.06% and a weighted average years to maturity of 8.8 years, as compared to7.49% and 7.3 years, respectively, as of December 31, 2004.

*Commercial RealEstate Loans and Securities*

All of our floating rate commercial real estate loansand securities have index reset frequencies of less than twelve months. Theweighted average coupon on our floating rate commercial real estate loans andsecurities was 8.30% and 5.60% as of September 30, 2005 and December 31,2004, respectively. As of September 30, 2005 and December 31, 2004,the weighted average years to maturity of our floating rate commercial realestate loans and securities was 3.9 years and 5.7 years,respectively.

As of September 30,2005, our fixed rate commercial real estate loans and securities had a weightedaverage coupon of 7.55% and a weighted average years to maturity of****5.1** **years. Wehad no investments in fixed rate commercial real estate loans or securities asof December 31, 2004.

**Portfolio Purchases**

We purchased $6.5 billion and $11.9 billionpar amount of investments during the three and nine-month periods ended September 30,2005, respectively. For the period from August 12, 2004 (Inception)through September 30, 2004 we purchased $22 million par amount ofinvestments.

The table below summarizesour investment portfolio purchases for the periods indicated and includes thepar amount, or face amount, of the securities and loans that were purchased:

**Investment Portfolio Purchases(Amounts in thousands)**

| ** **                              | ** ** | **Three month period  ended  September 30, 2005** | ** ** | **Nine month period  ended  September 30, 2005** | ** ** | **August 12, 2004  (Inception) through  September 30, 2004** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **Par Amount**                                              | ** ** | **%**                                                                | ** ** | **Par Amount**                                                                   | ** ** | **%** | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| **Securities:**                         | ** ** | ** **                                                       | ** ** | ** **                                                           | ** ** | ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Residential ARM  Securities             |       | $                                                                | 886,566    |                                                                 | 13.5       | %                                                                                     | $          | 1,625,771 |   | 13.7 | % |   | $ | — |   |   |   | % |
| Residential Hybrid ARM  Securities      |       | —                                                           |       | —                                                               |       | 2,935,532                                                                             |       | 24.7 |   |   | — |   |   | — |   |
| Corporate Debt  Securities              |       | 180,315                                                          |       | 2.8                                                                  |       | 398,820                                                                               |       | 3.3 |   |   | — |   |   | — |   |
| Commercial Real Estate  Debt Securities |       | 52,315                                                           |       | 0.8                                                                  |       | 62,315                                                                                |       | 0.5 |   |   | 12,000 |   |   | 54.5 |   |
| Total Securities  Principal Balance     |       | 1,119,196                                                        |       | 17.1                                                                 |       | 5,022,438                                                                             |       | 42.2 |   |   | 12,000 |   |   | 54.5 |   |
| Loans:                                  |       |                                                             |       |                                                                 |       |                                                                                  |       |   |   |   |   |   |   |   |   |
| Residential ARM Loans                   |       | 956,970                                                          |       | 14.6                                                                 |       | 1,393,471                                                                             |       | 11.7 |   |   | — |   |   | — |   |
| Residential Hybrid ARM  Loans           |       | 3,717,560                                                        |       | 56.9                                                                 |       | 3,717,560                                                                             |       | 31.2 |   |   | — |   |   | — |   |
| Corporate Loans                         |       | 509,673                                                          |       | 7.8                                                                  |       | 1,426,374                                                                             |       | 12.0 |   |   | 10,000 |   |   | 45.5 |   |
| Commercial Real Estate  Loans           |       | 235,450                                                          |       | 3.6                                                                  |       | 342,200                                                                               |       | 2.9 |   |   | — |   |   | — |   |
| Total Loans Principal  Balance          |       | 5,419,653                                                        |       | 82.9                                                                 |       | 6,879,605                                                                             |       | 57.8 |   |   | 10,000 |   |   | 45.5 |   |
| Grand Total Principal Balance           |       | $                                                                | 6,538,849  |                                                                 | 100.0      | %                                                                                     | $          | 11,902,043 |   | 100.0 | % |   | $ | 22,000 |   |   | 100.0 | % |

 

The table above excludespurchases of $24.7****million(purchase cost) of common and preferred stock during the nine month periodended September 30, 2005, and $0 (purchase cost) during the period from August 12,2004 (Inception) through September 30, 2004. There were no purchases ofcommon or preferred stock during the three-month period ended September 30,2005.

37

----

**Stockholders’Equity**

Our stockholders’ equity at September 30, 2005and December 31, 2004 totaled $1,616.6 million and$756.7 million, respectively. Included in our stockholders’ equity as ofSeptember 30, 2005 and December 31, 2004, is accumulated other comprehensiveincome (loss) totaling****$(13.2)million and $1.7 million, respectively.

Our average stockholders’ equity and return on averagestockholders’ equity for the three and nine month periods endedSeptember 30, 2005 were $1,609.6 million and 4.5% and $1,043.2 million and4.2%, respectively. Return on average stockholders’ equity is defined asannualized net income divided by weighted average stockholders’ equity. Ourweighted average stockholders’ equity and return on average equity for theperiod from August 12, 2004, the date we commenced operations, throughDecember 31, 2004, were $756.1 million and (2.3%), respectively. Ourweighted average stockholders’ equity for the period from July 7, 2004(date of incorporation) through December 31, 2004, is not consideredmeaningful, as substantive operations did not begin until August 12, 2004.

Our book value per fully diluted share as ofSeptember 30, 2005 and December 31, 2004 was $20.11 and $18.46,respectively, and is computed based on 80,374,063****and41,004,492 shares issued and outstanding as September 30, 2005 andDecember 31, 2004, respectively.

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

On June 21, 2005, our Board of Directors declareda cash distribution for the quarter ended June 30, 2005 on our common stockto stockholders of record on June 21, 2005. On July 21, 2005, ourBoard of Directors set the amount of the cash distribution at $0.40 per share,payable on August 2, 2005. The aggregate amount of the distribution**,** $16.4 million, exceeded net incomefor the quarter by $7.9 million.

On November 2, 2005,our Board of Directors declared a cash distribution of $0.32 per share forthe quarter ended September 30, 2005 on our common stock to stockholdersof record on November 16, 2005. The distribution will be paid onNovember 30, 2005.

**Liquidity and Capital Resources**

We manage our liquidity with the intention ofproviding the continuing ability to fund our operations and fulfill ourcommitments on a timely and cost-effective basis. As of September 30, 2005and December 31, 2004, we had unencumbered assets totaling $850.4 millionand $580.0 million, respectively, consisting of unpledged investments,cash and cash equivalents, and other assets. We also have the ability to borrowadditional amounts related to certain of our encumbered assets.

We believe that our liquidity level is in excess ofthat necessary to sufficiently enable us to meet our anticipated liquidityrequirements including, but not limited to, funding our purchases ofinvestments, required cash payments and additional collateral under ourborrowings and our derivative transactions, required periodic cash paymentsrelated to our derivative transactions, payment of fees and expenses related toour Management Agreement, payment of general corporate expenses and generalcorporate capital expenditures and distributions to our common stockholders. Asof September 30, 2005, we owed our Manager $3.4 million for thepayment of management fees and reimbursable expenses pursuant to the ManagementAgreement.

An increase in prepayment rates substantially aboveour expectations could, however, cause a temporary liquidity shortfall due tothe timing of the necessary margin calls on the financing arrangements and theactual receipt of the cash related to principal paydowns. In addition, anymaterial event that impacts capital markets participants may also impair ourability to access additional liquidity. If our cash 

38

----

resources are at any timeinsufficient to satisfy our liquidity requirements, we may have to sell assetsor issue debt or additional equity securities.

Our ability to meet our long-term liquidity andcapital resource requirements may be subject to our ability to obtainadditional debt financing and equity capital. We may increase our capital resourcesthrough offerings of equity securities (possibly including common stock and oneor more classes of preferred stock), commercial paper, medium-term notes,securitization transactions structured as secured financings, and senior orsubordinated notes. If we are unable to renew, replace or expand our sources offinancing on substantially similar terms, it may have an adverse effect on ourbusiness and results of operations. Upon liquidation, holders of our debtsecurities and lenders with respect to other borrowings, as well as any holdersof preferred stock that we may issue in the future, will receive a distributionof our available assets prior to holders of our common stock.

The decisions by investors and lenders to enter intoequity and financing transactions with us will depend upon a number of factors,including our historical and projected financial performance, compliance withthe terms of our current credit arrangements, industry and market trends, theavailability of capital and our investors’ and lenders’ policies and ratesapplicable thereto, and the relative attractiveness of alternative investmentor lending opportunities.

Any material event that impacts capital marketsparticipants may also impair our ability to access additional liquidity and wemay therefore be required to sell some or all of our portfolio investments inorder to maintain sufficient liquidity. Such sales may be at prices lower thanthe carrying value of our pledged investments, which would result in ourrecognition of such losses and reduced income.

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

**Sources of Funds**

Our sources of fundinghave consisted of the net proceeds from our August 2004 private placementof common stock and our June 2005 IPO of common stock of$755.5 million and $848.8 million, respectively. During the periodfrom August 12, 2004 (Inception) through December 31, 2004, ourprimary source of funding after our August 2004 private placementconsisted of borrowings under repurchase agreements. During the three and ninemonth periods ended September 30, 2005 our sources of borrowed fundingconsisted of borrowings under repurchase agreements and securitizationtransactions structured as secured financings. Our securitization transactionsare accounted for as a secured financing under SFAS No. 140, *Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*. The securitizationtransactions we have utilized for secured financings have consisted of CLOs.

*Equity Transactions*

On August 12, 2004,we completed our initial private placement of our common stock at $20.00 pershare that generated net proceeds of approximately $755.5 million. On June 29,2005, we completed our IPO of 37,500,000 shares of common stock that generatednet proceeds of approximately $848.8 million. We sold 37,471,250 commonshares at a price of $24.00 per share and selling stockholders sold 27,850shares. Our stock is listed on the New York Stock Exchange under the symbol “KFN”and began trading on June 24, 2005. On June 23, 2005, we effected areverse stock split of our common stock at a ratio of one share of common stockfor every two shares of common stock then outstanding.

39

----

*SecuritizationTransactions*

On March 30, 2005, we closed KKR Financial CLO2005-1, Ltd. (“CLO 2005-1”), a $1.0 billioncollateralized loan obligation transaction that provides us with securedfinancing for investments consisting of corporate loans and certain other loansand securities. The assets that are owned by CLO 2005-1 secure the CLO2005-1 senior, mezzanine, and subordinate notes payable, and as a result,those investments are not available to us, our creditors or stockholders. CLO2005-1 issued a total of $773.0 million of senior notes at par toinvestors and we retained $148.0 million of rated mezzanine notes and$85.5 million of unrated subordinated notes. The rated mezzanine notesconsists of $64 million rated A2/A, $64.0 million rated Baa3/BBB-,$15.0 million rated Ba2/BB-, and $5.0 million rated B2/B-. All of thenotes issued mature on April 26, 2017; however, we have the right to callthe notes at par any time after April 2008.

The manager for CLO 2005-1 is KKR FinancialAdvisors II, LLC (“KFA II”), a wholly-owned subsidiary of KKR FinancialLLC. As compensation for the performance of its obligations under thecollateral management agreement, KFA II is entitled to receive a seniorcollateral management fee of 0.15% per annum based on the aggregate principalamount of certain collateral, as calculated on a quarterly basis pursuant tothe terms of the indenture. KFA II, in its sole and absolute discretion, mayelect to defer or permanently waive payment of all or any portion of theforegoing fees on any related payment date. KFA II has elected to permanentlywaive the senior collateral management fees from March 30, 2005 through October 26,2005 and has advised us that it intends, but is not legally obligated, to waivesuch fees in the future until such time that our capital is fully deployed. Theamount of senior collateral management fees permanently waived totaledapproximately $750,000. There can be no assurances that KFA II will waive thesenior collateral management fees for any period(s) subsequent to October 26,2005.

In preparation for future securitization transactions,during the nine-month period ended September 30, 2005 we formed KKRFinancial CLO 2005-2, Ltd. (“CLO 2005-2”), KKR Financial CLO2005-3, Ltd. (“CLO 2005-3”), KKR Financial CLO 2006-1,Ltd. (“CLO 2006-1”), KKR Financial Market Value CLO 2005-1, Ltd. (“MVCLO 2005-1”), KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”),and KKR Financial CDO 2006-1, Ltd. (“CLO 2006-1”). CLO 2005-2,CLO 2005-3, CLO 2006-1, and MV CLO 2005-1 will be used toprovide secured financing principally for the purchase of corporate loans andsecurities. We formed CDO 2005-1 and CDO 2006-1 to provide securedfinancing principally for the purchase of commercial real estate loans andsecurities. CLO 2005-2 has entered into a $665.0 million warehousefacility, in the form of a repurchase agreement. At September 30, 2005,there was $532.2 million outstanding under the repurchase facility that bearsinterest at a rate of 30-day LIBOR plus 0.65%. As of September 30,2005, CLO 2005-2 had assets totaling $630.0 million. CDO 2005-1has entered into a $300 million warehouse facility, in the form of arepurchase agreement. At September 30, 2005, there was $187.9 millionoutstanding under the repurchase facility that bears interest at a rate of 30-dayLIBOR plus 1.10%. As of September 30, 2005, CDO 2005-1 had assetstotaling $359.0 million. As of September 30, 2005, CLO 2005-3,CLO 2006-1, MV CLO 2005-1, and CDO 2006-1 have not entered intoany warehouse facility agreements with third parties.

On September 30,2005, the Company closed a $5 billion asset-backed commercial paper facility. Thisfacility will provide the Company with an alternative source of funding itsinvestments by issuing secured liquidity notes that are rated A-1+, P-1,and F1+, by Standard and Poor’s, Moody’s and Fitch, respectively. Issuances ofsecured liquidity notes will be recorded as borrowings on the Company’sconsolidated balance sheet. As of September 30, 2005, no borrowings wereoutstanding under this facility.

*RepurchaseAgreements*

As of September 30, 2005, we had$9.5 billion outstanding on eleven repurchase facilities with a weightedaverage effective cost of 3.89% and a weighted average remaining term tomaturity of 24 days. As of September 30, 2005, we had pledged securitiesas collateral under the repurchase agreements with an 

40

----

aggregate amortized costof $11.0 billion****and anaggregate estimated fair value of $10.2 billion. Because we borrow underrepurchase agreements based on the estimated fair value of our pledgedsecurities, and because changes in interest rates can negatively impact thevaluation of our pledged securities, our ongoing ability to borrow under ourrepurchase facilities may be limited and our lenders may initiate margin callsin the event interest rates change or the value of our pledged securitiesdecline as a result of adverse changes in interest rates or credit spreads.

At September 30,2005, we had repurchase agreements with the following counterparties:

**Repurchase Agreements(Amounts in thousands)**

| **Counterparty**                          | ** ** | ** ** | ** ** | **Amount At  Risk(1)** | ** ** | **Weighted Average  Maturity  (Days)** | ** ** | **Weighted Average  Interest Rate** | ** ** |
|-------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|
| J.P. Morgan  Securities, Inc.        |       | $          | 117,951    |                        |       | 25                                          |       |                                          |       | 3.86 | % |   |
| Banc of America  Securities LLC           |       | 48,405     |       |                        | 27         |                                        |       |                                          | 3.89       | % |   |
| Liquid Funding, Ltd  (Bear Sterns)        |       | 44,981     |       |                        | 14         |                                        |       |                                          | 4.08       | % |   |
| Citigroup Global Markets  Ltd             |       | 37,672     |       |                        | 25         |                                        |       |                                          | 3.88       | % |   |
| Bear Sterns &  Co. Inc.          |       | 37,110     |       |                        | 18         |                                        |       |                                          | 3.84       | % |   |
| Morgan  Stanley & Co.            |       | 36,867     |       |                        | 28         |                                        |       |                                          | 3.89       | % |   |
| Credit Suisse First  Boston LLC           |       | 33,845     |       |                        | 26         |                                        |       |                                          | 3.86       | % |   |
| Bear Sterns Mortgage  Capital Corp        |       | 22,013     |       |                        | 1          |                                        |       |                                          | 4.29       | % |   |
| Merrill Lynch Government  Securities Inc. |       | 21,156     |       |                        | 28         |                                        |       |                                          | 3.88       | % |   |
| UBS Financial Services  Inc.              |       | 8,390      |       |                        | 22         |                                        |       |                                          | 3.94       | % |   |
| J. P. Morgan Chase Bank,  N.A.            |       | 5,624      |       |                        | 1          |                                        |       |                                          | 4.44       | % |   |
| Total                                     |       | $          | 414,014    |                        |       | 24                                          |       |                                          |       | 3.89 | % |   |

----

Notes:

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

*Secured CreditFacility*

During June 2005, weentered into a $275 million secured credit facility that matures on June 15,2006, with affiliates of J.P. Morgan Securities Inc. and Citigroup GlobalMarkets Inc. as agents, joint bookrunners, arrangers and lenders underthat facility. Participants in the secured credit facility include J.P. MorganChase Bank, N.A., Citicorp North America, Inc., and Bank of America, N.A.Among other things, the new facility limits the amount of distributions we maymake to 100% of our taxable income computed without giving effect to netoperating loss carryforwards and nonrecurring items (including, but not limitedto, stock- based compensation expense and bad debt write-offs), prohibitsdistributions in the event of certain defaults under the credit facility andspecifies negative covenants as to our leverage and net worth. Outstandingborrowings under our new credit facility will bear interest at either (i) analternate base rate per annum equal to the greater of (a) the prime ratein effect on such day, and (b) the federal funds effective rate in effecton such day plus  1¤2of 1% or (ii) an interest rate per annum equal to the rate of 30-dayLIBOR for such interest period multiplied by a Statutory Reserve Rate (asdefined in such credit facility), plus 1%.

*Capital Utilizationand Leverage*

As of September 30, 2005 and December 31,2004, we had stockholders’ equity totaling $1.6 billion and $756.7 million,respectively, and our leverage was****6.8 times and2.1 times, respectively.

41

----

As of September 30,2005, we believe that we have sufficient capital to increase borrowingssignificantly before becoming capital or leverage constrained.

*Off-Balance Sheet Commitments*

As of September 30,2005, we had committed to purchase corporate loans with aggregate commitmentstotaling $245.1 million. In a typical corporate loan or commercial realestate loan syndication, there is a delay between the time we are informed ofour allocable portion of such loan and the actual funding of such loan.

As of September 30,2005, we had purchased or participated in corporate loan delayed drawtransactions with aggregate commitments totaling $5.0 million. In adelayed draw transaction, we have made available to the borrower a statedamount to be drawn as needed within a specified future period of time.

*Contractual Obligations*

The table below summarizesour contractual obligations as of September 30, 2005. The table belowexcludes accrued interest expenses, contractual commitments related to ourderivatives, and the Management Agreement that we have with our Manager becausethose contracts do not have fixed and determinable payments:

**Contractual Obligations(Amounts in thousands)**

| ** **                                   | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **Total**                                 | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 Years** | ** ** | **More than  5 years** | ** ** |
| Repurchase agreements                        |       | $                                         | 10,231,010 |   |   | $ | 10,231,010 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |
| CLO 2005-1 senior  notes payable             |       | 773,000                                   |       |   | — |   |   |   | — |   |   |   | — |   |   | 773,000 |   |
| Demand loan                                  |       | 40,511                                    |       |   | 40,511 |   |   |   | — |   |   |   | — |   |   | — |   |
| Loan purchase and  participation commitments |       | 245,078                                   |       |   | 245,078 |   |   |   | — |   |   |   | — |   |   | — |   |
| Delayed draw loan  commitments               |       | 4,952                                     |       |   | 4,952 |   |   |   | — |   |   |   | — |   |   | — |   |
| Total                                        |       | $                                         | 11,294,551 |   |   | $ | 10,521,551 |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 773,000 |   |

 

**REIT Matters**

As of September 30,2005,we believe that we qualified as a REIT under the provisions of the Code.The Code requires that at least 75% of our total assets must be “real estateassets” as defined in the Code. The Code also requires that at least 75% of ourgross income come from real estate sources and 95% of our gross income comefrom real estate sources and certain other passive sources itemized in theCode, such as dividends and interest. As of September 30, 2005, we believethat we were in compliance with such requirements. As of September 30,2005, we also believe that we met all of the REIT requirements regarding theownership of our common stock and the distributions of our taxable income.

Tomaintain our status as a REIT for federal income tax purposes, we are requiredto declare dividends amounting to at least 90% of our taxable income for eachyear by the time we file our applicable tax return for such year and pay suchamounts on or before the first regular dividend payment date after suchdeclaration. In addition, for each taxable year, to avoid certain federalexcise taxes, we are required to declare and pay dividends amounting to certaindesignated percentages of our taxable income by the end of such taxable year.For the period covered by our calendar year 2004 federal tax return, we met allof the distribution requirements of a REIT. 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.

42

----

Total taxable income andREIT taxable income are non-GAAP financial measurements, and do not purport tobe an alternative to reported net income (loss) determined in accordance withGAAP as a measure of operating performance or to cash flows from operatingactivities determined in accordance with GAAP as a measure of liquidity. Totaltaxable income is the aggregate amount of taxable income generated by us and byour domestic and foreign taxable REIT subsidiaries. REIT taxable incomeexcludes the undistributed taxable income of our domestic taxable REITsubsidiary, which is not included in REIT taxable income until distributed tous. There is no requirement that our domestic taxable REIT subsidiarydistribute its earnings to us. REIT taxable income, however, includes thetaxable income of our foreign taxable REIT subsidiaries because we willgenerally be required to recognize and report their taxable income on a currentbasis. These non-GAAP financial measurements are important because we arestructured as a REIT and the Code requires that we pay substantially all of ourtaxable income in the form of distributions to our stockholders. The non-GAAPfinancial measurements of total taxable income and REIT taxable income arecritical in the determination of the amount of the minimum distributions thatwe must pay to our stockholders so as to comply with the rules set forthin the Code. Because not all companies use identical calculations, thispresentation of total taxable income and REIT taxable income may not be comparableto other similarly titled measures prepared and reported by other companies.The table below reconciles the differences between reported net income andtotal taxable income and REIT taxable income for the three and nine-monthperiods ended September 30, 2005 and the period from August 12, 2004(Inception) through September 30, 2004:

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

| ** **                                                            | ** ** | **Estimated  For the Three  Months Ended  September 30, 2005** | ** ** | **Estimated  For the Nine  Months Ended  September 30, 2005** | ** ** | **Estimated  For the Period from  August 12, 2004  (Inception) through  September 30, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **Amount**                                                                              | ** ** | **Per  Share**                                                                         | ** ** | **Amount**                                                                                                                           | ** ** | **Per  Share** | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income (loss)**                                       |       | $                                                                                       | 18,454     |                                                                                   | $          | 0.24                                                                                                                                 |       | $ | 33,072 |   | $ | 0.62 |   | $ | (3,430 | ) | $ | (0.09 | ) |
| Interest income  and expense                                          |       | 48                                                                                      |       | 0.00                                                                                   |       | 145                                                                                                                                  |       | 0.00 |   | — |   | — |   |
| Share-based  compensation                                             |       | 7,428                                                                                   |       | 0.09                                                                                   |       | 19,509                                                                                                                               |       | 0.36 |   | (21,888 | ) | (0.55 | ) |
| Depreciation of property  and  equipment                              |       | 144                                                                                     |       | 0.00                                                                                   |       | 274                                                                                                                                  |       | 0.01 |   | (7 | ) | (0.00 | ) |
| Lease abandonment  expense                                            |       | 795                                                                                     |       | 0.01                                                                                   |       | 795                                                                                                                                  |       | 0.01 |   | — |   | — |   |
| Provision for  loan losses                                            |       | 1,300                                                                                   |       | 0.02                                                                                   |       | 1,300                                                                                                                                |       | 0.02 |   | — |   | — |   |
| Losses on sales  of assets to third  parties                          |       | (126                                                                                    | )          | (0.00                                                                                  | )          | (674                                                                                                                                 | )          | (0.01 | ) | — |   | — |   |
| Gains on sales of  assets to affiliates                               |       | 145                                                                                     |       | 0.00                                                                                   |       | 4,432                                                                                                                                |       | 0.08 |   | — |   | — |   |
| Realized and  unrealized derivative  losses                           |       | (285                                                                                    | )          | (0.01                                                                                  | )          | (459                                                                                                                                 | )          | (0.01 | ) | — |   | — |   |
| Realized losses  (gains) on foreign currency translations             |       | (203                                                                                    | )          | (0.00                                                                                  | )          | 2,332                                                                                                                                |       | 0.05 |   | — |   | — |   |
| Income tax expense                                                    |       | 775                                                                                     |       | 0.01                                                                                   |       | 1,881                                                                                                                                |       | 0.04 |   | — |   | — |   |
| **Total  taxable income (loss)**                                      |       | 28,475                                                                                  |       | 0.36                                                                                   |       | 62,607                                                                                                                               |       | 1.17 |   | (25,325 | ) | (0.64 | ) |
| Undistributed  taxable income of domestic taxable REIT subsidiary     |       | (1,709                                                                                  | )          | (0.02                                                                                  | )          | (3,781                                                                                                                               | )          | (0.07 | ) | — |   | — |   |
| **REIT  taxable income (loss)**                                       |       | $                                                                                       | 26,766     |                                                                                   | $          | 0.34                                                                                                                                 |       | $ | 58,826 |   | $ | 1.10 |   | $ | (25,325 | ) | $ | (0.64 | ) |
| **Number of common shares  outstanding:**                             |       |                                                                                    |       |                                                                                   |       |                                                                                                                                 |       |   |   |   |   |   |   |
| Weighted-average  diluted common shares outstanding during the period |       | 78,492                                                                                  |       |                                                                                   |       | 53,519                                                                                                                               |       |   |   | 39,796 |   |   |   |

 

43

----

Our Board of Directors hasadopted a policy to distribute to our stockholders amounts required to maintainour status as a REIT and to avoid federal excise taxes, in each case asdiscussed above. This distribution policy takes into account a number of factors,including, but not limited to, our actual results of operations, our financialcondition and our total taxable income and REIT taxable income. The actualamount and timing of distributions, if any, will be at the discretion of ourboard of directors and may not be in even amounts throughout our fiscal year.Pursuant to this policy, on April 5, 2005, our Board of Directorsauthorized a cash distribution of $0.25 per share to our stockholders of recordon April 5, 2005. This distribution was paid on April 18, 2005. Theaggregate amount of the distribution was $10.3 million. On June 21,2005, our Board of Directors declared a cash distribution for the quarter endedJune 30, 2005 to stockholders of record on June 21, 2005. On July 21,2005 our Board of Directors set the amount of the cash distribution at $0.40per share, payable on August 2, 2005. The aggregate amount of thedistribution was $16.4 million. The aggregate amount of distributions paidto common stockholders’ during the nine-month period ended September 30,2005, totaled $26.7 million, which is less than the Company’s estimatedtotal taxable income for the nine-month period ended September 30, 2005,of $62.6 million, as well as the estimated REIT taxable income for thenine-month period ended September 30, 2005 of $58.8 million. OnNovember 2, 2005, the Company’s Board of Directors declared a cashdistribution for the quarter ended September 30, 2005 on the Company’scommon stock of $0.32 per share. The distribution will be payable onNovember 30, 2005 to stockholders of record as of the close of business onNovember 16, 2005. The aggregate amount of the distribution will be $25.7million. Neither the payment of these distributions nor the existence of ourdistribution policy guarantees that we will make future distributions to ourstockholders of any particular level, or at all. In addition, the amounts ofthese distributions do not constitute any kind of projection as to the amountof future distributions, if any.

**InformationRegarding Excess Inclusion Income for Tax-Exempt, Non-U.S. and Net OperatingLoss Shareholders**

We believe that a portionof our 2005 dividends may be deemed excess inclusion income. This type ofincome in particular can impact taxpayers subject to the Unrelated BusinessIncome Tax (“UBIT”).

Ingeneral, under federal income tax rules, excess inclusion income has thefollowing effects:

1)              Tax-exemptshareholders (other than certain government-related entities) will typically besubject to UBIT and will need to pay tax on the portion of their dividendclassified as excess inclusion income;

2)              Non-U.S.shareholders will be subject to the 30 percent U.S. federal withholding tax onthis income without reduction under any otherwise applicable income tax treaty;and

3)              Shareholderstypically may not offset the portion of their dividends classified as excessinclusion income with net operating losses.

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

**Exemptionfrom Regulation 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 notissue redeemable securities and are primarily engaged in the business ofpurchasing or otherwise acquiring mortgages and other liens on and interests inreal estate.

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 

44

----

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

Based on the no-actionletters issued by the Division, we classify our investment in residentialmortgage loans as qualifying real estate assets, as long as the loans are “fullysecured” by an interest in real estate. That is, if the loan-to-value ratio ofthe loan is equal to or less than 100%, then we consider the mortgage loan aqualifying real estate asset. We do not consider loans with loan-to-valueratios in excess of 100% to be qualifying real estate assets for the 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-agency mortgage-backedsecurities do not constitute qualifying real estate assets for purposes of the55% test, because they represent less than the entire beneficial interest inthe related pool of mortgage loans. The Division, however, has indicated in aseries of no-action letters that in certain circumstances a company’sinvestment in non-agency mortgage- backed securities is the “functionalequivalent” of owning the underlying mortgage loans. We own mortgage-backedsecurities that we classify as qualifying real estate assets because we believethat we own the functional equivalent of the underlying mortgage loans.

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

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

45

----

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 exemption providedif (i) the securities of the subsidiary are owned exclusively by personswho at the time of acquisition of the securities are “qualified purchasers” asthat term is defined in the Investment Company Act and (ii) none of thenon-real estate subsidiaries is making or proposing to make a public offeringof its securities. Other subsidiaries may qualify, on their own, for theexclusion designed for companies primarily engaged in the business ofpurchasing or otherwise acquiring mortgages and other liens on and interests inreal estate, the same exclusion from regulation that we rely upon for ourexclusion from regulation. To the extent that we form subsidiaries in thefuture, we must ensure that they qualify for their own separate exclusion fromregulation 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.

**Quantitativeand Qualitative Disclosures About Market Risk**

**Market Risks**

*Currency Risks*

From time to time, we may make investments that aredenominated in a foreign currency through which we may be subject to foreigncurrency exchange risk.

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

*Interest Rate Risk*

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

Interest rate risk impacts our interest income,interest expense, prepayments, amortization of purchase premiums, accretion ofpurchase discounts, and the fair value of our investments, interest ratederivatives, and liabilities. We manage interest rate risk and make interestrate risk decisions by evaluating our projected earnings under selectedinterest rate scenarios. We also use static measures of interest rate riskincluding duration. During periods of increasing interest rates we are biasedto purchase investments that are floating rate and we have had that bias sinceour inception. We manage our interest rate risk using various techniquesranging from the purchase of floating rate investments to the use of interestrate derivatives. We generally fund our variable rate investments with variablerate borrowings with similar interest rate reset frequencies. We fund our fixedrate and our hybrid investments with short-term variable rate borrowings and wemay use interest rate derivatives to hedge the variability of the cash flowsassociated with our existing or forecasted variable rate borrowings. Hedgingactivities are complex and 

46

----

accounting for interestrate derivatives as fair value or cash flow hedges in accordance with SFAS No. 133is difficult. We may not be able to execute certain hedging strategies becausewe are a REIT and there are complex rules regarding how our hedges impactour compliance with the REIT requirements.

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

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

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

The following tablesummarizes the estimated net fair value of our derivative instruments held at September 30,2005 and December 31, 2004 (amounts in thousands):

**Derivative FairValue**

| ** **                         | ** ** | **Net Fair Value**                     | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **As of September 30, 2005** | ** ** | **As of December 31, 2004** | ** ** |
| **Cash  Flow Hedges:**             |       |                                             |       |   |   |   |   |   |   |
| Interest rate corridors            |       |                                             | $          | 12,699 |   |   |   | $ | — |   |   |
| Interest rate swaps                |       |                                             | 21,186     |   |   |   | — |   |   |
| **Free-Standing  Derivatives:**    |       |                                             |       |   |   |   |   |   |   |
| Interest rate swaptions            |       |                                             | 162        |   |   |   | 223 |   |   |
| Interest rate swaps                |       |                                             | 78         |   |   |   | — |   |   |
| Credit default swaps               |       |                                             | 47         |   |   |   | (625 | ) |   |
| Total rate of return swaps         |       |                                             | 184        |   |   |   | — |   |   |
| Forward foreign exchange contracts |       |                                             | —     |   |   |   | (125 | ) |   |
| Net fair value                     |       |                                             | $          | 34,356 |   |   |   | $ | (527 | ) |   |

 

*Effect on FairValue*

Another component ofinterest rate risk is the effect changes in interest rates will have on themarket value of our investments, liabilities, and our interest ratederivatives. We are exposed to the risk that the market value of ourinvestments will increase or decrease at different rates than that of ourliabilities and our interest rate derivatives. We primarily assess our interestrate risk by estimating the duration of our investments, liabilities, andinterest rate derivatives. Duration essentially measures the market price 

47

----

volatilityof our investments, liabilities, and interest rate derivatives. We generallycalculate duration using various financial models and financial data servicesand software and models made available to us by various dealers. Differentmodels and methodologies can produce different duration numbers for the sameinvestments, liabilities, and interest rate derivatives.

*Risk Management*

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

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

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

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

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

**Item 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.

**Item 4.**                        Controlsand Procedures

Under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, we conducted an evaluation of the effectiveness of thedesign and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended, asof the end of the period covered by this report (the “Evaluation Date”). Basedon this evaluation, our principal executive officer and principal financialofficer concluded as of the Evaluation Date that our disclosure controls andprocedures were effective such that the information relating to us, includingour consolidated subsidiaries, required to be disclosed in our Securities andExchange Commission (“SEC”) reports (i) is recorded, processed, summarizedand reported within the time periods specified in SEC rules and forms, and(ii) is accumulated and communicated to our management, including ourprincipal executive and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

As previously disclosed in our registration statementon Form S-11 (Registration No. 333-124103), in connectionwith its audit of our consolidated financial statements for the period ended December 31,2004, our independent registered public accounting firm, on March 8, 2005identified to us three matters involving our internal controls over financialreporting that it considered to be reportable conditions under standardsestablished by the American Institute of Certified Public Accountants, whichreportable conditions in its judgment constituted material weaknesses. Underthese standards, in each of these areas the design or operation of our internalcontrols did not reduce to a relatively low level the risk that misstatementscaused by error or fraud in amounts that would be material may occur and not bedetected within a timely period.

The first reportable condition related to our failureto have well-established internal controls over our financial closing andreporting process. Specifically, through the March 8, 2005 letter date,several of our 

48

----

Manager’s employees in theareas of accounting and financial reporting had been with our Manager for alimited period of time, and additional internal controls needed to beestablished with respect to the segregation of duties of these individuals inthe posting and review of individual journal entries. Moreover, additionalspecific internal controls were required regarding verification andreconciliation of our general ledger as our financial statements are closed ona monthly basis. The second reportable condition related to our reliance ondata gathering and processing methods based upon information gathered aftertransaction dates that entail a greater risk of error. Specifically, inpreparation of our financial statements and underlying records, we relied oncustodian statements, bank statements and other information gathered after thetransaction dates to identify transactions and amounts that needed to berecorded. These data-gathering and processing methods entail greater risk oferror than do methods involving timely processing of transactions. The thirdreportable condition related to our failure to be as self sufficient withrespect to the application of accounting policies for complex transactions aswe ultimately need to be. As with the first reportable condition discussedabove, the existence of this condition at March 8, 2005 principallyrelated to the limited periods of time that several of our Manager’s accountingand financial reporting staff had been employed by our Manager, and the need atsuch time for these individuals to establish more robust procedures for theongoing selection and application of accounting policies for many of ourtransactions.

We are actively remediating the identified reportableconditions. Specifically, subsequent to March 8, 2005 our Chief OperatingOfficer became our Chief Financial Officer and we hired individuals to fill thepositions of Controller; Accounting Policies and External Reporting Manager;Treasurer; Assistant Controller; Assistant Treasurer; and Financial AnalysisManager. 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 with Section 404of the Sarbanes-Oxley Act of 2002. Due to the recently announced one-yeardelay in the required compliance schedule for non-accelerated filers, we willbe required to issue a management report on our assessment of internal controlsover financial reporting in our Annual Report on Form 10-K for theyear ended December 31, 2006.

There were no other changes in our internal controlover financial reporting identified in connection with the foregoing evaluationthat occurred during the three months ended September 30, 2005 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

49

----

**PART II. OTHERINFORMATION**

**Item 1.****                        *Legal Proceedings***

None.

**Item 2*.******                        UnregisteredSales of Equity Securities and Use of Proceeds***

**(d)****          Useof Proceeds**

None.

**Item 3.****                        *Defaults Upon Senior Securities***

None.

**Item 4.****                        *Submission of Matters to a Vote of Security Holders***

None.

**Item 5.        *Other Information***

None.

**Item 6.****                        *Exhibits***
| 3.1*   |   | Articles of Amendment and Restatement of the  Registrant                                                                                                                                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2*   |   | Form of Articles of Amendment                                                                                                                                                                                                           |
| 3.3*   |   | Form of Articles of Amendment                                                                                                                                                                                                           |
| 3.4*   |   | Amended and Restated Bylaws of the Registrant                                                                                                                                                                                                |
| 4.1*   |   | Form of Certificate for Common Stock                                                                                                                                                                                                    |
| 4.2*   |   | Registration Rights Agreement, dated as of  August 12, 2004 between the Registrant and Friedman, Billings,  Ramsey & Co., Inc.                                                                                            |
| 10.1*  |   | Management Agreement, dated as of August 12,  2004, between Registrant and KKR Financial Advisors LLC                                                                                                                                   |
| 10.2*  |   | Amended and Restated 2004 Stock Incentive Plan                                                                                                                                                                                               |
| 10.3*  |   | Form of Nonqualified Stock Option Agreement                                                                                                                                                                                             |
| 10.4*  |   | Form of Restricted Stock Award Agreement                                                                                                                                                                                                |
| 10.5*  |   | Form of Restricted Stock Award Agreement for Non-Employee  Directors                                                                                                                                                                    |
| 10.6*  |   | License Agreement, dated as of August 12, 2004,  between the Registrant and Kohlberg Kravis Roberts & Co. L.P.                                                                                                                 |
| 10.7*  |   | Letter Agreement, dated as of August 12, 2004,  between the Registrant and KKR Financial Advisors LLC                                                                                                                                   |
| 10.8*  |   | Credit Agreement, dated as of June 16, 2005,  among the Registrant, KKR TRS Holdings, Inc., the Lenders party thereto,  and JPMorgan Chase Bank, N.A., as Administrative Agent                                                     |
| 10.9*  |   | First Amendment to Credit Agreement, dated as of  June 17, 2005, among the Registrant, KKR TRS Holdings, Inc., the  Existing Lenders party thereto, JPMorgan Chase Bank, N.A., as Administrative  Agent, and Bank of America, N.A. |
| 10.10* |   | Collateral Management Agreement, dated as of  March 30, 2005, between KKR Financial CLO 2005-1, Ltd. and KKR  Financial Advisors II, LLC                                                                                                |
| 10.11* |   | Fee Waiver Letter, dated April 15, 2005, between  KKR Financial CLO 2005-1, Ltd., KKR Financial Advisors II, LLC and  JPMorgan Chase Bank, N.A.                                                                                         |
| 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                                                                                                                                                                                        |

----

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

**             Filedherewith.

50

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, KKR Financial Corp. has duly caused this report to be signed onits behalf 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/ DAVID A.  NETJES    |          | Chief Financial Officer and Chief Operating Officer    |
| **David  A. Netjes**    |          | (Principal  Financial and Accounting Officer)          |
|                         |               |                                                        |  |  |  |  |

 

Date: November 14, 2005

----