**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

** **

| **ý**                                         | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                               | ** ** | ** **                                                                                              |
| **For the quarterly period ended: March 31, 2006** |
| ** **                                         | ** ** | ** **                                                                                              |
| **OR**                                             |
| ** **                                         | ** ** | ** **                                                                                              |
| **o**                                              | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transitionperiod from                  to                  **

** **

**Commission file number001-32542**

** **

**KKR FINANCIAL CORP.**

**(Exact name of registrant as specified in its governinginstruments)**

 

| 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 telephone number, including area code

** **

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities and Exchange Act of 1934 during the preceding12 months and (2) has been subject to such filing requirements forthe past 90 days. Yes  ý    No  o

 

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

 

Large acceleratedfiler  o          Accelerated filer  o             Non-accelerated filer  ý

 

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

 

The number of shares ofthe registrant’s common stock outstanding as of May 5, 2006 was 80,374,061.

 

 

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** **

**TABLEOF CONTENTS**

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

 

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**PART I. FINANCIAL INFORMATION**

** **

**Item 1. FinancialStatements (Unaudited)**

** **

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

 
| ** **                                                                                                                                               | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| **Assets**                                                                                                                                               | ** ** | ** **          | ** ** | ** **             | ** ** |
| Cash and cash  equivalents                                                                                                                               |       | $                   | 19,853     |                   | $          | 16,110 |   |
| Restricted cash  and cash equivalents                                                                                                                    |       | 127,673             |       | 80,223                 |       |
| Securities  available-for-sale, $6,286,793 and $5,910,399 pledged as collateral as of  March 31, 2006 and December 31, 2005, respectively           |       | 6,842,052           |       | 6,149,506              |       |
| Loans, net of  allowance for loan losses of $1,500 as of March 31, 2006 and  December 31, 2005                                                      |       | 8,521,380           |       | 8,846,341              |       |
| Derivative  assets                                                                                                                                       |       | 103,428             |       | 58,898                 |       |
| Interest  receivable                                                                                                                                     |       | 64,932              |       | 59,993                 |       |
| Principal  receivable                                                                                                                                    |       | 4,513               |       | 7,108                  |       |
| Non-marketable  equity securities                                                                                                                        |       | 101,032             |       | 52,500                 |       |
| Other assets                                                                                                                                             |       | 30,676              |       | 19,861                 |       |
| **Total  assets**                                                                                                                                        |       | $                   | 15,815,539 |                   | $          | 15,290,540 |   |
| **Liabilities**                                                                                                                                          | ** ** | ** **          | ** ** | ** **             | ** ** |
| Repurchase  agreements                                                                                                                                   |       | $                   | 8,774,319  |                   | $          | 9,761,258 |   |
| Collateralized  loan obligation senior secured notes                                                                                                     |       | 1,500,000           |       | 1,500,000              |       |
| Asset-backed  secured liquidity notes                                                                                                                    |       | 3,033,868           |       | 2,008,069              |       |
| Secured  revolving credit facility                                                                                                                       |       | 57,634              |       | 54,000                 |       |
| Secured demand  loan                                                                                                                                     |       | 40,511              |       | 40,511                 |       |
| Junior  subordinated notes                                                                                                                               |       | 51,550              |       | —                 |       |
| Payable for  securities purchases                                                                                                                        |       | 562,555             |       | 196,315                |       |
| Accounts  payable, accrued expenses and other liabilities                                                                                                |       | 62,509              |       | 45,925                 |       |
| Accrued interest  payable                                                                                                                                |       | 21,777              |       | 21,415                 |       |
| Related party  payable                                                                                                                                   |       | 5,180               |       | 3,673                  |       |
| Income tax  liability                                                                                                                                    |       | 1,275               |       | 2,763                  |       |
| Derivative  liabilities                                                                                                                                  |       | 544                 |       | 1,465                  |       |
| **Total  liabilities**                                                                                                                                   |       | 14,111,722          |       | 13,635,394             |       |
| **Stockholders’  Equity**                                                                                                                           | ** ** | ** **          | ** ** | ** **             | ** ** |
| Preferred stock,  $0.01 par value, 50,000,000 shares authorized and none issued and outstanding  at March 31, 2006 and December 31, 2005            |       | —              |       | —                 |       |
| Common stock,  $0.01 par value, 250,000,000 shares authorized and 80,374,061 shares issued  and outstanding at March 31, 2006 and December 31, 2005 |       | 804                 |       | 804                    |       |
| Additional  paid-in-capital                                                                                                                              |       | 1,646,779           |       | 1,639,996              |       |
| Accumulated  other comprehensive income                                                                                                                  |       | 61,994              |       | 18,344                 |       |
| Accumulated  deficit                                                                                                                                     |       | (5,760              | )          | (3,998                 | )          |
| **Total  stockholders’ equity**                                                                                                                     |       | 1,703,817           |       | 1,655,146              |       |
| **Total  liabilities and stockholders’ equity**                                                                                                     |       | $                   | 15,815,539 |                   | $          | 15,290,540 |   |

 

See notes to condensedconsolidated financial statements.

 

2

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

** **
| ** **                                                            | ** ** | **For the three   months ended   March 31, 2006** | ** ** | **For the three   months ended   March 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| **Net investment income:**                                            | ** ** | ** **                                        | ** ** | ** **                                        | ** ** |
| Securities interest income                                            |       | $                                                 | 79,964     |                                              | $          | 23,869 |   |
| Loan interest income                                                  |       | 125,106                                           |       | 10,888                                            |       |
| Dividend income                                                       |       | 883                                               |       | 534                                               |       |
| Other interest income                                                 |       | 1,845                                             |       | 255                                               |       |
| Total investment income                                               |       | 207,798                                           |       | 35,546                                            |       |
| Interest expense                                                      |       | (156,563                                          | )          | (20,449                                           | )          |
| Net investment income                                                 |       | 51,235                                            |       | 15,097                                            |       |
| **Other income:**                                                     | ** ** | ** **                                        | ** ** | ** **                                        | ** ** |
| Net realized and unrealized gain on derivatives and  foreign exchange |       | 10                                                |       | 127                                               |       |
| Net realized gain on investments                                      |       | 1,448                                             |       | 343                                               |       |
| Fee and other income                                                  |       | 215                                               |       | 368                                               |       |
| Total other income                                                    |       | 1,673                                             |       | 838                                               |       |
| **Non-investment expenses:**                                          | ** ** | ** **                                        | ** ** | ** **                                        | ** ** |
| Related party management compensation                                 |       | 14,440                                            |       | 8,008                                             |       |
| Professional services                                                 |       | 947                                               |       | 397                                               |       |
| Loan servicing expense                                                |       | 3,996                                             |       | 267                                               |       |
| Insurance expense                                                     |       | 224                                               |       | 217                                               |       |
| Directors expenses                                                    |       | 373                                               |       | 199                                               |       |
| General and administrative expenses                                   |       | 2,228                                             |       | 619                                               |       |
| Total non-investment expenses                                         |       | 22,208                                            |       | 9,707                                             |       |
| Income before income tax expense                                      |       | 30,700                                            |       | 6,228                                             |       |
| Income tax expense                                                    |       | 312                                               |       | 112                                               |       |
| Net income                                                            |       | $                                                 | 30,388     |                                              | $          | 6,116 |   |
| Net income per common share:                                          |       |                                              |       |                                              |       |
| Basic                                                                 |       | $                                                 | 0.39       |                                              | $          | 0.15 |   |
| Diluted                                                               |       | $                                                 | 0.38       |                                              | $          | 0.15 |   |
| Weighted-average number of common shares  outstanding:                |       |                                              |       |                                              |       |
| Basic                                                                 |       | 77,675                                            |       | 39,796                                            |       |
| Diluted                                                               |       | 79,314                                            |       | 40,301                                            |       |
| Distributions declared per common share                               |       | $                                                 | 0.40       |                                              | $          | — |   |
|                                                                       |            |                                                   |            |                                                   |            |  |  |  |

 

Seenotes to condensed consolidated financial statements.

 

3

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**KKRFinancial Corp. and SubsidiariesCondensed Consolidated Statement of Changes in Stockholders’ Equity(Unaudited)(Amounts in thousands)**

** **
| ** **                                                        | ** ** | **Shares of  Common  Stock** | ** ** | **Common  Stock at  Par  Value** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|-----------------------------------------------|------------|--------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| **Balance  at January 1, 2006**                                   |       | 80,374                            |       | $                                     | 804        |                             | $          | 1,639,996                                     |       | $                        | 18,344     |                                  | $          | (3,998                                | )          |   |   | $ | 1,655,146 |   |
| Net income                                                        |       | —                            |       | —                                |       | —                           |       | —                                        |       | 30,388                   |       | $                                     | 30,388     |                                  | 30,388     |   |
| Net change in  unrealized gain on cash flow hedges                |       | —                            |       | —                                |       | —                           |       | 47,067                                        |       | —                   |       | 47,067                                |       | 47,067                                |       |
| Net change in  unrealized loss on securities available-for-sale   |       | —                            |       | —                                |       | —                           |       | (3,417                                        | )          | —                   |       | (3,417                                | )          | (3,417                                | )          |
| Comprehensive income                                              |       |                              |       |                                  |       |                             |       |                                          |       |                     |       | $                                     | 74,038     |                                  |       |   |
| Cash  distributions on common stock                               |       | —                            |       | —                                |       | —                           |       | —                                        |       | (32,150                  | )          |                                  |       | (32,150                               | )          |
| Amortization of  restricted common stock and common stock options |       | —                            |       | —                                |       | 6,783                            |       | —                                        |       | —                   |       |                                  |       | 6,783                                 |       |
| **Balance  at March 31, 2006**                               |       | 80,374                            |       | $                                     | 804        |                             | $          | 1,646,779                                     |       | $                        | 61,994     |                                  | $          | (5,760                                | )          |   |   | $ | 1,703,817 |   |

 

See notes tocondensed consolidated financial statements.

 

4

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

** **
| ** **                                                                     | ** ** | **Three months ended  March 31, 2006** | ** ** | **Three months ended  March 31, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| **Cash  flows from operating activities:**                                     | ** ** | ** **                             | ** ** | ** **                             | ** ** |
| Net income                                                                     |       | $                                      | 30,388     |                                   | $          | 6,116 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                   |       |                                   |       |
| Unrealized gain  (loss) on derivatives                                         |       | 643                                    |       | (403                                   | )          |
| Unrealized gain  on equity short positions                                     |       | (53                                    | )          | —                                 |       |
| Realized gain  (loss) on foreign currency translation                          |       | (374                                   | )          | 192                                    |       |
| Share-based  compensation                                                      |       | 6,783                                  |       | 4,746                                  |       |
| Net gain on sale  of securities available-for-sale                             |       | (639                                   | )          | (343                                   | )          |
| Net gain on sale  of loans                                                     |       | (810                                   | )          | —                                 |       |
| Depreciation and  net amortization                                             |       | 804                                    |       | 728                                    |       |
| Deferred income  tax (benefit) expense                                         |       | (590                                   | )          | 112                                    |       |
| Changes in  assets and liabilities:                                            |       |                                   |       |                                   |       |
| Interest  receivable                                                           |       | (4,939                                 | )          | (15,014                                | )          |
| Other assets                                                                   |       | (7,009                                 | )          | 1                                      |       |
| Related party  payable                                                         |       | 1,507                                  |       | (38                                    | )          |
| Accounts  payable, accrued expenses and other liabilities                      |       | 15,737                                 |       | (281                                   | )          |
| Accrued interest  payable                                                      |       | 362                                    |       | 3,536                                  |       |
| Net cash  provided by (used in) operating activities                           |       | 41,810                                 |       | (648                                   | )          |
| **Cash  flows from investing activities:**                                     | ** ** | ** **                             | ** ** | ** **                             | ** ** |
| Purchase of  securities available-for-sale                                     |       | (833,894                               | )          | (3,437,355                             | )          |
| Principal  payments on securities available-for-sale                           |       | 495,160                                |       | 103,454                                |       |
| Proceeds from  sale of securities available-for-sale                           |       | 13,638                                 |       | 9,921                                  |       |
| Purchase of  loans                                                             |       | (638,449                               | )          | (695,309                               | )          |
| Principal  payments on loans                                                   |       | 858,254                                |       | 64,059                                 |       |
| Proceeds from  sale of loans                                                   |       | 104,714                                |       | —                                 |       |
| Purchases of  non-marketable equity securities                                 |       | (50,930                                | )          | —                                 |       |
| Payments on  non-marketable equity securities                                  |       | 2,405                                  |       | —                                 |       |
| Proceeds from sale  of derivatives                                             |       | 973                                    |       | —                                 |       |
| Net additions to  restricted cash and cash equivalents                         |       | (47,449                                | )          | (350,875                               | )          |
| Addition of  leasehold improvements and equipment                              |       | (2,701                                 | )          | (109                                   | )          |
| Net cash used in  investing activities                                         |       | (98,279                                | )          | (4,306,214                             | )          |
| **Cash  flows from financing activities:**                                     | ** ** | ** **                             | ** ** | ** **                             | ** ** |
| Proceeds from  borrowings:                                                     |       |                                   |       |                                   |       |
| Repurchase  agreements                                                         |       | 29,203,926                             |       | 15,452,632                             |       |
| Asset-backed  secured liquidity notes                                          |       | 8,090,097                              |       | —                                 |       |
| Collateralized  loan obligation senior secured notes                           |       | —                                 |       | 666,021                                |       |
| Secured  revolving credit facility                                             |       | 100,000                                |       | —                                 |       |
| Secured demand  loan                                                           |       | —                                 |       | 9,000                                  |       |
| Junior  subordinated notes                                                     |       | 50,000                                 |       | —                                 |       |
| Other  capitalized costs                                                       |       | (2,876                                 | )          | —                                 |       |
| Purchase of  interest rate derivatives                                         |       | —                                 |       | (10,072                                | )          |
| Repayments of  borrowings:                                                     |       |                                   |       |                                   |       |
| Repurchase  agreements                                                         |       | (30,190,865                            | )          | (11,764,847                            | )          |
| Asset-backed  secured liquidity notes                                          |       | (7,061,554                             | )          | —                                 |       |
| Secured  revolving credit facility                                             |       | (96,366                                | )          | —                                 |       |
| Distributions on  common stock                                                 |       | (32,150                                | )          | —                                 |       |
| Net cash  provided by financing activities                                     |       | 60,212                                 |       | 4,352,734                              |       |
| **Net  increase in cash and cash equivalents**                                 |       | 3,743                                  |       | 45,872                                 |       |
| **Cash  and cash equivalents at beginning of period**                          |       | 16,110                                 |       | 7,219                                  |       |
| **Cash  and cash equivalents at end of period**                                |       | $                                      | 19,853     |                                   | $          | 53,091 |   |
| **Supplemental  cash flow information:**                                       | ** ** | ** **                             | ** ** | ** **                             | ** ** |
| Cash paid for  interest                                                        |       | $                                      | 156,201    |                                   | $          | 16,993 |   |
| Cash paid for  taxes                                                           |       | $                                      | 1,838      |                                   | $          | — |   |
| **Non-cash  investing and financing activities:**                              | ** ** | ** **                             | ** ** | ** **                             | ** ** |
| Unsettled  securities trades                                                   |       | $                                      | 562,555    |                                   | $          | — |   |

 

Seenotes to condensed consolidated financial statements.

 

5

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**KKR Financial Corp. andSubsidiaries**

 

**Notes to Condensed ConsolidatedFinancial Statements (Unaudited)**

 

**Note 1.Organization**

** **

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

 

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

 

OnAugust 12, 2004, the Company completed its initial private placement ofshares of its common stock at $20.00 per share that generated net proceeds ofapproximately $755.5 million. On June 29, 2005, the Company completedits initial public offering (the “IPO”) of 37,500,000 shares of common stockthat generated net proceeds of approximately $848.8 million. The Companysold 37,471,250 common shares at a price of $24.00 per share and sellingstockholders sold 28,750 shares. On June 23, 2005 the Company effectuateda reverse stock split of its common stock at a ratio of one share of commonstock for every two shares of common stock then outstanding. The accompanyingconsolidated financial statements have been adjusted to give effect to thereverse stock split for all periods presented. The Company’s stock is listed onthe New York Stock Exchange under the symbol “KFN” and began trading onJune 24, 2005.

 

**Note 2.Summary of Significant Accounting Policies**

** **

**Basisof Presentation**

** **

The accompanying condensedconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America (“GAAP”).The consolidated financial statements include the accounts of the Company andits taxable REIT subsidiaries: KKR TRS Holdings, Inc. (“KKR TRS”); KKRFinancial CLO 2005-1, Ltd. (“CLO 2005-1”); KKR Financial CLO 2005-2, Ltd.(“CLO 2005-2”); KKR Financial CLO 2006-1, Ltd. (“CLO 2006-1”), andKKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”). The Company intends tomake a taxable REIT subsidiary election with respect to KKR Financial CLO 2006-2,Ltd. (“CLO 2006-2”) in the future. KKR TRS was formed to make, from time totime, certain investments that would not be REIT qualifying investments if madedirectly by the Company, and to earn income that would not be REIT qualifyingincome if earned directly by the Company. CLO 2005-1, CLO 2005-2,CLO 2006-1, and CLO 2006-2 are entities established to executecollateralized loan obligation (“CLO”) secured financing transactions. CDO 2005-1is an entity established to complete a collateralized debt obligation (“CDO”)secured financing transaction. The consolidated financial statements alsoinclude the accounts of the Company’s qualified REIT subsidiaries: KKRFinancial Mortgage Corp. (“KKR Mortgage”); KKR QRS #1, Inc. (“KKR QRS”);KKR Pacific Funding Trust and KKR Pacific Funding Depositor Corporation(collectively, “KKR Pacific”); and KKR Atlantic Funding Trust and KKR AtlanticFunding Depositor Corporation (collectively, “KKR Atlantic”). KKR Mortgage wasformed to sell, from time to time, the Company’s whole loan mortgage pools inresidential mortgage-backed securitization (“RMBS”) transactions. KKR QRS wasformed to hold the residual interests in RMBS transactions structured as realestate mortgage investment conduits (“REMICs”) for tax purposes. KKR Pacific andKKR Atlantic were formed to finance the Company’s RMBS investments through theissuance of asset-backed secured liquidity notes. The term “Company” refers tothese entities collectively, unless otherwise noted. The entities consolidatedby the Company are either wholly-owned subsidiaries or entities established tocomplete secured financing transactions that are considered to be variableinterest entities and for which the Company is the primary beneficiary. Foradditional information, see “Consolidation” below. Certain amounts for priorperiods have been reclassified to conform to the current****presentation.

 

6

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**Useof Estimates**

** **

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

 

**Consolidation**

** **

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

 

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

 

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

 

**Cashand Cash Equivalents**

** **

Cash and cashequivalents include cash on hand, cash held in banks and highly liquidinvestments with original maturities of three months or less. Interest incomeearned on cash and cash equivalents is recorded in other interest income.

 

**RestrictedCash and Cash Equivalents**

** **

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

 

**SecuritiesAvailable-for-Sale**

** **

The Company classifiesits investments in securities as available-for-sale as the Company may sellthem prior to maturity and does not hold them principally for the purpose ofselling them in the near term. These investments are carried at estimated fairvalue, with unrealized gains and losses reported in accumulated othercomprehensive income. Estimated fair values are based on quoted market prices,when available, or on estimates provided by independent pricing sources ordealers who make markets in such securities. Upon the sale of a security, therealized net gain or loss is computed 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-

 

7

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than-temporary. TheCompany considers many factors in determining whether the impairment of asecurity is deemed to be other-than-temporary, including but not limited to thelength of time the security has had a decline in estimated fair value below itsamortized cost, the amount of the unrealized loss, the intent and ability ofthe Company to hold the security for a period of time sufficient for a recoveryin value, recent events specific to the issuer or industry, external creditratings and recent changes in such ratings.

 

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

 

**Non-marketableEquity Securities**

** **

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

 

**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 may decrease, the Company may electto 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.

 

Interest income on loansincludes interest at stated coupon rates adjusted for accretion of purchasediscounts and the amortization of purchase premiums. For corporate and commercialreal estate loans, unamortized premiums and discounts are recognized ininterest income over the contractual life, adjusted for actual prepayments, ofthe loans using the effective interest method. For residential mortgage loans,unamortized premiums and discounts are recognized over the contractual life,adjusted for estimated prepayments using the effective interest method.

 

**Allowanceand Provision for Loan Losses**

** **

The Company maintains anallowance for loan losses at a level that management considers adequate basedon an evaluation of known and inherent risks in the loan portfolio, includinghistorical and industry loss experience, economic conditions and trends,estimated fair values and the quality of collateral, estimated fair values ofthe loans and other relevant factors.

 

8

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Toestimate the allowance for loan losses, the Company first identifies impairedloans. Loans are generally evaluated for impairment individually, but loanspurchased on a pooled basis with relatively smaller balances and substantiallysimilar characteristics may be evaluated collectively for impairment. TheCompany considers a loan to be impaired when, based on current information andevents, management believes it is probable that the Company will be unable tocollect all amounts due pursuant to the contractual terms of the loanagreement. When a loan is impaired, the allowance for loan losses is increasedby the amount of the excess of the amortized cost basis of the loan over itsestimated fair value. Estimated fair value may be determined based on(i) observable market quotes; (ii) the estimated sales price of thecollateral less estimated disposition costs; or (iii) the present value ofprojected future net cash flows. Increases in the allowance for loan losses arerecognized in the statements of operations as a provision for loan losses. Acharge-off or write-down of a loan is recorded, and the allowance for loanlosses is reduced, when the loan or a portion thereof is considereduncollectible and of such little value that further pursuit of collection isnot warranted.

 

Animpaired loan may be left on accrual status during the period the Company ispursuing repayment of the loan; however, the loan is placed on non-accrual statusat such time as: (i) management believes that scheduled debt servicepayments will not be met within the coming 12 months; (ii) the loanbecomes 90 days delinquent; (iii) management determines the borroweris incapable of, or has ceased efforts toward, curing the cause of theimpairment; or (iv) the net realizable value of the underlying collateralsecuring the loan approximates the Company’s carrying value of such loan. Whileon non-accrual status, previously recognized accrued interest is reversed andinterest income is recognized only upon actual receipt.

 

**LeaseholdImprovements and Equipment**

** **

Leasehold improvementsand equipment are carried at cost less depreciation and amortization andreviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of the assets might not be recoverable. Equipment isdepreciated using the straight-line method over the estimated useful lives ofthe respective assets of three years. Leasehold improvements are amortized on astraight-line basis over the shorter of their estimated useful lives or leaseterms. Leasehold improvements 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, asset-backed secured liquidity notes, warehouse facilities, demandloans, and other secured and unsecured borrowings. The Company recognizesinterest expense on all borrowings on an accrual basis.

 

**TrustPreferred Securities**

 

In March 2006, theCompany formed KKR Financial Capital Trust I (the “Trust”) for the sole purposeof issuing trust preferred securities. In accordance with FIN 46R, the Trust isnot consolidated by the Company as the Company has determined that it is notthe primary beneficiary of the Trust. The Company owns 100% of the common equityof the Trust, which also issued $50.0 million of preferred securities tounaffiliated investors. The Company’s $1.55 million investment in the commonshares of the Trust is included in other assets on the Company’s consolidatedfinancial statements.

 

9

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**DerivativeFinancial Instruments**

** **

The Company recognizesall derivatives on the consolidated balance sheet at estimated fair value. Inaccordance with SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, as amended andinterpreted, the Company designates and documents each derivative contract asone of the following at the time the contract is executed: (i) a hedge ofa recognized asset or liability or an unrecognized firm commitment; (ii) ahedge of a forecasted transaction or of the variability of cash flows to bereceived or paid related to a recognized asset or liability; (iii) a hedgeof a net investment in a foreign operation; or (iv) a derivativeinstrument not designated as a hedging instrument.

 

Inaccordance with SFAS No. 133, the Company designates certain of itsderivative instruments as cash flow hedges and formally documents its hedgerelationships, including identification of the hedging instruments and thehedged items, as well as its risk management objectives and strategies forundertaking the hedge transaction, prior to the execution of the derivativecontract. The Company assesses the effectiveness of the hedge both at inceptionand on an on-going basis and determines whether the hedge is highly effectivein offsetting changes in cash flows of the hedged item. The Company records theeffective portion of changes in the estimated fair value of the cash flowhedges in accumulated other comprehensive income and subsequently reclassifiesthe related amount of accumulated other comprehensive income to earnings in theconsolidated statements of operations when the hedging relationship isterminated. If it is determined that a derivative has ceased to be a highlyeffective hedge, the Company will discontinue hedge accounting for suchtransaction. For derivatives that are not designated as hedges (“free-standingderivatives”), all changes in estimated fair value are recognized in theconsolidated statements of operations.

 

**ForeignCurrency**

** **

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

 

**ManagerCompensation**

** **

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-BasedPayments**

** **

The Company accounts forshare-based compensation issued to its Directors and to its Manager using thefair value based methodology prescribed by SFAS No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”).Compensation cost related to restricted common stock issued to the Company’sDirectors is measured at its estimated fair value at the grant date, and isamortized and expensed over the vesting period on a straight-line

 

10

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basis. Compensation costrelated to restricted common stock and common stock options issued to theManager is initially measured at estimated fair value at the grant date, and isremeasured on subsequent dates to the extent the awards are unvested. TheCompany has elected to use the graded vesting attribution method pursuant toSFAS No. 123(R) to amortize compensation expense for the restrictedcommon shares and common stock options granted to the Manager.

 

**IncomeTaxes**

** **

The Company has electedto be taxed as a REIT and is required to comply with the provisions of the Codewith respect thereto. Accordingly, the Company is not subject to federal incometax to the extent that its distributions to stockholders satisfy the REITrequirements and certain asset, income and ownership tests and recordkeepingrequirements are fulfilled. Even though the Company qualifies for federaltaxation as a REIT, it may be subject to some amount of federal, state, localand foreign taxes based on the Company’s taxable income.

 

KKR TRS, CLO 2005-1, CLO2005-2, CLO 2006-1, CLO 2006-2 and CDO 2005-1 are not consolidated for federalincome tax return purposes. For financial reporting purposes, current anddeferred taxes are provided for on the portion of earnings recognized by theCompany with respect to its interest in KKR TRS, a domestic taxable REITsubsidiary, because it is taxed as a regular subchapter C corporation under theprovisions of the Code. Deferred income tax assets and liabilities are computedbased on temporary differences between the GAAP consolidated financialstatements and the federal income tax basis of assets and liabilities as ofeach consolidated balance sheet date. CLO 2005-1, CLO 2005-2, CLO 2006-1and CDO 2005-1, the Company’s foreign taxable REIT subsidiaries, and CLO2006-2, which will elect to be a taxable REIT subsidiary in the future, 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 no provisionfor income taxes for the three months ended March 31, 2006 is required;however, the Company will generally be required to include their currenttaxable income in its calculation of REIT taxable income.

 

**EarningsPer Share**

** **

In accordance with SFASNo. 128, *Earnings per Share*,the Company presents both basic and diluted earnings per common share (“EPS”)in its consolidated financial statements and footnotes thereto. Basic earningsper common share (“Basic EPS”) excludes dilution and is computed by dividingnet income or loss allocable to common stockholders by the weighted averagenumber of common shares, including vested restricted common shares, outstandingfor the period. Diluted earnings per share (“Diluted EPS”) reflects thepotential dilution of common stock options and unvested restricted commonstock, if they are not anti-dilutive. See Note 3 for earnings per commonshare computations.

 

11

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**RecentAccounting Pronouncements**

 

In February 2006,the FASB issued SFAS No. 155, *Accounting for CertainHybrid Financial Instruments*. Key provisions of SFAS No. 155include: (1) a broad fair value measurement option for certain hybridfinancial instruments that contain an embedded derivative that would otherwiserequire bifurcation; (2) clarification that only the simplest separationsof interest payments and principal payments qualify for the exception affordedto interest-only strips and principal-only strips from derivative accountingunder paragraph 14 of SFAS No. 133 (thereby narrowing such exception);(3) a requirement that beneficial interests in securitized financialassets be analyzed to determine whether they are freestanding derivatives orwhether they are hybrid instruments that contain embedded derivatives requiringbifurcation; (4) clarification that concentrations of credit risk in theform of subordination are not embedded derivatives; and (5) elimination ofthe prohibition on a QSPE holding passive derivative financial instruments thatpertain to beneficial interests that are or contain a derivative financialinstrument. In general, these changes will reduce the operational complexityassociated with bifurcating embedded derivatives, and increase the number ofbeneficial interests in securitization transactions, including interest-onlystrips and principal-only strips, required to be accounted for in accordancewith SFAS No. 133. The Company is required to adopt SFAS 155 in the firstquarter of 2007. The Company does not expect that the adoption of SFASNo. 155 will have a material effect on its consolidated financialstatements.

 

**Note 3.Earnings per Share**

** **

The Company calculatesbasic net income per common share by dividing net income for the period by theweighted-average shares of its common stock outstanding for the period. Dilutednet income per common share takes into account the effect of dilutiveinstruments, such as common stock options and unvested restricted common stock,but uses the average share price for the period in determining the number ofincremental shares that are to be added to the weighted-average number ofshares of its common stock outstanding. The following table presents areconciliation of basic and diluted net income per common share for the threemonths ended March 31, 2006 and 2005 (amounts in thousands, except per shareinformation):

 

12

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| ** **                                                                | ** ** | **Three months ended   March 31, 2006** | ** ** | **Three months ended   March 31, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| **Basic:**                                                                | ** ** | ** **                              | ** ** | ** **                              | ** ** |
| Net income                                                                |       | $                                       | 30,388     |                                    | $          | 6,116 |   |
| Weighted-average number of common shares outstanding                      |       | 77,675                                  |       | 39,796                                  |       |
| Basic net income per common share                                         |       | $                                       | 0.39       |                                    | $          | 0.15 |   |
| **Diluted:**                                                              | ** ** | ** **                              | ** ** | ** **                              | ** ** |
| Net income                                                                |       | $                                       | 30,388     |                                    | $          | 6,116 |   |
| Weighted-average number of common shares outstanding                      |       | 77,675                                  |       | 39,796                                  |       |
| Plus: Incremental shares from assumed conversion of  dilutive instruments |       | 1,639                                   |       | 505                                     |       |
| Adjusted weighted-average number of common shares  outstanding            |       | 79,314                                  |       | 40,301                                  |       |
| Diluted net income per common share                                       |       | $                                       | 0.38       |                                    | $          | 0.15 |   |

** **

**Note 4. Securities Available-for-Sale**

** **

The following tablesummarizes the Company’s securities classified as available-for-sale as ofMarch 31, 2006, which are carried at estimated fair value (amounts inthousands):

 
| **Description**                        | ** ** | **Amortized  Cost** | ** **      | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Estimated  Fair Value** | ** **    |
|----------------------------------------|------------|---------------------|-----------------|------------------------------|------------|---------------------------------|------------|--------------------------------|---------------|
| Residential mortgage-backed securities |       | $                   |  6,158,177 |                         | $          |  13,140                    |       | $                              |  (56,443 | ) | $ |  6,114,874 |   |
| Commercial mortgage-backed securities  |       | 69,815              |            | 341                          |       | (178                            | )          | 69,978                         |          |
| Asset-backed securities                |       | 21,629              |            | 71                           |       | —                          |       | 21,700                         |          |
| Corporate securities                   |       | 566,529             |            | 16,622                       |       | (3,972                          | )          | 579,179                        |          |
| Common and preferred stock             |       | 56,534              |            | 485                          |       | (698                            | )          | 56,321                         |          |
| Total                                  |       | $                   |  6,872,684 |                         | $          |  30,659                    |       | $                              |  (61,291 | ) | $ |  6,842,052 |   |

 

The following table showsthe gross unrealized losses and fair value of the Company’s securitiesinvestments, aggregated by length of time that the individual securities havebeen in a continuous unrealized loss position, at March 31, 2006:

 
| ** **                              | ** ** | **Less Than 12 months** | ** ** | **12 Months or More** | ** ** | **Total**      | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------|------------|----------------|------------|
| **Description**                         | ** ** | **Fair Value**          | ** ** | **Unrealized Loss**   | ** ** | **Fair Value** | ** ** | **Unrealized Loss** | ** ** | **Fair Value** | ** ** | **Unrealized Loss** | ** ** |
| Residential  mortgage-backed securities |       | $                       | 457,885    |                  | $          | (629           | )          | $ | 2,061,131 |   | $ | (55,814 | ) | $ | 2,519,016 |   | $ | (56,443 | ) |
| Commercial  mortgage-backed securities  |       | 41,315                  |       | (178                  | )          | —         |       | — |   | 41,315 |   | (178 | ) |
| Corporate  securities                   |       | 89,846                  |       | (3,972                | )          | —         |       | — |   | 89,846 |   | (3,972 | ) |
| Common and  preferred stock             |       | 17,129                  |       | (698                  | )          | —         |       | — |   | 17,129 |   | (698 | ) |
| Total                                   |       | $                       | 606,175    |                  | $          | (5,477         | )          | $ | 2,061,131 |   | $ | (55,814 | ) | $ | 2,667,306 |   | $ | (61,291 | ) |
|                                         |            |                         |            |                       |            |                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

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

 

All securities in anunrealized loss position at December 31, 2005 have been in an unrealizedloss position for less than one year.

 

13

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During the three monthsended March 31, 2006, the Company’s gross realized gains from the sales ofsecurities were $0.6 million. The Company had gross realized losses of eleventhousand from the sales of securities during the three months ended March 31,2006. In the three months ended March 31, 2005, the Company’s grossrealized gains from the sales of securities were $0.3 million. The Company hadno gross realized losses from the sales of securities during the three monthsended March 31, 2005.

 

Note 6 to theseconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged securities available-for-sale for borrowingsunder repurchase agreements, asset-backed secured liquidity notes, and allother secured financing transactions. The following table summarizes theestimated fair value of securities pledged as collateral under repurchaseagreements, asset-backed secured liquidity notes, and all other securedfinancing transactions as of March 31, 2006:

 
| **(amounts in thousands)**                                           | ** ** | **Residential  Mortgage-Backed  Securities** | ** ** | **Commercial  Mortgage-Backed  Securities** | ** ** | **Corporate  Securities(1)** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                                            | 4,485,502  |                                        | $          | 258,884                      |       | $ | 384,982 |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       | 920,486                                      |       | —                                      |       | —                       |       |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —                                       |       | —                                      |       | 7,466                        |       |
| Pledged as  collateral for borrowings under secured demand loan                |       | —                                       |       | 45,387                                      |       | —                       |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —                                       |       | 5,014                                       |       | 179,072                      |       |
| Total                                                                          |       | $                                            | 5,405,988  |                                        | $          | 309,285                      |       | $ | 571,520 |   |

 

The following tablesummarizes the estimated fair value of securities pledged as collateral underrepurchase agreements, asset-backed secured liquidity notes, and all othersecured financing transactions as of December 31, 2005:

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

 

----

(1)             Includesasset-backed securities.

 

14

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**Note 5.Loans**

** **

The following tablesummarizes the Company’s loans as of March 31, 2006 (amounts in thousands):

 
| ** **                                                | ** ** | **Principal** | ** ** | **Unamortized  Premium/(Discount)** | ** ** | **Net  Amortized Cost** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|-------------------------|------------|
| Residential mortgage loans                                |       | $             | 6,120,533  |                                | $          | 21,791                  |       | $ | 6,142,324 |   |
| Corporate loans                                           |       | 2,069,452     |       | (3,313                              | )          | 2,066,139               |       |
| Commercial real estate loans                              |       | 315,442       |       | (1,025                              | )          | 314,417                 |       |
| Allowance for loan losses for residential mortgage  loans |       | (1,500        | )          | —                              |       | (1,500                  | )          |
| Total loans held  for investment                          |       | 8,503,927     |       | 17,453                              |       | 8,521,380               |       |
| Loans held for sale                                       |       | —        |       | —                              |       | —                  |       |
| Total loans, net  of allowance for loan losses            |       | $             | 8,503,927  |                                | $          | 17,453                  |       | $ | 8,521,380 |   |

 

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

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

 

15

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**During the year ended December 31, 2005, the Companypurchased $5.9 billion of securities in connection with five securitizationtransactions backed by $4.5 billion of residential hybrid ARM loans and $1.4billion of residential ARM loans. In each of the five securitizationtransactions, the Company purchased all of the securities issued, including thesubordinate classes. Included in the $5.9 billion of securities purchased were$0.4 billion of loans contributed to the securitization transactions by theCompany, resulting in a net purchase by the Company of $5.5 billion ofsecurities. Of the $5.9 billion of securities purchased, approximately 96% wererated AAA by Standard & Poor’s Ratings Service or Standard &Poor’s. Each of the special-purpose entities that issued the securities are notconsidered qualifying special-purpose entities as defined by SFAS No. 140and are treated as VIEs under FIN 46R. The Company has determined that it isthe primary beneficiary of each of the special-purpose entities that issued thesecurities; accordingly, the Company recorded its investments as loans and notsecurities.**

** **

**During September 2005, the Company securitized $959.2million of residential ARM loans and retained all of the securities issued inthe securitization transaction, including the subordinate classes. While theCompany retained all of the securities, which are legal assets of the Company,the loans transferred in this securitization are owned by a special purposeentity and the loans are not available to the Company, its creditors orstockholders. Of the $959.2 million of securities issued, approximately $908.8million, or 95%, were rated AAA by Standard & Poor’s. While theCompany transferred the loans to a separate bankruptcy-remote legal entity, theCompany did not account for the transaction as a sale as the securitizationtransaction did not meet the criteria for sales treatment under SFASNo. 140. Accordingly, the Company did not record a gain or loss inconnection with the securitization transaction and accounts for the transferredassets as loans on its consolidated balance sheet.**

** **

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

 
| **Delinquency Status** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       | 79                            |       | $                         | 39,408     |   |
| 60 to 89 days               |       | 5                             |       | 2,001                     |       |
| 90 days or more             |       | 6                             |       | 1,424                     |       |
| In foreclosure              |       | 5                             |       | 1,211                     |       |
| Total                       |       | 95                            |       | $                         | 44,044     |   |

                       

The following tablesummarizes the delinquency statistics of residential mortgage loans as ofDecember 31, 2005 (dollar amounts in thousands):

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

 

No corporate loans orcommercial real estate loans were delinquent as of March 31, 2006 orDecember 31, 2005.

 

16

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The following tablesummarizes the changes in the allowance for loan losses for the Company’sresidential mortgage loan portfolio during the three months ended March 31,2006 (amounts in thousands):

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

** **

As of March 31, 2006 andDecember 31, 2005, the Company had not recorded an allowance for loanlosses for its commercial real estate or corporate loan portfolios. Inreviewing the Company’s portfolio of commercial real estate loans and corporateloans, the Company determined that no loans were impaired as of March 31,2006 or December 31, 2005.

 

Note 6 to theseconsolidated financial statements describes the Company’s borrowings underwhich the Company has pledged loans for borrowings under repurchase agreements,asset-backed secured liquidity notes, and all other secured financingtransactions. The following table summarizes the carrying value of loanspledged as collateral under repurchase agreements, asset-backed securedliquidity notes, and all other secured financing transactions as of March 31,2006:

 
| **(amounts in thousands)**                                           | ** ** | **Residential  Mortgage Loans** | ** ** | **Corporate Loans** | ** ** | **Commercial Real  Estate Loans** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|
| Pledged as  collateral for borrowings under repurchase agreements              |       | $                                    | 3,831,250  |                     | $          | 241,609                                     |       | $ | 258,884 |   |
| Pledged as  collateral for asset-backed secured liquidity notes                |       | 2,192,394                            |       | —                   |       | —                                      |       |
| Pledged as  collateral for borrowings under secured revolving credit facility  |       | —                               |       | 88,470                   |       | —                                      |       |
| Pledged as  collateral for collateralized loan obligation senior secured notes |       | —                               |       | 1,658,679                |       | 55,533                                      |       |
| Total                                                                          |       | $                                    | 6,023,644  |                     | $          | 1,988,758                                   |       | $ | 314,417 |   |

 

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

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

 

17

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**Note 6. Borrowings**

** **

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

 

Certain information withrespect to the Company’s borrowings as of March 31, 2006 is summarized in thefollowing table (amounts in thousands):

 
| ** **                           | ** ** | **Outstanding  Borrowings** | ** ** | **Weighted  Average  Borrowing  Rate** | ** ** | **Weighted  Average  Remaining  Maturity  (in days)** | ** ** | **Fair Value  of Collateral (1)** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Repurchase agreements                |       | $                           | 8,184,096  |                                   | 4.87       | %                                                          | 23         |                                             | $          | 8,340,852 |   |
| Demand loan                          |       | 40,511                      |       | 5.38                                   |       | 15                                                         |       | 45,387                                           |       |
| Secured revolving credit facility    |       | 57,634                      |       | 5.63                                   |       | 15                                                         |       | 96,081                                           |       |
| Asset-backed secured liquidity notes |       | 3,033,868                   |       | 4.77                                   |       | 16                                                         |       | 3,100,902                                        |       |
| CLO 2005-1 senior secured notes      |       | 773,000                     |       | 4.91                                   |       | 4,044                                                      |       | 975,103                                          |       |
| CLO 2005-2 senior secured notes      |       | 727,000                     |       | 5.07                                   |       | 4,258                                                      |       | 940,434                                          |       |
| CLO 2006-1 repurchase agreements     |       | 401,238                     |       | 5.35                                   |       | 67                                                         |       | 622,241                                          |       |
| CDO 2005-1 repurchase agreements     |       | 188,985                     |       | 5.88                                   |       | 20                                                         |       | 274,466                                          |       |
| Junior subordinated notes            |       | 51,550                      |       | 7.64                                   |       | 10,980                                                     |       | —                                           |       |
| Total                                |       | $                           | 13,457,882 |                                   |       |                                                       |       |                                             | $          | 14,395,466 |   |

 

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

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

 

----

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

 

18

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

 

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

 

During April 2005the Company formed CDO 2005-1 and began borrowing on a $300.0 millionwarehouse facility, in the form of a repurchase agreement, to purchasecommercial real estate obligations. The repurchase facility bears interest at arate of 30-day LIBOR plus 1.10% and as of March 31, 2006, there was $189.0million outstanding.

 

During June 2005,the Company entered into a $275.0 million secured revolving creditfacility. This revolving credit facility matures on June 30, 2006, and, asof March 31, 2006, the Company had $57.6 million of borrowingsoutstanding. The revolving credit facility bears interest at 30-day LIBORplus 1.00%.

 

On September 30,2005, the Company closed a $5.0 billion asset-backed secured liquiditynote facility. This facility provides the Company with an alternative source offunding its residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard &Poor’s, Moody’s Investors Service, or Moody’s, and Fitch Inc., respectively.Issuances of asset-backed secured liquidity notes are recorded as borrowings onthe Company’s consolidated balance sheet. At March 31, 2006, the Company had$3.0 billion of asset-backed secured liquidity notes outstanding.

 

On November 3,2005, the Company closed CLO 2005-2, its second $1.0 billion CLO transactionthat provides financing for investments consisting of corporate loans andcertain other loans and securities. The investments that are owned by CLO 2005-2collateralize the CLO 2005-2 debt, and as a result, those investments are notavailable to the Company, its creditors or stockholders. CLO 2005-2 issued atotal of $752.0 million of senior secured notes at par to investors. Inaddition, the Company retained $168.0 million of rated mezzanine notes and$98.5 million of unrated subordinate notes issued by CLO 2005-2.

 

The senior notes issuedto investors by CLO 2005-2 consist of three classes of notes as follows:(i) $545.0 million of class A-1 notes bearing interest atthree-month LIBOR plus 0.26%; (ii) $57.0 million of class B notesbearing interest at three-month LIBOR plus 0.43%; and(iii) $150.0 million of class A-2 Delayed Draw notes bearinginterest on the drawn amount at three-month LIBOR plus 0.26% (at March 31, 2006,$125.0 million of the delayed draw notes were drawn). All of the notes issuedmature on November 26, 2017, though the Company has the right to call thenotes at par any time after November 2009.

 

During 2005, the Companyformed CLO 2006-1 and during December 2005 executed a $500.0 millionwarehouse facility, in the form of a repurchase agreement, to finance thepurchase of corporate loans and certain other loans and securities. Therepurchase facility bears interest at a rate of 30-day LIBOR plus 0.65% and asof March 31, 2006, there was****$290.3 millionoutstanding. Additionally, CLO 2006-1 had $110.9 million outstanding under aseparate repurchase agreement from the repurchase facility as of March 31,2006. Also during December 2005, the Company formed CLO 2006-2 andexecuted a $450.0 million warehouse facility, in 

 

19

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the form of a repurchaseagreement, to finance the purchase of corporate loans and certain other loansand securities. The repurchase facility bears interest at a rate of 30-dayLIBOR plus 0.65% and as of March 31, 2006, there were no borrowingsoutstanding.

 

During March 2006, theCompany formed KKR Financial Capital Trust I (the “Trust”) for the sole purposeof issuing trust preferred securities. On March 28, 2006, the Trust issuedpreferred securities to unaffiliated investors for gross proceeds of $50.0million and common securities to the Company for $1.6 million. The combinedproceeds were invested by the Trust in $51.6 million of junior subordinated notesissued by the Company. The junior subordinated notes are the sole assets of theTrust and mature on April 30, 2036, but are callable on or after April 30,2011. Interest is payable quarterly at a fixed rate of 7.635% (ten-year LIBORplus 2.45%) through March 2016 and thereafter at a floating rate equal tothree-month LIBOR plus 2.65%.

 

On March 30, 2006, theCompany closed its second $5.0 billion asset-backed secured liquidity notefacility. This facility provides the Company with an alternative source offunding its residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard & Poor’s,Moody’s, and Fitch Inc., respectively. At March 31, 2006, the Company had noborrowings outstanding under this facility.

 

**Note 7.Derivative Financial Instruments**

** **

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

 

20

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**KKR Financial Corp. andSubsidiaries**

**Notes to Consolidated FinancialStatements (Continued)**

 

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

 
| ** **                      | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| **Cash  Flow Hedges:**          |       |                                     |       |                                        |       |
| Interest rate  corridors        |       | $                                        | 19,766     |                                        | $          | 14,762 |   |
| Interest rate  swaps            |       | 82,893                                   |       | 40,796                                      |       |
| **Free-Standing  Derivatives:** |       |                                     |       |                                        |       |
| Interest rate  swaptions        |       | 200                                      |       | 879                                         |       |
| Interest rate  swaps            |       | —                                   |       | 198                                         |       |
| Credit default  swaps           |       | 347                                      |       | 71                                          |       |
| Total rate of  return swaps     |       | (322                                     | )          | 727                                         |       |
| Net fair value                  |       | $                                        | 102,884    |                                        | $          | 57,433 |   |

 

**Note 8.Accumulated Other Comprehensive Income**

** **

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

 
| ** **                                              | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Net unrealized  losses on available-for-sale securities |       | $                                        | (30,632    | )                                           | $          | (27,215 | ) |
| Net unrealized  gains on cash flow hedges               |       | 92,626                                   |       | 45,559                                      |       |
| Accumulated  other comprehensive income                 |       | $                                        | 61,994     |                                        | $          | 18,344 |   |

 

 

21

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

 
| ** **                                                              | ** ** | **Three months  ended March 31,  2006** | ** ** | **Three months  ended March 31,  2005** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Unrealized gains  on securities available-for-sale:                     |       |                                                   |       |                                                   |       |
| Unrealized  holding losses arising during period                        |       | $                                                      | (4,056     | )                                                      | $          | (37,056 | ) |
| Reclassification  adjustments for gains (losses) realized in net income |       | 639                                                    |       | (343                                                   | )          |
| Unrealized  losses on securities available-for-sale                     |       | (3,417                                                 | )          | (37,399                                                | )          |
| Unrealized gains  on cash flow hedges                                   |       | 47,067                                                 |       | 15,220                                                 |       |
| Other  comprehensive income (loss)                                      |       | $                                                      | 43,650     |                                                   | $          | (22,179 | ) |

 

**Note 9.Stock Options and Restricted Stock**

** **

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

 

Theexercise price for any stock option granted under the 2004 Stock Incentive Planmay not be less than 100% of the fair market value of the shares of commonstock at the time the common stock option is granted. Each common stock optionmust terminate no more than ten years from the date it is granted. The 2004Stock Incentive Plan, as amended, authorizes that a total of 7,964,625 sharesmay be used to satisfy awards under the 2004 Stock Incentive Plan. The Companymade its initial grants under the 2004 Stock Incentive Plan on August 12,2004, and August 19, 2004, the dates that the Company closed its initialprivate placement of common stock and the date that the over-allotment optionwas exercised, respectively.

 

Thefollowing table summarizes restricted common stock transactions:

 
| ** **                                                              | ** ** | **Manager** | ** ** | **Directors** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------|------------|-------------|------------|---------------|------------|-----------|------------|
| **Unvested shares as of January 1, 2006** |       | 2,670,911   |       | 28,321        |       | 2,699,232 |       |
| Issued                                                                  |       | —      |       | —        |       | —    |       |
| Vested                                                                  |       | —      |       | —        |       | —    |       |
| Forfeited                                                               |       | —      |       | —        |       | —    |       |
| **Unvested  shares as of March 31, 2006**                          |       | 2,670,911   |       | 28,321        |       | 2,699,232 |       |

 

Theshares of restricted common stock granted to the directors were valued usingthe fair market value at the time of grant, which was $24.90 and $20.00 pershare, for the shares of restricted common stock granted in 2005 and 2004,respectively. Pursuant to SFAS No. 123(R), the Company is required tovalue any unvested shares of restricted common stock granted to the Manager atthe current market price. The Company valued the unvested restricted commonstock at $22.43 and $21.25 per share at March 31, 2006 and March 31,2005, respectively.

 

22

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Thefollowing table summarizes common stock option transactions:

 
| ** **                                 | ** ** | **Number  of Options** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| **Outstanding  as of January 1, 2006**     |       | 1,989,779                   |       | $                                              | 20.00      |   |
| Granted                                    |       | —                      |       | —                                         |       |
| Exercised                                  |       | —                      |       | —                                         |       |
| Forfeited                                  |       | —                      |       | —                                         |       |
| **Outstanding  as of March 31, 2006** |       | 1,989,779                   |       | $                                              | 20.00      |   |

 

Noneof the common stock options outstanding were exercised at March 31, 2006and March 31, 2005, respectively. As of March 31, 2006, 663,260****common stock options were exercisable, and no common stockoptions were exercisable as of March 31, 2005. The common stockoptions are valued using the Black-Scholes model using the followingassumptions:

 
| ** **     | ** ** | **As of  March 31, 2006** | ** ** | **As of  March 31, 2005** | ** ** |
|----------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| Expected life  |       | 8.3 years                                |       | 9.3 years                                |       |
| Discount rate  |       | 4.96                                     | %          | 4.66                                     | %          |
| Volatility     |       | 20                                       | %          | 20                                       | %          |
| Dividend yield |       | 9                                        | %          | 9                                        | %          |

 

Theestimated fair value of the common stock options was $1.60 and $1.26 atMarch 31, 2006 and March 31, 2005, respectively. For the quarter endedMarch 31, 2006 and March 31, 2005, the components of share-basedcompensation expense are as follows (amounts in thousands): 

 
| ** **                                      | ** ** | **For the three  months ended  March 31, 2006** | ** ** | **For the three  months ended  March 31, 2005** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Options granted  to Manager                     |       | $                                                                        | (12        | )                                                                        | $          | 508 |   |
| Restricted  shares granted to Manager           |       | 6,621                                                                    |       | 4,164                                                                    |       |
| Restricted  shares granted to certain directors |       | 174                                                                      |       | 74                                                                       |       |
| Total  share-based compensation expense         |       | $                                                                        | 6,783      |                                                                     | $          | 4,746 |   |

 

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

** **

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

 

TheManagement Agreement provides, among other things, that the Company pays to theManager, in exchange for managing the day-to-day operations of the Company,certain fees and reimbursements, consisting of a base management fee, anincentive fee, and reimbursement for out-of-pocket and certain other costsincurred by

 

23

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the Manager and onbehalf of the Company. All rent incurred by the Manager is paid by the Companyand the Company is a party to the lease.

 

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

 

Forthe three months ended March 31, 2006, the Company incurred$7.1 million in base management fees and $0.7 million in managementincentive fees. In addition, the Company recognized share-based compensationexpense related to common stock options and restricted common stock granted tothe Manager of $6.6 million for the three months ended March 31, 2006 (seeNote 9). The Company also reimbursed the Manager $1.4 million for expensesfor the three months ended March 31, 2006. The Company incurred base managementfees and reimbursed the Manager for expenses of $3.3 million and$0.9 million, respectively, for the three months ended March 31, 2005. TheCompany incurred no management incentive fees for the three months ended March31, 2005. In addition, the Company recognized share-based compensation expenserelated to common stock options and restricted common stock granted to theManager of $4.7 million for the three months ended March 31, 2005. Basemanagement fees incurred and share-based compensation expense relating to commonstock options and restricted common stock granted to the Manager are includedin management compensation to related party on the consolidated statements of operations.Expenses incurred by the Manager and reimbursed by the Company are reflected inthe respective consolidated statement of operations non-investment expensecategory based on the nature of the expense.

 

Anaffiliate of the Company’s Manager has entered into separate managementagreements with the respective investment vehicles for CLO 2005-1 and CLO2005-2 and is entitled to receive fees for the services performed as collateralmanager. To date, the collateral manager has waived approximately $1.5 millionof management fees payable to it from CLO 2005-1, which covers the periodcommencing in March 2005 and ending in April 2006 and has waived approximately$0.8 million of management fees payable to it from CLO 2005-2, which covers theperiod commencing November 2005 and ending in May 2006. The waivers for CLO2005-1 and CLO 2005-2 expire in April 2006 and May 2006, respectively, andthere is no guarantee that the collateral manager will waive such managementfees subsequent to those dates.

 

DuringJanuary 2006, the Company invested $40 million in a series of corporatefloating rate notes which were rated BB by Standard & Poor’s and wereissued by an unaffiliated third party. KKR Financial Advisors II, LLC, awholly-owned subsidiary of the Company’s Manager, is the collateral manager forthe unaffiliated third party in connection with this corporate floating ratenote transaction.

 

**Note 11.** Subsequent Event

** **

OnMay 3, 2006, the Company’s Board of Directors declared a cash distribution forthe three months ended March 31, 2006 on the Company’s common stock of $0.45per share, payable on May 31, 2006 to stockholders of record as of the close ofbusiness on May 17, 2006.

 

OnMay 3, 2006, the Compensation Committee of the Board of Directors (the“Compensation Committee”) of the Company granted the Company’s Chairman of theBoard of Directors $120,000 of restricted common stock and granted Directorsnot affiliated with the Company an aggregate amount of $588,575 of restrictedcommon stock. The actual number of shares to be granted will be determinedbased upon the dollar value of the grants divided by the closing share price ofthe Company’s common stock on July 3, 2006. The restricted common stock grants vest in one-third annual increments.

 

24

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**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. Thefollowing management’s discussion and analysis (“MD&A”) is intended toassist the reader in understanding our business. The MD&A is provided as asupplement to, and should be read in conjunction with, our CondensedConsolidated Financial Statements and accompanying notes included in thisQuarterly Report on Form 10-Q and our Consolidated Financial Statements andaccompanying notes included in our Annual Report on Form 10-K for the yearended December 31, 2005.*

 

**ForwardLooking Statements**

 

Certain information contained in this Quarterly Report onForm 10-Q constitutes “forward-looking” statements within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934 that are based on our current expectations,estimates and projections. Pursuant to those sections, we may obtain a “safeharbor” for forward-looking statements by identifying those and by accompanyingthose statements with cautionary statements, which identify factors that couldcause actual results to differ from those expressed in the forward-lookingstatements. Statements that are not historical facts, including statementsabout our beliefs and expectations, are forward-looking statements. The words“believe,” “anticipate,” “intend,” “aim,” “expect,” “strive,” “plan,”“estimate,” and “project,” and similar words identify forward-lookingstatements. Such statements are not guarantees of future performance, events orresults and involve potential risks and uncertainties. Accordingly, actualresults and the timing of certain events could differ materially from thoseaddressed in forward-looking statements due to a number of factors including,but not limited to, changes in interest rates and market values, changes inprepayment rates, general economic conditions, and other factors not presentlyidentified. Other factors that may impact our actual results are discussed inour Annual Report on Form 10-K under the section titled “Risk Factors.”  We do not undertake, and specificallydisclaim, any obligation to publicly release the result of any revisions thatmay be made to any forward-looking statements to reflect the occurrence ofanticipated or unanticipated events or circumstances after the date of suchstatements.

 

**ExecutiveOverview**

** **

Weare a specialty finance company that invests in multiple asset classes and usesleverage to generate competitive leveraged risk-adjusted returns subject tomaintaining our status as a REIT, and our exemption from regulation under theInvestment Company Act of 1940, as amended (the “Investment Company Act”). Ourobjective is to provide competitive returns to our investors through acombination of dividends and capital appreciation. As part of our multi-assetclass strategy, we seek to invest opportunistically in those asset classes thatcan generate competitive leveraged risk-adjusted returns. Investing in multipleasset classes does not, however, reduce or eliminate many of the risksassociated with our investment portfolio such as geographic concentration risk,asset class concentration risk, market risk and credit risk. We currently makeinvestments in the following asset classes: (i) residential mortgage loansand mortgage-backed securities; (ii) corporate loans and debt securities;(iii) commercial real estate loans and debt securities; (iv) asset-backedsecurities; and (v) marketable and non-marketable equity securities. Wealso make opportunistic investments in other asset classes from time to time.Our investment guidelines do not impose any limitations on the amount of ourinvestments in any specific asset class, industry, or investment. Our income isgenerated primarily from the difference between the interest and dividendincome earned on our investments and the cost of our borrowings, plus(i) realized and unrealized gains and losses our free-standingderivatives, (ii) realized gains and losses from the sales of investments, and(iii) fee income.

 

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

 

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***CashDistributions to Stockholders***

*** ***

OnMay 3, 2006, our Board of Directors declared a cash distribution for thequarter ended March 31, 2006 on our common stock of $0.45 per share. Thedistribution will be payable on May 31, 2006 to stockholders of record as ofthe close of business on May 17, 2006.

 

***InvestmentPortfolio***

*** ***

Asof March 31, 2006 our investment portfolio totaled $15.4 billion, representingan increase of 2.7% from $15.0 billion as of December 31, 2005. As ofMarch 31, 2006, our investment portfolio primarily consisted of residentialmortgage loans and securities totaling $12.3 billion, corporate loans andsecurities totaling $2.7 billion, commercial real estate loans and securitiestotaling $384.4 million, and marketable equity securities consisting ofpreferred and common stock totaling $56.3 million. In addition, we heldinvestments in non-marketable equity securities totaling $101.0 million as ofMarch 31, 2006.

 

***FundingActivities***

*** ***

DuringMarch 2006, we formed KKR Financial Capital Trust I (“the Trust”) for the solepurpose of issuing and selling trust preferred securities. On March 28, 2006,the Trust issued preferred securities to unaffiliated investors for grossproceeds of $50.0 million and common securities to us for $1.6 million. Thecombined proceeds were invested by the Trust in $51.6 million of juniorsubordinated notes issued by us. The junior subordinated notes are the soleassets of the Trust and mature on April 30, 2036, but are callable on or afterApril 30, 2011. Interest is payable quarterly at a fixed rate of 7.635%(ten-year LIBOR plus 2.45%) through March 2016 and thereafter at a floatingrate equal to three-month LIBOR plus 2.65%.

 

OnMarch 30, 2006, we closed our second $5.0 billion asset-backed securedliquidity note facility. This facility provides us with an alternative sourceof funding our residential mortgage-backed securities by issuing asset-backedsecured liquidity notes that are rated A-1+, P-1, and F1+, by Standard & Poor’sRatings Service, or Standard & Poor’s, Moody’s Investors Service, or Moody’s,and Fitch Inc., respectively. At March 31, 2006, we had no borrowingsoutstanding under this facility.

 

**Critical AccountingPolicies**

** **

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

 

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***RevenueRecognition***

*** ***

Weaccount for interest income on our investments using the effective yieldmethod. For investments purchased at par, the effective yield is thecontractual coupon rate on the investment. Unamortized premiums and discountson non-residential mortgage-backed securities are recognized in interest incomeover the contractual life, adjusted for actual prepayments, of the securitiesusing the effective interest method. For securities representing beneficialinterests in securitizations (i.e., residential mortgage-backed securities),unamortized premiums and discounts are recognized over the contractual life,adjusted for estimated prepayments and estimated credit losses of thesecurities using the effective interest method. Actual prepayment and creditloss experience is reviewed quarterly and effective yields are recalculated whendifferences arise between prepayments and credit losses originally anticipatedcompared to amounts actually received plus anticipated future prepayments.

 

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

 

Asof March 31, 2006, unamortized purchase premiums and unaccreted purchasediscounts on our investment portfolio totaled $40.1 million and $(48.8)million, respectively.

 

***Share-BasedPayment***

*** ***

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

 

Becausewe remeasure the amount of compensation costs associated with the unvestedrestricted common stock and unvested common stock options that we issued to ourManager as of each reporting period, our share-based compensation expense reportedin our consolidated financial statements will change based on the estimatedfair value of our common stock and this may result in earnings volatility. Forthe three months ended March 31, 2006, share-based compensation totaled $6.8million. As of March 31, 2006, substantially all of the non-vested common stockoptions and restricted common stock issued that is subject to SFASNo. 123(R) is subject to remeasurement.

 

***Classificationsof Investment Securities***

*** ***

Ourinvestments in securities are classified as “available-for-sale” and arerecorded and reported on our consolidated balance sheet at estimated fair valuewith unrealized gains and losses reported in accumulated other comprehensiveincome (loss) on our consolidated balance sheet. We designate and classify ourinvestments in securities as available-for-sale because we may sell them priorto their maturity date. We do not designate and classify our investments insecurities as trading securities because we do not intend to trade them or sellthem in the near term. We determine the estimated fair value of our investmentsin securities using quoted market prices,

 

27

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dealers who make marketsin the securities, 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.

 

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

*** ***

Ourpolicies permit us to enter into derivative contracts, including interest rateswaps, interest rate corridors, interest rate swaptions, interest ratestraddles, and credit and currency derivatives. We use interest ratederivatives to manage interest rate risk. We formally document relationshipsbetween our hedging instruments and our hedged transactions as of the inceptiondate of the hedge, including (i) our risk management objective and hedgestrategy, (ii) the risk that we are hedging, (iii) the hedginginstruments, consisting of the derivative instruments that comprise the hedge,(iv) the hedged transaction, consisting of the recognized or forecastedtransaction that we are hedging, (v) the method that we used to assess thehedge’s effectiveness on a retrospective and prospective basis, and(vi) the methodology that we will use to measure hedge ineffectiveness. Onthe date that we enter into an interest rate derivative transaction wedesignate the interest rate derivative as (i) a hedge of a forecastedtransaction or of the variability of cash flows related to a recognizedliability (“cash flow hedge”) or (ii) held for trading (“tradinginstrument”). Our interest rate swaptions are undesignated derivative contractsand accounted for as trading instruments, and our interest rate swap andinterest rate corridor contracts are designated and accounted for as cash flowhedges. As of March 31, 2006, we have not entered into any interest ratederivative transactions that are designated as a hedge of the estimated fairvalue of a recognized asset or liability or of an unrecognized firm commitment(“fair value hedge”).

 

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

 

Weare not required to account for our derivative contracts using hedge accountingas described above. If we decide not to designate the derivative contracts ashedges or if we fail to fulfill the criteria necessary to qualify for hedgeaccounting, then the changes in the estimated fair values of our derivativecontracts would affect periodic earnings immediately potentially resulting inthe increased volatility of our earnings. The qualification requirements forhedge accounting are complex and as a result we must evaluate, designate, andthoroughly document each hedge transaction at inception and performineffectiveness analysis and prepare related documentation at inception and ona recurring basis thereafter. As of March 31, 2006, the estimated fair value ofour derivatives totaled $102.9 million. As of March 31, 2006, the estimatedfair value of interest rate derivatives accounted for as cash flow hedgestotaled approximately $102.7 million and the net change in unrealized gain onsuch cash flow hedges totaled approximately $92.6 million, which amount isrecorded in accumulated other comprehensive income in the consolidatedstatements of changes in stockholders’ equity.

 

***Impairments***

*** ***

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

 

28

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we make a determinationthat the impairment is other-than-temporary, we recognize an impairment lossequal to the difference between the amortized cost basis and the estimated fairvalue of the investment. We consider many factors in determining whether theimpairment of an investment is other-than-temporary, including but not limitedto the length of time the security has had a decline in estimated fair valuebelow its amortized cost, the amount of the loss, the intent and our financialability to hold the investment for a period of time sufficient for a recoveryin its estimated fair value, recent events specific to the issuer or industry,external credit ratings and recent downgrades in such ratings. As of March 31,2006, we had aggregate unrealized losses on our securities classified asavailable-for-sale of approximately $61.3****million, whichif not recovered may result in the recognition of future losses.

 

***Allowancefor Loan Losses***

*** ***

Wemaintain an allowance for loan losses at a level that we believe is adequatebased on an evaluation of known and inherent risks related to our loaninvestments. When determining the adequacy of the allowance for loan losses weconsider historical and industry loss experience, economic conditions andtrends, the estimated fair values of our loans, credit quality trends and otherfactors that we determine are relevant. To estimate the allowance for loanlosses, we first identify impaired loans. Loans are generally evaluated forimpairment individually, but loans purchased on a pooled basis with relativelysmaller balances and substantially similar characteristics may be evaluatedcollectively for impairment. We consider a loan to be impaired when, based oncurrent information and events, we believe it is probable that we will beunable to collect all amounts due to us based on the contractual terms of theloan. When a loan is impaired, the allowance for loan losses is increased bythe amount of the excess of the amortized cost basis of the loan over itsestimated fair value. Increases in the allowance for loan losses are recognizedin our results of operations as a provision for loan losses. When we make adetermination that some or all of a loan is uncollectible, we charge-off orwrite-down the loan and the allowance for loan losses is reduced.

 

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

 

29

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**RecentAccounting Pronouncements**

** **

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

 

**Resultsof Operations**

** **

**Quarterended March 31, 2006 compared to quarter ended March 31, 2005**

** **

*Summary*

* *

Ournet income for the quarter ended March 31, 2006 totaled $30.4 million (or$0.38 per diluted share) as compared to net income of $6.1 million (or $0.15per diluted share) for the quarter ended March 31, 2005. During the quarterended March 31, 2006, our investment portfolio increased by 2.7% from$15.0 billion as of December 31, 2005 to $15.4 billion as of March31, 2006.

 

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*NetInvestment Income*

* *

Thefollowing table presents the components of our net investment income for thequarters ended March 31, 2006 and 2005:

 

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

** **
| ** **                                                            |   | **For the three  months ended  March 31, 2006** | ** ** | **For the three**

**months ended  March 31, 2005** | ** ** |
|-----------------------------------------------------------------------|--------|---------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Investment  Income:                                                   |   |                                                                |       |                                                                    |       |
| Residential  mortgage loans and securities interest income            |   | $                                                                   | 146,130    |                                                                    | $          | 25,053 |   |
| Corporate loans  and securities interest income                       |   | 50,414                                                              |       | 9,432                                                                   |       |
| Commercial real  estate loans and securities interest income          |   | 8,638                                                               |       | 912                                                                     |       |
| Other interest  income                                                |   | 1,845                                                               |       | 254                                                                     |       |
| Common and  preferred stock dividend income                           |   | 883                                                                 |       | 534                                                                     |       |
| Net  premium/discount (amortization) accretion                        |   | (112                                                                | )          | (639                                                                    | )          |
| Total investment  income                                              |   | 207,798                                                             |       | 35,546                                                                  |       |
| Interest  Expense:                                                    |   |                                                                |       |                                                                    |       |
| Repurchase  agreements interest expense                               |   | 106,062                                                             |       | 20,448                                                                  |       |
| Collateralized  loan obligation senior secured notes interest expense |   | 17,965                                                              |       | —                                                                  |       |
| Asset-backed  secured liquidity notes interest expense                |   | 31,476                                                              |       | —                                                                  |       |
| Secured  revolving credit facility interest expense                   |   | 750                                                                 |       | —                                                                  |       |
| Demand loan  interest expense                                         |   | 504                                                                 |       | —                                                                  |       |
| Junior  subordinated notes interest expense                           |   | 32                                                                  |       | —                                                                  |       |
| Other interest  expense                                               |   | 941                                                                 |       | 1                                                                       |       |
| Interest rate  swaps interest expense, net                            |   | (1,167                                                              | )          | —                                                                  |       |
| Total interest  expense                                               |   | (156,563                                                            | )          | (20,449                                                                 | )          |
| Net investment  income                                                |   | $                                                                   | 51,235     |                                                                    | $          | 15,097 |   |

 

Aspresented in the table above, our net investment income increased by $36.1million for the quarter ended March 31, 2006 compared to the quarter endedMarch 31, 2005. The change from 2005 to 2006 is primarily attributable to theincrease in our investment portfolio since March 31, 2005. As of March 31,2006, we held $15.4 billion in investments in loans and securitiesavailable-for-sale and had borrowings outstanding totaling $13.5 billion. Incomparison, as of March 31, 2005, investments in loans and securitiesavailable-for-sale totaled $6.3 billion and borrowings outstanding totaled $5.9billion.

 

*OtherIncome*

* *

Thefollowing table presents the components of our interest income for the quartersended March 31, 2006 and 2005:

 

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

** **
| ** **                                                              | ** ** | **For the three  months ended  March 31, 2006** | ** ** | **For the three  months ended  March 31, 2005** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Net realized and  unrealized gain on derivatives and foreign exchange:  |       |                                                                     |       |                                                                     |       |
| Interest rate  swaptions                                                |       | $                                                                        | 33         |                                                                     | $          | (92 | ) |
| Interest rate  swaps                                                    |       | 161                                                                      |       | —                                                                   |       |
| Credit default  swaps                                                   |       | (258                                                                     | )          | 398                                                                      |       |
| Total rate of  return swaps                                             |       | (300                                                                     | )          | —                                                                   |       |
| Foreign exchange  translation                                           |       | 374                                                                      |       | (179                                                                     | )          |
| Total realized  and unrealized gain on derivatives and foreign exchange |       | 10                                                                       |       | 127                                                                      |       |
| Net realized  gain on investments                                       |       | 1,448                                                                    |       | 343                                                                      |       |
| Fee and other  income                                                   |       | 215                                                                      |       | 368                                                                      |       |
| Total other  income                                                     |       | $                                                                        | 1,673      |                                                                     | $          | 838 |   |

 

Aspresented in the table above, other income totaled $1.7 million for thequarter ended March 31, 2006 as compared to $0.8 million for the quarterended March 31, 2005. The increase in total other income from the prior periodis primarily attributable to increased investment activity since March 31,2005.

 

*Non-InvestmentExpenses*

 

Thefollowing table presents the components of our non-investment expenses for thequarters ended March 31, 2006 and 2005:

 

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

** **
| ** **                              | ** ** | **For the three  months ended  March 31, 2006** | ** ** | **For the three  months ended  March 31, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Related party  management compensation: |       |                                                                |       |                                                                |       |
| Base management  fees                   |       | $                                                                   | 7,158      |                                                                | $          | 3,337 |   |
| Incentive fee                           |       | 673                                                                 |       | —                                                              |       |
| Share-based  compensation               |       | 6,609                                                               |       | 4,671                                                               |       |
| Related party  management compensation  |       | 14,440                                                              |       | 8,008                                                               |       |
| Professional  services                  |       | 947                                                                 |       | 397                                                                 |       |
| Loan servicing  expense                 |       | 3,996                                                               |       | 267                                                                 |       |
| Insurance  expense                      |       | 224                                                                 |       | 217                                                                 |       |
| Directors  expenses                     |       | 373                                                                 |       | 199                                                                 |       |
| General and  administrative expenses    |       | 2,228                                                               |       | 619                                                                 |       |
| Total  non-investment expenses          |       | $                                                                   | 22,208     |                                                                | $          | 9,707 |   |

 

Aspresented in the table above, our non-investment expenses increased by $12.5million for the three months ended March 31, 2006 compared to the three monthsended March 31, 2005. The increase in non-investment expenses from the priorperiod is primarily attributable to our growth since March 31, 2005. Thesignificant components of non-investment expense are described below.

 

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Managementcompensation to related parties consists of base management fees payable to ourManager pursuant to the Management Agreement, incentive management fees, andshare-based compensation related to restricted common stock and common stockoptions granted to our Manager. The base management fee payable was calculatedin accordance with the Management Agreement and is based on an annual rate of1.75% times “equity” as defined in the Management Agreement. Our Manager isalso entitled to an incentive fee provided that our quarterly “net income,” asdefined in the Management Agreement, before the incentive fee exceeds a definedreturn hurdle. We did not exceed the applicable hurdle during the three monthsended March 31, 2005.

 

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

 

*IncomeTax Provision*

* *

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

 

KKRTRS Holdings, Inc., our domestic taxable REIT subsidiary, is taxed as aregular subchapter C corporation under the provisions of the Code. KKR TRSHoldings, Inc. was formed to make, from time to time, certain investmentsthat would not be REIT qualifying investments if made directly by us, and toearn income that would not be REIT qualifying income if earned directly by us.For the three months ended March 31, 2006, KKR TRS Holdings, Inc. hadpre-tax net income of $0.7 million and the provision for income taxestotaled $0.3 million. As of March 31, 2006, KKR TRS Holdings, Inc. had anincome tax liability of $1.0 million.

 

KKRFinancial CLO 2005-1, Ltd., KKR Financial CLO 2005-2, Ltd., KKRFinancial CDO 2005-1, Ltd., and KKR Financial CLO 2006-1, Ltd., are foreigntaxable REIT subsidiaries that were established to facilitate securitizationtransactions structured as secured financing transactions. They are organizedas exempted companies incorporated with limited liability under the laws of theCayman Islands, and are generally exempt from federal and state income tax atthe corporate entity level because they restrict their activities in the UnitedStates to trading in stock and securities for their own account. Therefore,despite their status as taxable REIT subsidiaries, they generally will not besubject to corporate income tax on their earnings, and no provisions for incometaxes for the three months ended March 31, 2006 were recorded; however, we willgenerally be required to include their current taxable income in ourcalculation of REIT taxable income.

 

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**FinancialCondition**

** **

**Summary**

** **

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

 

Thetable below summarizes our investment portfolio as of March 31, 2006 classifiedby interest rate type:

 

**InvestmentPortfolio(Amounts in thousands)**

** **
| ** **                              | ** ** | **Carrying Value** | ** ** | **Amortized Cost** | ** ** | **Estimated  Fair Value** | ** ** | **Portfolio Mix  % by Fair Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-------------------------|------------|--------------------------------|------------|---------------------------------------------------|------------|
| **Floating  Rate:**                     |       |                    |       |                    |       |                           |       |                                              |       |
| Residential ARM  Loans                  |       | $                       | 2,011,296  |                    | $          | 2,011,296                      |       | $                                                 | 2,006,260  |   | 13.1 | % |
| Residential ARM  Securities             |       | 4,038,675               |       | 4,031,312               |       | 4,038,675                      |       | 26.4                                              |       |
| Corporate Loans                         |       | 2,041,139               |       | 2,041,139               |       | 2,063,278                      |       | 13.5                                              |       |
| Corporate Debt  Securities              |       | 320,177                 |       | 313,801                 |       | 320,177                        |       | 2.1                                               |       |
| Commercial Real  Estate Loans           |       | 278,707                 |       | 278,707                 |       | 277,499                        |       | 1.8                                               |       |
| Commercial Real  Estate Debt Securities |       | 62,512                  |       | 62,665                  |       | 62,512                         |       | 0.4                                               |       |
| Total Floating  Rate                    |       | 8,752,506               |       | 8,738,920               |       | 8,768,401                      |       | 57.3                                              |       |
| **Hybrid  Rate:**                       |       |                    |       |                    |       |                           |       |                                              |       |
| Residential  Hybrid ARM Loans           |       | 4,131,028               |       | 4,131,028               |       | 4,082,764                      |       | 26.8                                              |       |
| Residential  Hybrid ARM Securities      |       | 2,076,199               |       | 2,126,865               |       | 2,076,199                      |       | 13.6                                              |       |
| Total Hybrid  Rate                      |       | 6,207,227               |       | 6,257,893               |       | 6,158,963                      |       | 40.4                                              |       |
| **Fixed  Rate:**                        |       |                    |       |                    |       |                           |       |                                              |       |
| Corporate Loans                         |       | 25,000                  |       | 25,000                  |       | 25,000                         |       | 0.2                                               |       |
| Corporate Debt  Securities              |       | 280,702                 |       | 274,357                 |       | 280,702                        |       | 1.8                                               |       |
| Commercial Real  Estate Loans           |       | 35,710                  |       | 35,710                  |       | 35,154                         |       | 0.2                                               |       |
| Commercial Real  Estate Debt Securities |       | 7,466                   |       | 7,150                   |       | 7,466                          |       | 0.1                                               |       |
| Total Fixed Rate                        |       | 348,878                 |       | 342,217                 |       | 348,322                        |       | 2.3                                               |       |
| Total                                   |       | $                       | 15,308,611 |                    | $          | 15,339,030                     |       | $                                                 | 15,275,686 |   | 100.0 | % |

 

Thetable above excludes marketable equity securities with a fair value of $56.3million and amortized cost of $56.5 million, and non-marketable equitysecurities with a fair value of $101.0 million and amortized cost of $101.0million as of March 31, 2006. As of March 31, 2006 the aggregate amortized costvalue of the Company’s investment portfolio exceeded the aggregate fair valueof its portfolio by $63.6 million and, as of the same date, the Companyhad unrealized gains totaling $92.6 million related to its cash flowhedges, as defined under SFAS No. 133. As of March 31, 2006, the aggregatenet unamortized purchase discount related to the Company’s investment portfoliowas $8.7 million.

 

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

 

**InvestmentPortfolio(Amounts in thousands)**

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

 

Thetable above excludes marketable equity securities with a fair value of $47.0million and amortized cost of $47.2 million, and non-marketable equitysecurities with a fair value of $52.5 million and amortized cost of $52.5million as of December 31, 2005. As of December 31, 2005, theaggregate amortized cost value of the Company’s investment portfolio exceededthe aggregate fair value of its portfolio by $54.1 million and, as of thesame date, the Company had unrealized gains totaling $45.6 million relatedto its cash flow hedges, as defined under SFAS No. 133. As ofDecember 31, 2005, the aggregate net unamortized purchase discount relatedto the Company’s investment portfolio was $6.7 million.

 

**AssetQuality**

** **

*AssetQuality Review*

* *

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

 

35

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

 

*SecuritiesAvailable-for-Sale*

* *

Thefollowing table summarizes the par value of our debt investment securitiesportfolio by investment class stratified by Moody’s and Standard &Poor’s ratings category as of March 31, 2006:

 

**InvestmentSecurities(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 3,973,749  |                                         | $          | 2,062,152                       |       | $                                                      | —     |      | $          | — |   | $ | 6,035,901 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 20,803                               |       | 28,607                                       |       | —                          |       | —                                                 |       | 49,410    |       |
| A1/A+ through  A3/A-         |       | 14,997                               |       | 18,204                                       |       | 40,000                          |       | —                                                 |       | 73,201    |       |
| Baa1/BBB+ through  Baa3/BBB- |       | 10,643                               |       | 9,709                                        |       | 40,516                          |       | 7,177                                                  |       | 68,045    |       |
| Ba1/BB+ through  Ba3/BB-     |       | 5,322                                |       | 3,901                                        |       | 169,500                         |       | 29,000                                                 |       | 207,723   |       |
| B1/B+ through  B3/B-         |       | 3,870                                |       | 2,601                                        |       | 190,815                         |       | —                                                 |       | 197,286   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 130,274                         |       | —                                                 |       | 130,274   |       |
| Non-Rated                    |       | 9,190                                |       | 6,502                                        |       | 29,000                          |       | 35,736                                                 |       | 80,428    |       |
| Total                        |       | $                                    | 4,038,574  |                                         | $          | 2,131,676                       |       | $                                                      | 600,105    |      | $          | 71,913 |   | $ | 6,842,268 |   |

 

Thefollowing table shows the par value of our debt investment securities portfolioby investment class stratified by Moody’s and Standard & Poor’sratings category as of December 31, 2005:

 

**InvestmentSecurities(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **Residential  ARM Securities** | ** ** | **Residential  Hybrid ARM  Securities** | ** ** | **Corporate  Debt  Securities** | ** ** | **Commercial  Real Estate Debt  Securities** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Aaa/AAA                      |       | $                                    | 3,310,426  |                                         | $          | 2,132,297                       |       | $                                                      | —     |      | $          | — |   | $ | 5,442,723 |   |
| Aa1/AA+ through  Aa3/AA-     |       | 21,497                               |       | 28,692                                       |       | —                          |       | —                                                 |       | 50,189    |       |
| A1/A+ through  A3/A-         |       | 15,498                               |       | 18,259                                       |       | —                          |       | —                                                 |       | 33,757    |       |
| Baa1/BBB+  through Baa3/BBB- |       | 10,998                               |       | 9,729                                        |       | 41,540                          |       | 45,692                                                 |       | 107,959   |       |
| Ba1/BB+ through  Ba3/BB-     |       | 5,499                                |       | 3,913                                        |       | 159,500                         |       | 25,000                                                 |       | 193,912   |       |
| B1/B+ through  B3/B-         |       | 3,999                                |       | 2,608                                        |       | 153,815                         |       | —                                                 |       | 160,422   |       |
| Caa1/CCC+ and  lower         |       | —                               |       | —                                       |       | 108,505                         |       | 10,800                                                 |       | 119,305   |       |
| Non-Rated                    |       | 9,499                                |       | 6,521                                        |       | 27,000                          |       | 4,000                                                  |       | 47,020    |       |
| Total                        |       | $                                    | 3,377,416  |                                         | $          | 2,202,019                       |       | $                                                      | 490,360    |      | $          | 85,492 |   | $ | 6,155,287 |   |

 

*Loans*

* *

Ourresidential mortgage loan portfolio totaled $6.1 billion as of March 31, 2006and $6.4 billion as of December 31, 2005. As of March 31, 2006 andDecember 31, 2005, 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 were738****and 66.2%, respectively, as ofMarch 31, 2006. As of December 31, 2005, the weighted averageoriginal FICO® score and weighted average LTV ratio of our residential ARM loanportfolio were 737 and 67.2%, respectively. As of March 31, 2006 ourresidential ARM loan investment portfolio did not have any material concentrationsin investor owned properties, multi-unit housing properties, condominiumproperties and/or cooperative properties. A material portion of our residentialARM loans are non-conforming mortgage loans, not due to credit quality, butbecause the mortgage loans have balances that exceed the maximum balancesnecessary to qualify as a conforming mortgage loan.

 

36

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

 
| **Delinquency Status** | ** ** | **Number of Loans** | ** ** | **Principal Amount** | ** ** |
|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| 30 to 59 days               |       | 79                            |       | $                         | 39,408     |   |
| 60 to 89 days               |       | 5                             |       | 2,001                     |       |
| 90 days or more             |       | 6                             |       | 1,424                     |       |
| In foreclosure              |       | 5                             |       | 1,211                     |       |
| Total                       |       | 95                            |       | $                         | 44,044     |   |

 

The following tablesummarizes the delinquency statistics of residential mortgage loans as ofDecember 31, 2005 (dollar amounts in thousands):

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

 

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

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

 

Ourcorporate loan portfolio totaled $2.1****billion as ofMarch 31, 2006 and $1.9 billion as of December 31, 2005. Our corporateloan portfolio consists of debt obligations of corporations, partnerships andother entities in the form of first and second lien loans, mezzanine loans andbridge loans. We performed an allowance for loan losses analysis as of March31, 2006 and December 31, 2005, and we have made the determination that noallowance for loan losses was required for our corporate loan portfolio as ofMarch 31, 2006 or December 31, 2005.

 

37

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

 

**CorporateLoans(Amounts in thousands)**

** **
| **Ratings Category**    | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                   |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                   |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | 2,000                                    |       | 2,000                                       |       |
| Ba1/BB+ through  Ba3/BB-     |       | 711,974                                  |       | 673,644                                     |       |
| B1/B+ through  B3/B-         |       | 1,195,571                                |       | 1,095,368                                   |       |
| Caa1/CCC+ and  lower         |       | 30,324                                   |       | 21,547                                      |       |
| Non-Rated                    |       | 129,583                                  |       | 107,826                                     |       |
| Total                        |       | $                                        | 2,069,452  |                                        | $          | 1,900,385 |   |

 

Ourcommercial real estate loan portfolio totaled $314.4 million and$521.7 million as of March 31, 2006 and December 31, 2005,respectively. Our commercial real estate loan portfolio consists of senior,mezzanine, and bridge loans that are secured by commercial real estate.

 

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

 

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

 

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

** **
| **Ratings Category**    | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Aaa/AAA                      |       | $                                        | —     |                                        | $          | — |   |
| Aa1/AA+ through  Aa3/AA-     |       | —                                   |       | —                                      |       |
| A1/A+ through  A3/A-         |       | —                                   |       | —                                      |       |
| Baa1/BBB+  through Baa3/BBB- |       | —                                   |       | —                                      |       |
| Ba1/BB+ through  Ba3/BB-     |       | 30,742                                   |       | 60,929                                      |       |
| B1/B+ through  B3/B-         |       | —                                   |       | 75,000                                      |       |
| Caa1/CCC+ and  lower         |       | 75,000                                   |       | 50,000                                      |       |
| Non-Rated                    |       | 209,700                                  |       | 336,821                                     |       |
| Total                        |       | $                                        | 315,442    |                                        | $          | 522,750 |   |

 

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**AssetRepricing Characteristics**

** **

*Summary*

* *

Thetable below summarizes the repricing characteristics of our investmentportfolio as of March 31, 2006 and December 31, 2005, and isclassified by interest rate type:

 

**InvestmentPortfolio(Amounts in thousands)**

** **
| ** **                              | ** ** | **As of March 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amortized Cost**                      | ** ** | **Portfolio Mix**                          | ** ** | **Amortized Cost** | ** ** | **Portfolio Mix** | ** ** |
| Floating Rate:                          |       |                                         |       |                                            |       |   |   |   |   |
| Residential ARM  Loans                  |       | $                                            | 2,011,296  |                                            | 13.1       | % | $ | 2,175,929 |   | 14.5 | % |
| Residential ARM  Securities             |       | 4,031,312                                    |       | 26.3                                            |       | 3,369,763 |   | 22.5 |   |
| Corporate Loans                         |       | 2,041,139                                    |       | 13.3                                            |       | 1,872,277 |   | 12.5 |   |
| Corporate Debt  Securities              |       | 313,801                                      |       | 2.0                                             |       | 277,030 |   | 1.9 |   |
| Commercial Real  Estate Loans           |       | 278,707                                      |       | 1.8                                             |       | 486,096 |   | 3.2 |   |
| Commercial Real  Estate Debt Securities |       | 62,665                                       |       | 0.4                                             |       | 63,168 |   | 0.4 |   |
| Total Floating  Rate                    |       | 8,738,920                                    |       | 56.9                                            |       | 8,244,263 |   | 55.0 |   |
| Hybrid Rate:                            |       |                                         |       |                                            |       |   |   |   |   |
| Residential  Hybrid ARM Loans           |       | 4,131,028                                    |       | 26.9                                            |       | 4,252,893 |   | 28.4 |   |
| Residential  Hybrid ARM Securities      |       | 2,126,865                                    |       | 13.9                                            |       | 2,197,020 |   | 14.7 |   |
| Total Hybrid  Rate                      |       | 6,257,893                                    |       | 40.8                                            |       | 6,449,913 |   | 43.1 |   |
| Fixed Rate:                             |       |                                         |       |                                            |       |   |   |   |   |
| Corporate Loans                         |       | 25,000                                       |       | 0.2                                             |       | 25,000 |   | 0.2 |   |
| Corporate Debt  Securities              |       | 274,357                                      |       | 1.8                                             |       | 202,748 |   | 1.4 |   |
| Commercial Real  Estate Loans           |       | 35,710                                       |       | 0.2                                             |       | 35,646 |   | 0.2 |   |
| Commercial Real  Estate Debt Securities |       | 7,150                                        |       | 0.1                                             |       | 19,833 |   | 0.1 |   |
| Total Fixed Rate                        |       | 342,217                                      |       | 2.3                                             |       | 283,227 |   | 1.9 |   |
| Total                                   |       | $                                            | 15,339,030 |                                            | 100.0      | % | $ | 14,977,403 |   | 100.0 | % |

 

Thetable above excludes marketable equity securities with a fair value of $56.3million and amortized cost of $56.5 million, and non-marketable equitysecurities with a fair value of $101.0 million and amortized cost of $101.0million as of March 31, 2006.

 

*ResidentialARM Securities*

* *

Asof March 31, 2006, substantially all of our residential ARM securitieswere comprised of one-month LIBOR floating rate securities that reprice monthlyand were subject to a weighted average maximum net interest rate of 9.94% whichis materially above the then current weighted average net coupon of 5.88%. Ourrepricing risk on our portfolio of residential ARM securities increasesmaterially if interest rates continue to increase to a level where the weightedaverage coupon rate approaches the weighted average maximum net interest rateof 9.94% because the weighted average coupon is subject to a maximum rate, orcap, which is approximately equal to the weighted average maximum interest rateof 9.94%.

 

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

 

39

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*ResidentialHybrid ARM Securities*

* *

Asof March 31, 2006, all of our residential hybrid ARM securities hadunderlying mortgage loans that were originated as 5/1 hybrid ARM loans. As ofMarch 31, 2006, we owned 100% of the securities that represent 100% of thebeneficial interest in the 5/1 hybrid ARM loans underlying our portfolio ofhybrid ARM securities. When the underlying residential hybrid mortgage loansconvert from fixed rate to floating rate, the underlying mortgage loans willhave an interest rate based on one-year LIBOR or one-year constant maturitytreasury index, or CMT, depending upon if the underlying mortgage loan is aLIBOR- or CMT-based mortgage loan. On the date that the residential hybrid ARMloans convert from a fixed rate to a floating rate loan, which we refer to asthe roll date, our portfolio of residential hybrid ARM loans will have aweighted average coupon that is the sum of (i) the post-roll date index,and (ii) the weighted average post-roll date net margin. As ofMarch 31, 2006 all of the mortgage loans underlying our residential hybridARM securities had a post-roll date index reset frequency of one year with 34%based on six-month or one-year LIBOR and 66% based on one-year CMT. Ourrepricing risk on our portfolio of residential hybrid ARM loans increasesmaterially if interest rates continue to increase to a level where, subsequentto the roll date, the weighted average net coupon rate approaches the weightedaverage post roll date maximum net interest rate of 9.43% because the post rolldate weighted average net coupon is subject to a maximum rate, or cap, which isapproximately equal to the weighted average post roll date maximum net interestrate of 9.43%. The weighted average coupon on the portfolio of residentialhybrid securities is 4.18% as of March 31, 2006. As of March 31,2006, the weighted average months until roll date for the mortgage loansunderlying our residential hybrid ARM securities was 35.

 

Asof December 31, 2005, all of our residential hybrid ARM securities hadunderlying mortgage loans that were originated as 5/1 hybrid ARM loans. As ofDecember 31, 2005, we owned 100% of the securities that represent 100% ofthe beneficial interest in the 5/1 hybrid ARM loans underlying our portfolio ofhybrid ARM securities. When the underlying residential hybrid mortgage loansconvert from fixed rate to floating rate, the underlying mortgage loans willhave an interest rate based on one-year LIBOR or one-year constant maturitytreasury index, or CMT, depending upon if the underlying mortgage loan is aLIBOR- or CMT-based mortgage loan. On the date that the residential hybrid ARMloans convert from a fixed rate to a floating rate loan, which we refer to asthe roll date, our portfolio of residential hybrid ARM loans will have aweighted average coupon that is the sum of (i) the post-roll date index,and (ii) the weighted average post-roll date net margin. As ofDecember 31, 2005 all of the mortgage loans underlying our residentialhybrid ARM securities had a post-roll date index reset frequency of one yearwith 35% based on six-month or one-year LIBOR and 65% based on one-year CMT.Our repricing risk on our portfolio of residential hybrid ARM loans increasesmaterially if interest rates continue to increase to a level where, subsequentto the roll date, the weighted average net coupon rate approaches the weightedaverage post roll date maximum net interest rate of 9.43% because the post rolldate weighted average net coupon is subject to a maximum rate, or cap, which isapproximately equal to the weighted average post roll date maximum net interestrate or 9.43%. The weighted average coupon on the portfolio of residentialhybrid securities is 4.13% as of December 31, 2005. As ofDecember 31, 2005, the weighted average months until roll date for themortgage loans underlying our residential hybrid ARM securities was 36.

 

*ResidentialARM Loans*

* *

Asof March 31, 2006, all of our residential ARM loans were comprised of one-monthLIBOR floating rate loans that reprice monthly and were subject to a weightedaverage maximum net interest rate of****11.90%, whichis well above the then current weighted average net coupon of****5.52%. Our repricing risk on our portfolio of residentialARM loans increases materially if interest rates continue to increase to alevel where the weighted average net coupon rate approaches the weightedaverage maximum interest rate of 11.90% because the weighted average coupon issubject to a maximum rate, or cap, which is approximately equal to the weightedaverage maximum interest rate of 11.90%.

 

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

 

 

40

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

 

*ResidentialHybrid ARM Loans*

* *

As of March 31,2006, all of our residential hybrid ARM loans were originated as either 3/1 or5/1 hybrid ARM loans. When the loans convert from fixed rate to floating rate,the underlying mortgage loans will have an interest rate based on one-yearLIBOR or one-year CMT. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and(ii) the weighted average post-roll date net margin. As of March 31,2006 all of our residential hybrid ARM loans had a post-roll date index resetfrequency of one-year with 43% based on six-month or one-year LIBOR and 57%based on one-year CMT. Our repricing risk on our portfolio of residentialhybrid ARM loans increases materially if interest rates continue to increase toa level where, subsequent to the roll date, the weighted average net couponrate approaches the weighted average post-roll date maximum net interest rateof 10.13%****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 of 10.13%.The weighted average net coupon on the portfolio of residential hybrid loans is4.85% as of March 31, 2006. As of March 31, 2006, the weightedaverage months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 43.

 

As of December 31,2005, all of our residential hybrid ARM loans were originated as either 3/1 or5/1 hybrid ARM loans. When the loans convert from fixed rate to floating rate,the underlying mortgage loans will have an interest rate based on one-yearLIBOR or one-year CMT. On the date that the residential hybrid ARM loansconvert from a fixed rate to a floating rate loan, which we refer to as theroll date, our portfolio of residential hybrid ARM loans will have a weightedaverage coupon that is the sum of (i) the post-roll date index, and(ii) the weighted average post-roll date net margin. As of December 31,2005 all of our residential hybrid ARM loans had a post-roll date index resetfrequency of one-year with 43% based on six-month or one-year LIBOR and 57%based on one-year CMT. Our repricing risk on our portfolio of residentialhybrid ARM loans increases materially if interest rates continue to increase toa level where, subsequent to the roll date, the weighted average net couponrate approaches the weighted average post-roll date maximum net interest rateof 10.13%****because the post-roll date weightedaverage net coupon is subject to a maximum rate, or cap, which is approximatelyequal to the weighted average post-roll date maximum net interest rate or10.13%. The weighted average net coupon on the portfolio of residential hybridloans is 4.85% as of December 31, 2005. As of December 31, 2005, theweighted average months until roll date for the mortgage loans underlying ourresidential hybrid ARM securities was 44.

 

*CorporateLoans and Securities*

* *

All of our floating ratecorporate loans and securities have index reset frequencies of less than twelvemonths with the majority of the loans resetting at least quarterly. Theweighted average coupon on our floating rate corporate loans and securities was7.53% and 7.12% as of March 31, 2006 and December 31, 2005, respectively.As of both March 31, 2006 and December 31, 2005, the weighted averageyears to maturity of our floating rate corporate loans and securities was 6.3 years.

 

As of March 31,2006, our fixed rate corporate debt securities had a weighted average coupon of10.21% and a weighted average years to maturity of****7.9****years, as compared to 10.58% and 8.7 years,respectively, as of December 31, 2005.

 

*CommercialReal Estate Loans and Securities*

* *

All of our floating ratecommercial real estate loans and securities have index reset frequencies ofless than twelve months. The weighted average coupon on our floating ratecommercial real estate loans and securities was 7.68% and 8.70% as of March 31,2006 and December 31, 2005, respectively. As of March 31, 2006 and

 

41

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December 31, 2005,the weighted average years to maturity of our floating rate commercial realestate loans and securities was****4.9** **years and 3.7 years, respectively.

 

As of March 31, 2006 ourfixed rate commercial real estate loans and securities had a weighted averagecoupon of 7.77% and a weighted average years to maturity of 7.2 years, ascompared to 7.95% and 7.7 years, respectively, as of December 31, 2005.

 

**PortfolioPurchases**

** **

We purchased$1.8 billion and $4.0 billion par amount of investments during thequarters ended March 31, 2006 and March 31, 2005 respectively.

 

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

 

**Investment PortfolioPurchases(Amounts in thousands)**

 
| ** **                              | ** ** | **Three months ended  March 31, 2006** | ** ** | **Three months ended  March 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **Par Amount**                              | ** ** | **%**                                  | ** ** | **Par Amount** | ** ** | **%** | ** ** |
| Securities:                             |       |                                             |       |                                   |       |   |   |   |   |
| Residential ARM  Securities             |       | $                                                | 1,063,776  |                                   | 58.1       | % | $ | 665,782 |   | 16.7 | % |
| Residential  Hybrid ARM Securities      |       | —                                           |       | —                                 |       | 2,636,492 |   | 66.0 |   |
| Corporate Debt  Securities              |       | 127,769                                          |       | 7.0                                    |       | 112,005 |   | 2.8 |   |
| Commercial Real  Estate Debt Securities |       | —                                           |       | —                                 |       | 10,000 |   | 0.2 |   |
| Total Securities  Principal Balance     |       | 1,191,545                                        |       | 65.1                                   |       | 3,424,279 |   | 85.7 |   |
| Loans:                                  |       |                                             |       |                                   |       |   |   |   |   |
| Residential ARM  Loans                  |       | 99,498                                           |       | 5.4                                    |       | 246,720 |   | 6.2 |   |
| Corporate Loans                         |       | 538,883                                          |       | 29.5                                   |       | 324,551 |   | 8.1 |   |
| Total Loans  Principal Balance          |       | 638,381                                          |       | 34.9                                   |       | 571,271 |   | 14.3 |   |
| Grand Total  Principal Balance          |       | $                                                | 1,829,926  |                                   | 100.0      | % | $ | 3,995,550 |   | 100.0 | % |

 

The table above excludespurchases of $10.4 million (purchase cost) of marketable equity securities and$50.9 million (purchase cost) of non-marketable equity securities during thethree months ended March 31, 2006 and $15.9 million (purchase cost) ofmarketable equity securities during the three months ended March 31, 2005.

 

**Stockholders’Equity**

** **

Our stockholders’ equityat each of March 31, 2006 and December 31, 2005 totaled $1.7 billion.Included in our stockholders’ equity as of March 31, 2006 and December 31,2005, is accumulated other comprehensive income totaling****$62.0million and $18.3 million, respectively.

 

Our average stockholders’equity and return on average stockholders’ equity for the quarter ended March31, 2006 were $1.7 billion and 7.4%, compared to $0.8 billion and 3.3%, forthe quarter ended March 31, 2005. Return on average stockholders’ equity isdefined as net income divided by weighted average stockholders’ equity.

 

Our book value percommon share as of March 31, 2006 and December 31, 2005 was $21.20 and$20.59, respectively, and were computed based on 80,374,061 shares issued andoutstanding as March 31, 2006 and December 31, 2005, respectively.

 

On May 3, 2006, our Boardof Directors declared a cash distribution of $0.45 per share for thequarter ended March 31, 2006 to stockholders of record on May 17, 2006.The distribution is payable on May 31, 2006. The aggregate amount of thedistribution,****$36.2 million, exceeded netincome for the quarter by $5.8 million.

 

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**Liquidityand Capital Resources**

** **

We manage our liquiditywith the intention of providing the continuing ability to fund our operationsand fulfill our commitments on a timely and cost-effective basis. We believethat our liquidity level is in excess of that necessary to sufficiently enableus to meet our anticipated liquidity requirements including, but not limitedto, funding our purchases of investments, required cash payments and additionalcollateral under our borrowings and our derivative transactions, requiredperiodic cash payments related to our derivative transactions, payment of feesand expenses related to our Management Agreement, payment of general corporateexpenses and general corporate capital expenditures and distributions to ourstockholders. As of March 31, 2006, we owed our Manager $5.2 million forthe payment of management fees and reimbursable expenses pursuant to theManagement Agreement.

 

An increase inprepayment rates substantially above our expectations could, however, cause atemporary liquidity shortfall due to the timing of the necessary margin callson the financing arrangements and the actual receipt of the cash related toprincipal paydowns. In addition, any material event that impacts capitalmarkets participants may also impair our ability to access additionalliquidity. If our cash resources are at any time insufficient to satisfy ourliquidity requirements, we may have to sell assets or issue debt or additionalequity securities.

 

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

 

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

 

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

 

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

 

**Sourcesof 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 monthsended March 31, 2006, our sources of borrowed funding consisted primarily ofborrowings under repurchase agreements and securitization transactionsstructured as secured financings. Our securitization transactions are accountedfor as secured borrowings under SFAS No. 140. The securitization transactionswe have utilized for secured financings have consisted of CLOs and asset-backedsecured liquidity notes.

 

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*SecuritizationTransactions*

* *

On March 30, 2006, weclosed our second $5.0 billion asset-backed secured liquidity note facility.This facility provides us with an alternative source of funding our residentialmortgage-backed securities by issuing asset-backed secured liquidity notes thatare rated A-1+, P-1, and F1+, by Standard & Poor’s, Moody’s and Fitch Inc,respectively. Issuances of asset-backed secured liquidity notes are recorded asborrowings on our Consolidated Balance Sheet. At March 31, 2006, no borrowingswere outstanding under this facility.

 

In preparation forfuture securitization transactions, during the year ended December 31,2005 we formed KKR Financial CDO 2005-1, Ltd. (“CDO 2005-1”), KKRFinancial CLO 2006-1, Ltd. (“CLO 2006-1”), and KKR Financial CLO 2006-2,Ltd. (“CLO 2006-2”). These entities will be used to provide secured financingprincipally for the purchase of corporate and commercial real estate loans andsecurities. CLO 2006-1 has executed a $500.0 million warehouse facility,in the form of a repurchase agreement. At March 31, 2006, there was $290.3million outstanding under the repurchase facility that bears interest at a rateof 30-day LIBOR plus 0.65%. Additionally, CLO 2006-1 had $110.9 millionoutstanding under a separate repurchase agreement from the repurchase facilityas of March 31, 2006. CDO 2005-1 has executed a $300.0 million warehousefacility, in the form of a repurchase agreement. At March 31, 2006 therewas $189.0 million outstanding under this facility that bears interest ata rate of 30-day LIBOR plus 1.10%. CLO 2006-2 has executed a $450.0 millionwarehouse facility, in the form of a repurchase agreement. At March 31,2006 there were no borrowings outstanding under this facility. Any borrowingswould bear interest at a rate of 30-day LIBOR plus 0.65%.

 

*RepurchaseAgreements*

* *

As of March 31, 2006, wehad $8.8 billion outstanding on repurchase facilities with tencounterparties with a weighted average effective rate of 4.91% and a weightedaverage remaining term to maturity of 25****days. Becausewe borrow under repurchase agreements based on the estimated fair value of itspledged investments, and because changes in interest rates can negativelyimpact the valuation of our pledged investments, our ongoing ability to borrowunder our repurchase facilities may be limited and our lenders may initiatemargin calls in the event interest rates change or the value of our pledgedsecurities decline as a result of adverse changes in interest rates or creditspreads.

 

*SecuredCredit Facility*

* *

During June 2005,we entered into a $275 million secured credit facility that matures onJune 30, 2006, with affiliates of J.P. Morgan Securities Inc. andCitigroup Global Markets Inc. as agents, joint bookrunners, arrangers andlenders under that facility. Participants in the secured credit facilityinclude J.P. Morgan Chase Bank, N.A., Citicorp North America, Inc., andBank of America, N.A. Among other things, the facility limits the amount ofdistributions we may make to 100% of our taxable income computed without givingeffect to net operating loss carryforwards and nonrecurring items (including,but not limited to, stock- based compensation expense and bad debt write-offs),prohibits distributions in the event of certain defaults under the creditfacility and specifies negative covenants as to our leverage and net worth.Outstanding borrowings under our credit facility bear interest at either(i) an alternate base rate per annum equal to the greater of (a) theprime rate in effect on such day, and (b) the federal funds effective ratein effect on such day plus 1⁄2 of 1% or (ii) an interest rate per annumequal to the rate of 30-day LIBOR for such interest period multiplied by aStatutory Reserve Rate (as defined in such credit facility), plus 1%. As ofMarch 31, 2006, we had $57.6 million of borrowings outstanding under thisfacility.

 

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*Junior Subordinated Notes*

 

During March 2006, weformed KKR Financial Capital Trust I (the “Trust”) for the sole purpose ofissuing trust preferred securities. On March 28, 2006, the Trust issued preferredsecurities to unaffiliated investors for gross proceeds of $50.0 million andcommon securities to us for $1.6 million. The combined proceeds were investedby the Trust in $51.6 million of junior subordinated notes issued by us. Thejunior subordinated notes are the sole assets of the Trust and mature on April30, 2036, but are callable on or after April 30, 2011. Interest is payablequarterly at a fixed rate of 7.635% (ten-year LIBOR plus 2.45%) through March2016 and thereafter at a floating rate equal to three-month LIBOR plus 2.65%.

 

*CapitalUtilization and Leverage*

* *

As of March 31, 2006 andDecember 31, 2005, we had stockholders’ equity totaling $1.7 billion, andour leverage was****7.9 times and 8.1 times,respectively.

 

As of March 31, 2006, webelieve that we have sufficient capital to increase borrowings significantlybefore becoming capital or leverage constrained.

 

*Off-BalanceSheet Commitments*

* *

As of March 31, 2006, wehad committed to purchase corporate loans with aggregate commitments totaling $215.6 million.In a typical corporate loan or commercial real estate loan syndication, thereis a delay between the time we are informed of our allocable portion of suchloan and the actual funding of such loan.

 

As of March 31,2006, we had purchased or participated in corporate loan delayed drawtransactions with aggregate commitments totaling $163.5 million. In a delayeddraw transaction, we have made available to the borrower a stated amount to bedrawn as needed within a specified future period of time.

 

**REITMatters**

** **

As of March 31,2006, we believe that we qualified as a REIT under the provisions of the Code.The Code requires that at the end of each calendar quarter at least 75% of ourtotal assets must be “real estate assets” as defined in the Code. The Code alsorequires that each year at least 75% of our gross income come from real estatesources and 95% of our gross income come from real estate sources and certainother passive sources itemized in the Code, such as dividends and interest. Asof March 31, 2006, we believe that we were in compliance with suchrequirements. As of March 31, 2006, we also believe that we met all of theREIT requirements regarding the ownership of our common stock and thedistributions of our taxable income.

 

To maintain our statusas a REIT for federal income tax purposes, we are required to declare and paydividends amounting to at least 90% of our taxable income for each year. Inaddition, for each taxable year, to avoid certain federal excise taxes, we arerequired to declare and pay dividends amounting to certain designatedpercentages of our taxable income by the end of such taxable year. Because weexpect to make distributions based on taxable income, we expect that ourdistributions may at times be more or less than our reported earnings computedin accordance with GAAP.

 

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Total taxable income andREIT taxable income are non-GAAP financial measurements, and do not purport tobe an alternative to reported net income determined in accordance with GAAP asa measure of operating performance or to cash flows from operating activitiesdetermined in accordance with GAAP as a measure of liquidity. Total taxableincome is the aggregate amount of taxable income generated by us and by ourdomestic and foreign taxable REIT subsidiaries. REIT taxable income excludesthe undistributed taxable income of our domestic taxable REIT subsidiary, whichis not included in REIT taxable income until distributed to us. There is norequirement that our domestic taxable REIT subsidiary distribute its earningsto us. REIT taxable income, however, includes the taxable income of our foreigntaxable REIT subsidiaries because we will generally be required to recognizeand report their taxable income on a current basis. These non-GAAP financialmeasurements are important because we are structured as a REIT and the Coderequires that we pay substantially all of our taxable income in the form ofdistributions to our stockholders. The non-GAAP financial measurements of totaltaxable income and REIT taxable income are critical in the determination of theamount of the minimum distributions that we must pay to our stockholders so asto comply with the rules set forth in the Code. Because not all companiesuse identical calculations, this presentation of total taxable income and REITtaxable income may not be comparable to other similarly titled measuresprepared and reported by other companies. The table below reconciles thedifferences between reported net income and total taxable income and REITtaxable income for the quarters ended March 31, 2006 and 2005:

 

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

 
| ** **                                                                   | ** ** | **Estimated for the  three months ended  March 31, 2006** | ** ** | **Three months ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **Amount**                                                                    | ** ** | **Per  Share**                                        | ** ** | **Amount** | ** ** | **Per  Share** | ** ** |
| **Reported  net income**                                                     |       | $                                                                             | 30,388     |                                                  | $          | 0.38 |   | $ | 6,116 |   | $ | 0.15 |   |
| Interest income  and expense                                                 |       | 2,093                                                                         |       | 0.03                                                  |       | 110 |   | — |   |
| Share-based  compensation                                                    |       | 6,783                                                                         |       | 0.09                                                  |       | 4,746 |   | 0.12 |   |
| Foreign currency  translation (gains) and losses                             |       | (374                                                                          | )          | —                                                |       | 192 |   | 0.01 |   |
| Gains on sales  of assets to affiliates                                      |       | 888                                                                           |       | 0.01                                                  |       | 4,253 |   | 0.11 |   |
| Realized and  unrealized derivative gains and losses                         |       | 1,416                                                                         |       | 0.02                                                  |       | (488 | )  | (0.01 | ) |
| Book/tax year  end difference adjustment for CLOs/CDOs                       |       | 8,168                                                                         |       | 0.10                                                  |       | — |   | — |   |
| Other                                                                        |       | 204                                                                           |       | —                                                |       | 52 |   | — |   |
| Income tax  expense                                                          |       | 312                                                                           |       | —                                                |       | 112 |   | — |   |
| **Total  taxable income**                                                    |       | 49,878                                                                        |       | 0.63                                                  |       | 15,093 |   | 0.38 |   |
| Undistributed  taxable (income) and loss of domestic taxable REIT subsidiary |       | (2,184                                                                        | )          | (0.03                                                 | )          | 221 |   | — |   |
| **REIT  taxable income**                                                     |       | $                                                                             | 47,694     |                                                  | $          | 0.60 |   | $ | 15,314 |   | $ | 0.38 |   |
| **Number  of common shares outstanding:**                                    | ** ** | ** **                                                                    | ** ** | ** **                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average  diluted common shares outstanding during the period        |       | 79,314                                                                        |       |                                                  |       | 40,301 |   |   |   |

 

Our Board of Directorshas adopted a policy to distribute to our stockholders amounts required tomaintain our status as a REIT and to avoid federal excise taxes, in each caseas discussed above. This distribution policy takes into account a number offactors, including, but not limited to, our actual results of operations, ourfinancial condition and our total taxable income and REIT taxable income. Theactual amount and timing of distributions, if any, will be at the discretion ofour Board of Directors and may not be in even amounts throughout our fiscalyear. Pursuant to this policy, on May 3, 2006, our Board of Directorsauthorized a cash distribution of $0.45 per common share to our stockholders ofrecord on May 17, 2006. This distribution payable on May 31, 2006. Theaggregate amount of the distribution is $36.2 million. Neither the paymentof this distribution nor the existence of

 

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

 

**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 from regulationunder the Investment Company Act, but also that each of our subsidiaries soqualifies.

 

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 otherwise acquiring mortgages and other liens on andinterests in real estate.” A series of no-action letters issued by the Divisionof Investment Management (the “Division”) of the SEC, however, reflects the viewthat at least 55% of a company’s assets must consist of mortgage loans andother assets that are considered the functional equivalent of mortgage loansfor purposes of the Investment Company Act (collectively, “qualifying realestate assets”), and an additional 25% of a company’s assets must consist ofreal estate-related assets, leaving no more than 20% of the company’s assets inmiscellaneous assets. These no-action letters also indicate what types ofassets can be considered qualifying real estate assets. No-action lettersissued by the Division are not binding except as they relate to the companiesto whom they are addressed, so investors should be aware that the Division maychange its position regarding what assets might constitute qualifying real estateassets at any time. If the Division were to

 

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change its position, wemight be required to change our investment strategy to comply with any newguidance provided by the Division. We cannot predict whether such a changewould be adverse to us.

 

Based on the no-actionletters issued by the Division, we classify our investment in residentialmortgage loans as qualifying real estate assets, as long as the loans are “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 and interestby 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’s investmentin non-agency mortgage- backed securities is the “functional equivalent” ofowning the underlying mortgage loans. We own mortgage-backed securities that weclassify as qualifying real estate assets because we believe that we own thefunctional equivalent of the underlying mortgage loans.

 

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

 

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

 

We will use this sameanalysis to determine whether to classify investments we make in the future asqualifying real estate assets. If we acquire securities that, collectively, areexpected to receive all of the principal and interest paid on the related poolof underlying mortgage loans (less fees, such as servicing and trustee fees,and expenses of the securitization), and we have foreclosure rights withrespect to those mortgage loans, then we will consider those securities,collectively, to be qualifying real estate assets. If another entity acquiresany of the

 

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securities that areexpected to receive cash flow from the underlying mortgage loans, then we willconsider whether we have the unilateral right to foreclose on the underlyingloans and whether our investment is a first loss position to decide whether itshould be classified as a qualifying real estate asset. If we own more than onesubordinate class, then, to determine the classification of the subordinateclasses that we own other than the first loss class, we would consider whethersuch classes are contiguous with the first loss class (with no other classesabsorbing losses after the first loss class and before any other subordinateclasses that we own), whether we own the entire amount of each such class andwhether we would continue to have the unilateral right to foreclose inconnection with each such class if the more subordinate classes were no longeroutstanding. If the answers to any of these questions is no, then we would notclassify that particular class, or classes senior to that class, as aqualifying real estate asset.

 

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

 

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

 

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

 

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

 

**Quantitativeand Qualitative Disclosures About Market Risk**

** **

**MarketRisks**

 

*CurrencyRisks*

* *

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

 

*InflationRisks*

* *

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

 

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*InterestRate Risk*

* *

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

 

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

 

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

 

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

 

The periodic and lifetimeinterest rate caps contained in our residential ARM loans and securities maylimit the repricing of our residential ARM loans and securities and, as aresult, we are exposed to the risk that repricing of our investments is limitedby the respective caps and our variable rate borrowings do not have any similarsuch caps. As a result our income on the investments that are subject to theperiodic and lifetime cap would remain constant while our cost of financingusing variable rate debt would increase. The periodic and lifetime interestrate caps may negatively impact future net interest margins and the fair valuesof our residential ARM loan and security investments.

 

The following tablesummarizes the estimated net fair value of our derivative instruments held at March31, 2006 and December 31, 2005 (amounts in thousands):

 

**DerivativeFair Value**

 
| ** **                      | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------|------------|--------------------------------|------------|---------------------------------------------|------------|
| **Cash  Flow Hedges:**          | ** ** | ** **                     | ** ** | ** **                                  | ** ** |
| Interest rate  corridors        |       | $                              | 19,766     |                                        | $          | 14,762 |   |
| Interest rate  swaps            |       | 82,893                         |       | 40,796                                      |       |
| **Free-Standing  Derivatives:** | ** ** | ** **                     | ** ** | ** **                                  | ** ** |
| Interest rate  swaptions        |       | 200                            |       | 879                                         |       |
| Interest rate  swaps            |       | —                         |       | 198                                         |       |
| Credit default  swaps           |       | 347                            |       | 71                                          |       |
| Total rate of  return swaps     |       | (322                           | )          | 727                                         |       |
| Net fair value                  |       | $                              | 102,884    |                                        | $          | 57,433 |   |

 

*RiskManagement*

* *

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

 

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

 

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

 

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

 

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

 

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

** **

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

 

**Item 4.**                          Controls andProcedures

** **

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

 

As previously disclosedin our registration statement on Form S-11 (Registration No. 333-124103),in connection with its audit of our consolidated financial statements for theperiod ended December 31, 2004, our independent registered publicaccounting firm, on March 8, 2005 identified to us three matters involvingour internal controls over financial reporting that it considered to bereportable conditions under standards established by the American Institute ofCertified Public Accountants, which reportable conditions in its judgmentconstituted material weaknesses. Under these standards, in each of these areasthe design or operation of our internal controls did not reduce to a relativelylow level the risk that misstatements caused by error or fraud in amounts thatwould be material may occur and not be detected within a timely period.

 

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

 

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more robust proceduresfor the ongoing selection and application of accounting policies for many ofour transactions.

 

We are activelyremediating the identified reportable conditions. Specifically, subsequent toMarch 8, 2005 our Chief Operating Officer became our Chief FinancialOfficer and we hired individuals to fill the positions of Controller; AssistantController; Treasurer; Chief Accounting Officer; 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 withSection 404 of the Sarbanes-Oxley Act of 2002. Due to the recentlyannounced one-year delay in the required compliance schedule fornon-accelerated filers, we will be required to issue a management report on ourassessment of internal controls over financial reporting in our Annual Reporton Form 10-K for the year ended December 31, 2006.

 

There were no otherchanges in our internal control over financial reporting identified inconnection with the foregoing evaluation that occurred during the three monthsended March 31, 2006 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PART II.OTHER INFORMATION**

 

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

** **

None.

 

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

** **

None.

 

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

** **

None.

 

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

** **

None.

 

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

** **

None.

 

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

 
| 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                       |

 

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

**             Filedherewith.

 

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**SIGNATURES**

** **

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

 
|                        |       | KKR  Financial Corp.                                   |
|------------------------|------------|--------------------------------------------------------|
|                   |       |                                                   |
|                   |       |                                                   |
| **Signature**          | ** ** | **Title**                                              |
| ** **             | ** ** |                                                   |
| /s/ SATURNINO S. FANLO |       | Chief  Executive Officer (Principal Executive Officer) |
| **Saturnino S. Fanlo** | ** ** | ** **                                             |
| ** **             | ** ** | ** **                                             |
| /s/ DAVID A. NETJES    |       | Chief  Financial Officer and Chief Operating Officer   |
| **David A. Netjes**    |       | (Principal  Financial and Accounting Officer)          |
| ** **             |       |                                                   |
| Date:  May 10, 2006    |       |                                                   |

 

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